© 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY An externality is … –the uncompensated impact of one person’s actions on the well-being of a bystander. Externalities –cause markets to be inefficient –fail to maximize total surplus

© 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY Negative externality –adverse impact on the bystander Positive externality –beneficial impact on the bystander

© 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY Negative Externalities –Automobile exhaust –Barking dogs (loud pets) –Industrial pollution

© 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY Positive Externalities –Immunizations –Restored historic buildings –Research into new technologies

© 2007 Thomson South-Western Costs and Benefits of Pollution Marginal Social Cost (MSC) is … –Additional cost imposed on society when one more unit is produced. MSC is our S curve.

© 2007 Thomson South-Western Costs and Benefits of Pollution Marginal Social Benefit (MSB) is … –Additional benefits received by society when one more unit is produced. MSB is our D curve.

© 2007 Thomson South-Western MSC and MCB of Pollution Quantity of Pollution emitted (tons) 0 MSC and MSB of Pollution MSB MSC Q OPT MSC = MSB

© 2007 Thomson South-Western Costs and Benefits of Pollution Will society, left unregulated, come to the optimal amount of pollution? NO

© 2007 Thomson South-Western The External Cost of Pollution A power plant is located in the Ohio River Valley. Who benefits? Who pays the costs? BenefitsCosts ProducersEnvironment ConsumersNon- consumers

© 2007 Thomson South-Western The External Cost of Pollution External Costs are those ‘we’ pay when we are NOT benefitting from an externality. (Negative externality)

© 2007 Thomson South-Western MSC, MSB in an Unregulated Market Quantity of Pollution emitted (tons) 0 MSC and MSB of Pollution MSB MSC Q OPT MSC = MSB $1000 Q MKT

© 2007 Thomson South-Western PRIVATE SOLUTIONS TO EXTERNALITIES Government action is not always needed to solve the problem of externalities. Types of Private Solutions –Moral codes and social sanctions –Charitable organizations –Integrating different types of businesses –Contracting between parties

© 2007 Thomson South-Western The Coase Theorem Coase theorem states a private solution may be found as long as … property rights are clearly defined Transactions costs are minimal Transaction costs are incurred when parties agreeing to and following through on a bargain

© 2007 Thomson South-Western Why Private Solutions Do Not Always Work Transaction costs are too high Communication costs Legal costs Delays in bargaining

© 2007 Thomson South-Western PUBLIC POLICIES TOWARD EXTERNALITIES When externalities are significant and private solutions are not found, government may attempt to solve the problem through... –command-and-control policies –market-based policies Corrective taxes Permits

© 2007 Thomson South-Western Command-and-Control Policies: Regulation Regulations: Forbid certain behaviors. Require certain behaviors. Examples: Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

© 2007 Thomson South-Western Market-Based Policy : Corrective Taxes Corrective taxes (Pigovian taxes) are taxes enacted to correct the effects of a negative externality.

© 2007 Thomson South-Western Tax on Pollution Quantity of Pollution emitted (tons) 0 MSC and MSB of Pollution MSB MSC Q OPT $500 Q MKT tax

© 2007 Thomson South-Western Tax on Pollution Tax ABOVE MSB curve Cheaper for firms to ‘fix’ the problem Pollution will be reduced to the socially optimal amount Financial incentive to ‘fix’ the problem

© 2007 Thomson South-Western Market-Based Policy : Tradable Pollution Permits Tradable pollution permits voluntary transfer of the right to pollute from one firm to another A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. Sam amount of pollution is reduced.

© 2007 Thomson South-Western Positive Externalities Positive Externality happens when … The production and consumption of a good also benefits 3 rd parties. Immunization Home improvement

© 2007 Thomson South-Western Private v. Social Benefits Total Social Benefit = Total Private Benefit + Total External Benefit mine + yours

© 2007 Thomson South-Western Private v. Social Benefits Marginal Social Benefit = Marginal Private Benefit (MPB) + Marginal External Benefit (MEB)

© 2007 Thomson South-Western Private v. Social Benefits Quantity of Home Improvements 0 Price, MSB MSB MSC Q OPT P OPT Q MKT P MSB P MKT Q MKT MPB MEB = MSB - MPB

© 2007 Thomson South-Western Private v. Social Benefits Market Outcome: Equilibrium = MPB intersects Q MKT MPB is ONLY for those who consume the G/S MPB + MEB = MSB Society is willing to pay at this level Market under produces which generate positive externalities. Q MKT is higher at P MSB Socially Optimal Outcome = MSB = MSC

© 2007 Thomson South-Western Private v. Social Benefits Dead Weight Loss: How could we eliminate Dead Weight Loss? Subsidy (Pigouvian subsidy) Voucher for home improvement goods Increases consumer willingness to pay

© 2007 Thomson South-Western Subsidy Effect Quantity of Home Improvements 0 Price, MSB MSB S Q OPT P MKT Q MKT P OPT P CON Q MKT MPB Subsidy

© 2007 Thomson South-Western Private v. Social Costs Total Social Cost = Total Private Cost + Total External Cost mine + yours

© 2007 Thomson South-Western Private v. Social Benefits Marginal Social Cost = Marginal Private Cost (MPC) + Marginal External Cost (MEC)

© 2007 Thomson South-Western Private v. Social Costs Quantity of Electricity 0 Price, MSC MSB MSC P OPT Q MKT P MKT P FIRM Q MKT D MPC

© 2007 Thomson South-Western Private v. Social Benefits Market Outcome: Equilibrium = MPC intersects Q MKT MPC is ONLY for those who incur the costs MPC+ MEC = MSC Society is willing to pay at this level Market over produces what generates negative externalities. Socially Optimal Outcome = MSB = MSC

© 2007 Thomson South-Western Private v. Social Benefits Dead Weight Loss: How could we eliminate Dead Weight Loss? Tax (Pigouvian subsidy) Increases each firm’s MPC

© 2007 Thomson South-Western Effect of a Tax Quantity of Electricity 0 Price, MSC MSB MSC P OPT Q MKT P MKT P FIRM Q MKT D MPC Tax