1. Copyright eStudy.us 2010 michael.roberson@eStudy.us
Externality – the uncompensated impact of one person’s actions on the well-being of a bystander
Negative Externality - is detrimental to third parties
Pollution
New House (back lot zoned for sewage plant)
Positive Externality - is beneficial to third parties
Vaccine
Education and Technology spillover
New House (back lot zone for a golf course)
Internalizing the externality – creating incentives to take account for the external effects of an action S1 S0
Optimum
External
Cost (Pollution) S0
Optimum
External
Benefit (Education) D1 D0 D0
Illustration - S0 is inefficient (excludes pollution cost to society, policy moves supply to the efficient S1 position
Illustration - D0 is inefficient (excludes social benefit of vaccine to society, policy moves demand to the efficient D1 position with includes private + social benefit
Public Policies Toward Externalities
Command and Control Policies: Regulation – government make behavior required or forbidden
Market Based Policy: Corrective Taxes and Subsidies – a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality
Gas tax (Congestion, Accidents, Pollution)
Tobacco tax (Health and Worker Productivity)
Roads and bridges?
Market Based Policy: Tradable Pollution Permits– issue permits to pollute (rations pollution to a socially optimal level by allowing market signals to determine efficient resource allocation)
Short term: Paper mill can easily reduce pollution
then sell permits to a steal company have trouble reducing pollution
provides for most efficient short term allocation of resource while reducing pollution
Both industries have a long term incentive to reduce pollution
Corrective Tax
Pollution Permits
Price of Pollution
Price of Pollution P P Q
Quantity of Pollution Q
Quantity of Pollution
Private Solutions Toward Externalities
Moral codes
Social sanctions
Charity (income tax deduction for gifts to universities (education and technology))
Self-interest / Contract (orchard and bee keeper)
Coase Theorem – the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
Disk’s dog spot barks and disturbs Jane
AT&T (Cingular) vs Sprint/Nextel in NASCAR
Private solutions don’t always work. Transaction cost (cost that parties incur in the process of agreeing to and following through on a bargain) can prevent a solution.