1. Externalities (a short presentation)

2. WHY EXTERNALITIES ARE IMPORTANT?
Adam Smith’s “invisible hand”: self-interested buyers and sellers maximize the total benefit that society can derive from a market.
This is true ONLY if there are no market failures

3. EXTERNALITIES AND MARKET INEFFICIENCY
An externality refers to the uncompensated impact of one person/firm’s actions on the well-being of another person/firm
When the impact is adverse, the externality is called a negative externality (smoking; loud stereo; etc.)
When the impact is beneficial, the externality is called a positive externality (vaccination; research; etc.)
Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

4. EXTERNALITIES AND MARKET INEFFICIENCY
RESULTS in the presence of externalities
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is socially desirable.
Let’s see WHY

5. Figure 1 The Market for Aluminum
Price of
Aluminum
Supply
(private cost)
Demand
(private value)
QMARKET
Equilibrium
Quantity of
Aluminum
Copyright © South-Western

6. Welfare Economics: A Recap
EXAMPLE: The Market for Aluminum
The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.
SOCIAL COST: include the individual cost plus the cost for the society (the negative externality )

7. Figure 2 Pollution and the Social Optimum
Price of
Social
cost
Aluminum
Cost of
pollution
Demand
(private value)
Supply
(private cost)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
Copyright © South-Western

8. Negative Externalities
EXAMPLE: The Market for Aluminum
SOCIAL OPTIMUM:
The intersection of the demand curve and the social-cost curve
RESULT: in the presence of a negative externality, the socially optimal output level is less than the market equilibrium quantity.

9. Negative Externalities
How to achieve Socially Optimal Output
Internalizing an externality: altering incentives so that people take account of the external effects of their actions.
EXAMPLE: government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

10. Positive Externalities
POSITIVE EXTERNALITY
We have a positive externality when the externality benefits other persons/firms
In this case, the social value of the good exceeds the private value.
EXAMPLE
technology spillover is a type of positive externality that exists when a firm’s innovation not only benefits the firm, but increases society’s pool of technological knowledge and thus benefits society as a whole.

11. Figure 3 Innovation and the Social Optimum
Price of
Innovation
Social
value
Supply
(private cost)
Demand
(private value)
QOPTIMUM
QMARKET
Quantity of
Innovation
Copyright © South-Western

12. Positive Externalities
HOW TO SOLVE THE MARKET FAILURE
Internalizing Externalities
Subsidies are the primary method for attempting to internalize positive externalities.
Example:
Government intervention in the economy that aims to promote technology-enhancing industries
Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention.
The patent is then said to internalize the externality.

13. The role of Government
When private parties cannot adequately deal with externalities, then the government steps in.
The government can either regulate behavior or internalize the externality by using taxes or by issuing permits.