Externalities Spillover Costs & Spillover Benefits Chapter 10 (pages 203-208)

Switzerland & Garbage 35 Liter Swiss Trash Bag

EXTERNALITIES An externality is the uncompensated impact of one person or firm’s actions on another person/society Both positive externalities & negative externalities exist All externalities are considered market failures (inefficient) That is, markets with externalities do not maximize total surplus (welfare) Governments can correct externalities with taxes or subsidies

Factory B Factory A

Negative Externalities Automobile exhaust Cigarette smoking Barking dogs Loud stereos in an apartment building Noisy Students Neighbor’s poorly maintained property

Positive Externalities Immunizations Restored historic buildings Research into new technologies Neighbor’s well maintained property Volunteering

Spillover Costs & Spillover Benefits Spillover Costs- external costs not included in supply curve (MC) External costs exist with ALL negative externalities MC is understated => which leads to overproduction Spillover Benefits-external benefits not included in demand curve (MB) External benefits exist with ALL positive externalities MB is understated => which leads to underproduction MC MB

Graphing Externalities When graphing negative externalities use MC & MB curves Then add any spillover cost or benefit to existing curve Marginal Social Cost (MSC) = MC + spillover cost (external cost) Marginal Social Benefit (MSB) = MB + spillover benefit (external benefit) MB MC Negative Externality MSC MB MC MSB Positive Externality

Internalizing Externalities Internalizing an externality involves altering incentives to improve market outcomes (i.e. to increase total welfare) Government Solutions Taxes or Subsidies Laws (immunization laws, pollution laws) Patents Free market Solution: Trading pollution credits => i.e. cap & trade

Internalizing Negative Externalities Aluminum Cans Assume this Factory Pollutes MSC Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output MC --------------- -------------------- Q2 P2 E2 MB Total Cost = Total Benefit Total Cost = MSC (MCP + MCS) Total Welfare is Maximized!

WORKSHEET Electric Cars Large SUV Production

Subsidizing Positive Externalities Assume these cars have external benefits Electric Cars Impose Subsidy = spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit

Bottled Water What is the real cost? Start 20 minutes in…

Documentary Demand Section 12 min. Recycle Section

Only 11 states have recycle deposits laws Only 20% of U.S. water bottles are recycled

Internalizing Negative Externalities Impose Tax = spillover cost This puts a price on “external costs” Reach socialy optimal output @ Q2 MSC = MCp + MCs (internal & external) Bottled Water MSC MC --------------- -------------------- Q2 P2 E2 MB