Externalities Lecture 10 – academic year 2015/16 Introduction to Economics Dimitri Paolini

What do we do today? The “external” effects of economic activities How do we internalize externalities?

Market efficiency: A brief recap In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus. “The invisible hand” (of the market) maximize the total benefit of society Markets are usually good instruments to organize the economic activity Sometimes, however: “market failures”

Externalities: definition and effects When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality. Whenever they do not take into account the “third party”, the equilibrium prices and quantities are not efficient. Therefore the externalities cause an inefficient allocation of resources, i.e. market failure.

The effects of externalities on society In the presence of externalities: Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market). The externalities can be negative or positive However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged ≠ optimal quantity.

Negative externalities Costs on other individuals (consumers or producers) that are not directly involved in the market exchange. Example: smoke of cigarettes, cars’ exhaust gas

Positive externalities Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange. Example: Vaccines, restoration of a piece of Art, investment in new technologies.

Externalities and market inefficiency Negative externalities in production Q market > Q optimum (socially desirable quantity) social costs > private costs Positive externalities in production Q market < Q optimum social costs < private costs

Negative externalities in consumption Q market > Q optimum (socially desirable quantity) Social benefit < private benefit Positive externalities in consumption Q market < Q optimum Social benefit > private benefit Externalities and market inefficiency

Negative externalities in production Equilibrium 0 Price of aluminium Q MARKET Demand (private value) Supply (private cost) Social cost Cost of pollution Q OPTIMUM Optimum Quantity of aluminium

Positive externalities in production Quantity of Robot of Robot 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private cost) Q MARKET Value of technologica l diffusion Equilibrium Social cost Optimum

Negative externalities in consumption Quantity of alcoholic drinks 0 Price of alcoholic drinks Demand (private value) Supply (private cost) Q MARKET Equilibrium Q OPTIMUM Optimum Social value

Positive externalities in consumption Quantity of education 0 Price of education Demand (private value) Supply (private cost) Q MARKET Equilibrium Q OPTIMUM Optimum Social value

Positive externalities: the diffusion of knowledge A firm that starts a project (e.g., to produce industrial robot) could develop a new technology / generate an innovation in production techniques so as to improve the initial project. Such an improvement could benefit the firm but also the society as a whole, because such knowledge will accumulate and becomes part of the social knowledge stock. Technology diffusion: positive externality

How to internalize externalities? Government Intervention : Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities; Ex. Pigovian Tax, Tradable permits, Private solution : Public intervention is not always either necessary or efficacious to deal with externalities > Coase’s Theorem Coase’s Theorem: if the parties in a transaction can negotiate over the allocation of resources without costs, then the market can solve the externality problem.

2. Market policies To align incentives and social optimum the Public Authority can decide to rely on “market policies”: Regulation: determine a certain level of environmental pollution that is allowed. Pigovian tax: create an incentive to reduce pollution. Tradable permits: voluntary transfer of the rights to pollute from one firm to the other.

Conclusion When the transaction between a buyer and a seller has effects on a third party, there is an externality. Negative (positive) externalities imply that the quantity that is exchanged in equilibrium is higher (lower) than the quantity that is socially desirable. Solutions to externalities can derive both from private parties and government intervention.