1. Copyright © 2004 South-Western I need a volunteer… You must be super awesome at texting. http://www.nytimes.com/interactive/2009/07/19/technology/20090719-driving-game.html?_r=0

2. Copyright©2004 South-Western 10 Externalities

3. Copyright © 2004 South-Western The Main Idea… Recall: Adam Smith’s “invisible hand” Markets allocate scarce resources with forces of S & D; equilibrium typically maximizes market welfare But market failures can still happen. Outcome of free market differs from socially optimal outcome Gov’t policies can sometimes improve things Video Clip: “Episode 31: Market Failures”

4. Copyright © 2004 South-Western EXTERNALITIES Externality = the uncompensated impact of one person’s actions on the well-being of a bystander For example, I played a terrible song at the start of class. You were innocent bystanders – you weren’t involved in me buying the song off of iTunes, but you still suffered the noise pollution.

5. Copyright © 2004 South-Western EXTERNALITIES When the impact on the bystander is adverse, the externality is called a negative externality Exhaust from cars Your neighbor’s barking dog Rebecca Black’s, “Friday” When the impact on the bystander is beneficial, the externality is called a positive externality Me getting a flu shot Education

6. Copyright © 2004 South-Western EXTERNALITIES CAUSE MARKET INEFFICIENCY In either case, decision maker fails to take into account the external effect of his or her behavior. This causes markets to be inefficient, and thus fail to maximize total surplus.

7. Copyright © 2004 South-Western Negative Externalities Externality imposes costs on bystanders Intersection of the demand curve and the social- cost curve determines optimal output level. Market quantity > Socially optimal level The market produces a larger quantity than is socially desirable (overproduction) Social Cost > Private Cost Add graph to your notes

8. Copyright © 2004 South-Western Figure 2 Pollution and the Social Optimum Copyright © 2004 South-Western Equilibrium Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q OPTIMUM Optimum Cost of pollution Q MARKET

9. Copyright © 2004 South-Western Life on Dismal Lake  I need five brave volunteers…

10. Copyright © 2004 South-Western Quick Quiz 1: Are You Picking Up What Was Put Down? The government taxes goods like alcohol, tobacco, and gasoline – you may be familiar with the term sin tax. Why do you think many economists support these types of taxes? Provide a brief written explanation along with a graph to support your reasoning. For your graph, pick one market to represent – alcohol, tobacco, or gas.

11. Copyright © 2004 South-Western Positive Externality Example: Education Externality benefits the bystanders Intersection of the supply curve and the social- value curve determines the optimal output level. Optimal Output Level > Equilibrium Quantity The market produces a smaller quantity than is socially desirable (underproduction) Social Value > Private Value Add graph to your notes Video Clip: “Episode 32: Externalities”

12. Copyright © 2004 South-Western Figure 3 Education and the Social Optimum Copyright © 2004 South-Western Quantity of Education 0 Price of Education Demand (private value) Social value Supply (private cost) Q MARKET Q OPTIMUM

13. Copyright © 2004 South-Western Quick Quiz 2: Are You Picking Up What Was Put Down? Give an example of positive externality. Explain why market outcomes are inefficient in the presence of this externality. Provide a graphical representation and explain how the government can remedy such a market failure. DON’T PEAK AT YOUR NOTES.

14. Copyright © 2004 South-Western Adjusting for Negative Externalities Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

15. Copyright © 2004 South-Western Addressing Externalities: Two Types of Public Policy Command-and-Control Policies: Regulate behavior directly Make certain behaviors illegal Environmental regulations; limit pollution

16. Copyright © 2004 South-Western Addressing Externalities: Two Types of Public Policy Market-Based Policies: provide incentives so private decision makers choose to solve problem on their own Policy 1: Corrective Taxes: used to counter effects of negative externalities; ideal tax should equal external costs (a.k.a. Pigovian Taxes) Subsidies: used to counter effects of positive externalities; ideal subsidy should equal external benefit Policy 2: Tradable Pollution Permits: Firms allotted certain amount of pollution per year; a free market for pollution rights develops as firms can buy and sell unused “units” of pollution Add graphs to your notes

17. Copyright © 2004 South-Western Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits Copyright © 2004 South-Western Quantity of Pollution 0 Price of Pollution Demand for pollution rights P Pigovian tax (a) Pigovian Tax 2.... which, together with the demand curve, determines the quantity of pollution. 1.A Pigovian tax sets the price of pollution... Q

18. Copyright © 2004 South-Western Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits Copyright © 2004 South-Western Quantity of Pollution 0 Demand for pollution rights Q Supply of pollution permits (b) Pollution Permits Price of Pollution 2.... which, together with the demand curve, determines the price of pollution. 1.Pollution permits set the quantity of pollution... P

19. Copyright © 2004 South-Western Quick Quiz #3 A glue factory and a steel mill emit smoke containing a chemical that is harmful if inhaled in large amounts. Describe three ways the town government may respond to this externality. What are the pros and cons of each solution? Create a chart on poster paper that shows the pros and cons of each strategy. Come to a consensus on which would be best and be prepared to defend your choice.

20. Copyright © 2004 South-Western Quick Quiz #4 We know education is beneficial to society, however, the cost of college is skyrocketing. On poster paper, explain how the government could address this problem and provide a graphical analysis. Discuss potential opposition to such plan(s).

21. Copyright © 2004 South-Western 2002 FRQ

22. Copyright © 2004 South-Western 2008 Form B FRQ

23. Copyright © 2004 South-Western PRIVATE SOLUTIONS TO EXTERNALITIES Government action is not always needed to solve the problem of externalities. Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties

24. Copyright © 2004 South-Western The Coase Theorem The Coase Theorem is a proposition that private parties can solve the problem of externalities on their own by bargaining without cost over the allocation of resources Example: Mrs. K’s barking dog

25. Copyright © 2004 South-Western Private Solutions Don’t Always Work  Transaction costs can be so high that private agreement is not possible The costs parties incur in the process of agreeing to and following through on a bargain

26. Copyright © 2004 South-Western In Summary… Sometimes the “invisible hand” fails to take into account the well-being of third parties – when a transaction impacts a third party, it’s called an externality Externalities can be positive or negative Those affected by externalities can sometimes solve the problem privately (Coase Theorem) When private parties cannot adequately deal with externalities, then the government steps in.

27. Copyright © 2004 South-Western Quick Quiz #4 Come up with your own externality story. Apply the Coase Theorem and provide a private solution. Give a specific scenario where the transaction costs may get in the way of the private solution.