1 Externality Here we study the situation where production leads to not only private costs, but also social costs.

2 Up to now in the course we have studied the behavior of buyers and sellers as they interact. We have only been concerned about the folks actually involved in the transactions. But in this section we look at an idea where third parties are affected by market transactions. Analogy: In a class room, say two people, or even a group of people, are holding a side conversation. It might even be a good conversation. The folks involved in the conversation are like the supply and demand actors we have studied so far. But, other people in the room may be affected by the conversation. They are not a party to the conversation but they get distracted by it, for example.

3 Review P S1 D1 Q P1 Q1

4 When you look at the equilibrium point in the market you notice that as we move from left to right on the quantity axis that up to the point of equilibrium the demand curve is higher than the supply curve. This means on all the units traded in the market the amount consumers are willing to pay is higher than the amount sellers need to receive in order to sell those units, except on the last unit, where the amount consumers are willing to pay equals the amount sellers need to receive. This is another way of saying the market outcome is efficient. Efficiency here is that items are made and have value at least as great as the resources that went into making the items.

5 Review and add new ideas In the graph a few screens ago we see the basic model of supply and demand. We did not make a big deal about it before, but we assumed in the past that the only costs of production were incurred by the producers. Thus costs were only private, or internal to the firms, and thus the supply curve only reflected the private costs of production. But, sometimes when production occurs there are additional costs external to the firm incurred by others.

6 External costs As an example of external cost, consider firms that pollute with huge smoke stacks. The firms pay their employees and other production costs, but the smoke makes nearby houses dirty. This dirt imposes a cost on the homeowner in the form of a lower property value, or the homeowner has to clean the house more often and this is a costly endeavor. When external costs are added to private costs we have social costs. When externalities exist the social costs of production are higher than the private costs. This is an example of a negative externality.

7 External Costs P S1 D1 Q P1 Q1 S2 Q2 P2

8 On the previous slide the true costs of production are reflected in S2, whereas S1 only reflects the private costs of production. Firms make decisions based on costs that they incur and thus in the market we would have S1 and firms would sell Q1 units. But, overall the social costs are reflected in S2. So, you can see the units of output from Q2 to Q1 actually have costs, both private and external, that are greater than the value consumers get on the units. This is considered wasteful from an overall societal point of view.

9 Internalize the Externality If the firms that impose the external cost on others can be made to internalize the external costs, then the supply curve would shift up, as on the previous screen. When external costs are internalized in the market, 1) the price in the market rises, 2) the output in the market falls. Another way to think about this is that if external costs exist (and are not internalized) in a market then the market price is too low and output is too high. If firms are made to pay the full costs of production, then they will have the incentive to reduce the problem in the least costly fashion.

10 Deadweight loss From a few screens ago, if in the market output goes beyond Q2 then on those units above Q2 the marginal benefit as reflected in the amount consumers are willing to pay is < MC. From a societal point of view, those additional units cost more than the benefits that people get from them. In this sense those units result in a deadweight loss. (Remember cost is an opportunity forgone.)

11 Solutions to Externalities It is thought that externalities can be internalized by either government intervention or through private means. Pigovian taxes Some guy named Arthur C. Piguo (pronounced pi goo, I believe) said the way to get the firms to produce Q2 is to tax them on the units of output they produce. In theory, if not in practice, tax them the amount that would make the supply curve shift from S1 to S2. Note with the tax that Q2 units will be made and pollution would still occur, but only on those units of output that have relatively high value to consumers. An analogy here is that cars produce pollution and we do not totally ban driving, we just try to reduce the driving that does not have high value relative to cost.

12 Government Regulation Another method that might work is government regulation. The government might restrict the output that can be made in an area of production or it might require the use of certain methods of production firms wouldn’t necessarily adopt on their own. Social Pressure Peer pressure can stop people from doing things, right? (It can also make you do things, maybe if you don’t even want to do it.) As an example think about littering. The cost of you littering is very low. You roll down the window of the car and let it rip, right? But, it costs all of us much more than it costs the litterer, so many people have ill feelings toward the litterers. These ill feelings then may make people cut back on the littering.

13 The Coase Theorem (Can you say “theorem?” Sure you can, let’s all say it together on the count of three. One, Two, Three… Theorem.) This guy named Ronald Coase had some ideas about externalities and he said maybe we do not need intervention by the government. Let’s think about an example. Dick owns a dog and he gets $500 worth of benefits from the dog. But Jane, Dick’s neighbor hates the dog barking and she has a cost of $800 because of the dog (maybe she is tired and her productivity at work falls by $800). Dick having the dog is inefficient because he values having the dog less than the cost the dog imposes on society.

14 If the law says barking dogs are against the law then Dick would have to get rid of his dog (or teach it to stop barking). This would be efficient here because, again, the value of the dog to Dick is less than the cost of the dog to Jane. If the law says Dick can have a barking dog, then Dick may still give up the dog. Here is how. Since Jane loses $800 from the dog being at Dick’s, if she can pay Dick anything less than $800 to get rid of the dog, then she will lose less than $800 that she will surely lose if he keeps the dog. Dick only values the dog at $500 so if he is offered more than that he would be better off. So if Jane pays Dick between $500 and $800 to get rid of the dog then the efficient solution would be achieved. So here, no matter what the law says (whether Dick can have a barking dog or not), Dick will not have the dog and this is the efficient outcome.

15 On the previous screen I mentioned two scenarios the law might take – people can have barking dogs or people can not have barking dogs. Whatever the law is we say there is a distribution of rights. Dick’s dog creates a negative externality for Jane. Coase said that maybe private economic actors can solve the externality problem on their own by bargaining and the efficient solution will occur. Coase and others have recognized the theorem is useful, but not always. If the costs of bargaining and enforcing the outcome of the bargain are relatively high, then maybe these transaction costs will make an agreeable bargain unlikely. One item that makes bargaining costs high is if the number of people is high. Coordinating large groups can be costly.

16 So, what have we done here? We noticed sometimes market outcomes impose costs on third parties – negative externalities. The externality, if left unchecked, means the market output is too high and the price too low. Taxes or regulation may solve the problem, but so might private bargaining. Let’s look at another example.

17 Say Abercrombie dumps toxins into a river and the toxins only hurt Fitch. Abercrombie could buy a filter to stop the toxins from getting to the river, but that costs him something and Fitch would gain. Say we have the following table when we consider the use of a filter and the no filter situation. (Note this is not game theory) with filterwithout filter Gains to Abercrombie Gains to Fitch Note the total gains are To say a situation is inefficient means that it can be rearranged in a way that would make at least some people better off without harming others.

18 I will come back to the inefficiency thing. Let’s look at the example some more. Let’s say we get a law that says Abercrombie can not dump the toxins unless he gets the okay from Fitch. When would Fitch say okay? If Fitch says okay his gain is 70, but it would be 100 if he said no way, you toxin spewing, no filter using producer. It doesn’t seem like Fitch would say okay. But, if Abercrombie pays Fitch, say $40, to go without a filter, then Fitch gets = 110. This is better than under either situation we saw for Fitch. Abercrombie would then have 150 – 40 = 110 and at least this is better than having to have the filter. So, having the filter is inefficient here because both can be better off by not having the filter.

19 Say the law says Abercrombie can dump all he wants. Will he use a filter? No! Abercrombie would gain 150 and Fitch would gain 70. So, under either assignment of law we do not get a filter used here. This means that as far as using a filter goes, the law does not matter. Note that Abercrombie likes the no filter law better and Fitch likes the get my permission law better because of the payments each gets under the different laws. Thus, the law does matter in terms of how much money ends up in the pocket of each person.

20 Positive externality Sometimes in a market the folks who buy the good or service are not the only ones who benefit from the good. Third parties may benefit. Two examples: 1) A company that cooks stuff for people will benefit the buyers of the food but will also benefit folks who do not buy the food but merely smell the food being made. 2) A person who buys a vaccination and uses it will not be able to make others sick. Thus more people than just the buyer benefit.

21 Positive Externality P S1 D1 Q P1 Q1 D2 P2 Q2

22 Positive Externality On the previous slide we see a market. If the externality is not internalized (meaning third party folks not being made to internalize the benefit) then we will have D1 and S1 with P1 and Q1. But, units of output from Q1 to Q2 have benefits at least as great as the cost and thus if produced would provide positive net benefits to society. As long as the externality is not internalized, then in this market output is too low and the price is too high.