Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities Chapter 10 © 2002 by Nelson, a division of Thomson Canada Limited

Principles of Microeconomics : Ch.10 Second Canadian Edition Overview  Externalities and Market Inefficiency  Private Solutions to Externalities  Public Policies toward Externalities

Principles of Microeconomics : Ch.10 Second Canadian Edition Market Efficiency: Chapter 7  Under the assumptions of perfect competition and no externalities, the economic well-being of a society is measured as: The sum of consumer and producer surplus!  The invisible hand is powerful but not omnipotent, which leads to market failure.

Principles of Microeconomics : Ch.10 Second Canadian Edition Market Failure  If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities. – Externalities cause markets to be inefficient, and thus fail.

Principles of Microeconomics : Ch.10 Second Canadian Edition Externality — Defined  The uncompensated effects that the production or consumption of goods have on third parties.  The impact of one person’s actions on the well-being of a bystander!

Principles of Microeconomics : Ch.10 Second Canadian Edition Externality — Effect on Society  In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market...  … the well-being of third parties are considered.

Principles of Microeconomics : Ch.10 Second Canadian Edition External Benefits — Positive Externalities  The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods.  The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.

Principles of Microeconomics : Ch.10 Second Canadian Edition External Costs — Negative Externalities  The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods.  The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externality  Automobile exhaust  Cigarette smoking Positive Externality  Immunizations  Restored historic buildings Identify Some Negative and Positive Externalities

Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities and Market Inefficiency - Negative Externalities  Negative externalities in production or consumption sometimes lead markets to produce a larger quantity than is socially desirable.  The Social Costs of production or consumption are greater than the private cost or private benefit by producers and consumers. This leads to market failure.

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example  Assume that the production process emits pollution — negative externality.  The cost to society of production is larger than the cost to the producer.  The Social Cost includes the private costs plus the costs to those bystanders adversely affected by the pollution. Reflects in a new Supply Curve...

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example Supply Private Cost Demand Private Value Q Market Market output before accounting for externality. Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example Demand Private Value Q Market Supply Social Cost Supply Private Cost Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example Demand Private Value Q Market Supply Social Cost Cost of Pollution - Decreases Supply Private Cost Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example The optimum output accounts for the externality. Q Optimum Supply Social Cost Q Market Supply Private Cost Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example The optimum output accounts for the externality. Supply Social Cost Market Over- Produces Product Q Optimum Q Market Supply Private Cost Price Shaded area is dead weight loss from over- production

Principles of Microeconomics : Ch.10 Second Canadian Edition Negative Externalities and Market Inefficiency - Graphical Example  The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity.  Attainment of the Optimal Output The government can internalize the externality by imposing a tax on the producer. The tax shifts private cost supply up to social cost supply and eliminates the deadweight loss.

Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities and Market Inefficiency - Positive Externalities  Positive externalities in production or consumption sometimes lead markets to produce a smaller quantity than is socially desirable.  The Social Costs of production or consumption are less than the private cost or private benefit to producers and consumers. This leads to market failure.

Principles of Microeconomics : Ch.10 Second Canadian Edition Positive Externalities and Market Inefficiency - Graphical Example Supply Private Cost Q Market Demand Private Value Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Supply Private Cost Demand Private Value Q Market Market output before accounting for externality. Positive Externalities and Market Inefficiency - Graphical Example Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Supply Private Cost Positive Externalities and Market Inefficiency - Graphical Example Value of Technology Spillover Q Optimum Demand Private Value Q Market Price

Principles of Microeconomics : Ch.10 Second Canadian Edition Supply Private Cost Positive Externalities and Market Inefficiency - Graphical Example Demand Private Value Market Under- Produces Product Q Market Q Optimum Price Shaded area is dead weight loss from under- production

Principles of Microeconomics : Ch.10 Second Canadian Edition Positive Externalities and Market Inefficiency - Graphical Example  The intersection of the demand curve and the social-cost curve determines the optimal output level — more than equilibrium quantity.  Attainment of the Optimal Output The government can internalize the externality by subsidizing the production — paying the producer to produce more than the equilibrium and eliminating the dead weight loss.

Principles of Microeconomics : Ch.10 Second Canadian Edition Government Policy Toward Externality  In situations where market failure occurs because of externalities, the government will attempt to internalize the externality by:  imposing a tax on goods with a negative externality. – implementing a subsidy on goods with a positive externality.

Principles of Microeconomics : Ch.10 Second Canadian Edition Quick Quiz  Give an example of a negative externality and a positive externality.  Explain why market outcomes are inefficient in the presence of externalities.

Principles of Microeconomics : Ch.10 Second Canadian Edition Overview Externalities and Market Inefficiency  Private Solutions to Externalities  Public Policies toward Externalities

Principles of Microeconomics : Ch.10 Second Canadian Edition Private Solutions to Externalities  Government action is not always needed to solve a problem of externalities.  Alternative private solutions: – Moral codes and social sanctions. – Charitable organizations focused on dealing with an externality.  Examples of private solutions...

Principles of Microeconomics : Ch.10 Second Canadian Edition Private Solutions to Externalities  Coase Theorem: – If private parties can bargain to their mutual advantage without cost, then the private market will always solve the problem of externalities and allocate resources efficiently. – Private bargaining can internalize the external effects, resulting in efficient solutions.

Principles of Microeconomics : Ch.10 Second Canadian Edition Failure of Private Solutions Approach  Sometimes the private solutions approach will fail because: – The transaction costs can be so high that private agreement is not possible.  Transaction costs are the costs that parties must incur to agree and follow through on a bargain.

Principles of Microeconomics : Ch.10 Second Canadian Edition Quick Quiz  Give an example of a private solution to an externality.  What is the Coase theorem?  Why does the private solutions approach often fail?

Principles of Microeconomics : Ch.10 Second Canadian Edition Overview Externalities and Market Inefficiency Private Solutions to Externalities  Public Policies toward Externalities

Principles of Microeconomics : Ch.10 Second Canadian Edition Public Policy Toward Externalities  When externalities are significant and when private solutions are not possible or incomplete, government may attempt to solve the problem by:  Command-and-Control policies – Market-Based policies

Principles of Microeconomics : Ch.10 Second Canadian Edition Command-and-Control Policies  Usually in the form of regulations: – making certain behaviour forbidden – making certain behaviour required  Examples: – All students must be immunized – Stipulating levels of pollution emissions

Principles of Microeconomics : Ch.10 Second Canadian Edition  Government use of taxes and subsidies to align private incentives with social efficiency. – Pigovian Taxes: designed to reflect the social costs of a negative externality and internalize the external cost to the offending entity. Market-Based Policies

Principles of Microeconomics : Ch.10 Second Canadian Edition Market-Based Policies  Tradable Pollution Permits: the voluntary transfer of the right to pollute from one firm to another. – Pollution permits which results in a new market for these permits. – Firms that can reduce pollution most easily will be willing to sell their permit, for whatever they can get.

Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities — Conclusion  Uncompensated effects that the production or consumption of goods have on third parties are called externalities. – Negative externalities: results in market equilibrium beyond the social optimum. – Positive externalities: results in market equilibrium short of social optimum.

Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities — Conclusion  Solutions to externalities can be accomplished: – through private agreements – through government intervention

Principles of Microeconomics : Ch.10 Second Canadian Edition Overview Externalities and Market Inefficiency Private Solutions to Externalities Public Policies toward Externalities