1. Unit 6 Chapter 17
Externalities

2. Discussion Should we as a society strive to eliminate pollution?
Should the use of phones in cars be made completely illegal?
Should smoking be illegal in all public places?

3. I. Externalities
External costs and external benefits of producing something.
The free market fails to include external costs or external benefits.

4. II. Costs
Marginal Social Cost of pollution: additional cost imposed on society as a whole by another unit of pollution.
Marginal Social Benefit of pollution: additional benefit to society from another unit of pollution.
Socially Optimal Quantity of pollution: quantity of pollution that makes society as well off as possible.
Marginal Private Cost: additional cost imposed on the firm by another unit of pollution

5. Negative Externalities
Smog
Traffic

6. III. Negative Externalities
External Costs of producing.
Ex. Pollution, Oil spill in gulf, Traffic Congestion,

7. IV. Pollution
In the absence of government intervention businesses pollute to much.
This is a market failure.

8. A Market Economy Produces Too Much Pollution
Marginal social cost, marginal social benefit
MSC of pollution
$400
Marginal social cost at QMKT
The market outcome is inefficient: marginal social cost of pollution exceeds marginal social benefit
300
Optimal Pigouvian tax on pollution O
200
Figure Caption: Figure 17-2: Why a Market Economy Produces Too Much Pollution
In the absence of government intervention, the quantity of pollution will be QMKT, the level at which the marginal social benefit of pollution is zero. This is an inefficiently high quantity of pollution: the marginal social cost, $400, greatly exceeds the marginal social benefit, $0. An optimal Pigouvian tax of $200, the value of the marginal social cost of pollution when it equals the marginal social benefit of pollution, can move the market to the socially optimal quantity of pollution, QOPT.
100
MSB of pollution
Marginal social benefit at QMKT Q Q Q
Quantity of pollution
OPT H M K T
emissions (tons)
Socially optimal quantity of pollution
Market-determined quantity of pollution

9. Market for Cigarettes P Supply = Marginal Social Cost D= Marginal
Socially optimal point
D= Marginal
Social Benefit Q
QFree Market

10. What will the MC/Supply look like when EXTERNAL costs are factored in?
Market for Cigarettes
What will the MC/Supply look like when EXTERNAL costs are factored in? P
Supply =
Marginal
Social Cost
Supply = Marginal
Private Cost
D=MSB Q
QOptimal
QFree Market 10

11. Market for Cigarettes
If the market produces QFM why is it a market failure? P
S =MSC
S=MPC
At QFM the MSC is greater than the MSB. Too much is being produced
Overallocation
D=MSB Q
QOptimal
QFree Market 11

12. Market for Cigarettes
What should the government do to fix a negative externality? P
S =MSC
S=MPC
Solution: Tax the amount of the externality
(Per Unit Tax)
D=MSB Q
QOptimal
QFree Market 12

13. Market for Cigarettes
What should the government do to fix a negative externality? P
S =MSC
=MPC
MSB = MSC
S=MPC
Solution: Tax the amount of the externality
(Per Unit Tax)
D=MSB Q
QOptimal
QFree Market 13

14. Thank You for Not Smoking
Second-hand smoke is an example of a negative externality. But how important is it?
A paper published in 1993 in the Journal of Economic Perspectives found that valuing the health costs of cigarettes depends on whether you count the costs imposed on members of smokers’ families.
If you don’t, the external costs of second-hand smoke have been estimated at about only $0.19 per pack smoked.
A 2005 study raised this estimate to $0.52 per pack smoked. If you include effects on smokers’ families, the number rises considerably.
If you include the effects of smoking by pregnant women on their unborn children’s future health, the cost is immense—$4.80 per pack.

15. IV. Solutions
Coase Theorem: Economy can reach efficient solutions with low transaction costs.
Economy can reach solutions on own.
Neighbors ex.

16. Policies Toward Pollution
Environmental standards are rules that protect the environment by specifying actions by producers and consumers. Generally such standards are inefficient because they are inflexible.
An emissions tax is a tax that depends on the amount of pollution a firm produces.
Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters.
Taxes designed to reduce external costs are known as Pigouvian taxes. 16

17. Positive Externalities

18. Positive Externalities
Situations that result in a BENEFIT for someone other than the original decision maker.
(EX: Flu Vaccines, Education, Home Renovation)

19. The Impeccable Economic Logic of Early
Childhood Intervention Programs
One problem facing any society is how to break what researchers call the “cycle of poverty.” Children who grow up with disadvantaged socioeconomic backgrounds are far more likely to also be poor adults.
A 2006 study found that high-quality early childhood programs focused on education and health care lead to significant advantages for kids. Children in programs were less likely to engage in destructive behaviors and more likely to end up with a job and to earn a higher salary later in life.
Another study in 2003 looked at early childhood intervention programs from a dollars-and-cents perspective, finding from $4 to $7 in benefits for every $1 spent on early childhood intervention programs.

20. D=Marginal Private Benefit
Market for Flu Shots
The marginal private benefit doesn’t include the additional benefits to society. P
S = MSC
D=Marginal Private Benefit Q
QFree Market 20

21. Market for Flu Shots
What will the MB/D look like when EXTERNAL benefits are factor in? P
S = MSC
D=Marginal Social Benefit
D=Marginal Private Benefit Q
QFM
QOptimal 21

22. Market for Flu Shots
If the market produces QFM why is it a market failure? P
S = MSC
D=Marginal Social Benefit
D=MSB Q
QFM
QOptimal 22

23. Market for Flu Shots At QFM the MSC is less than the MSB.
Too little is being produced P
S = MSC
D=Marginal Social Benefit
Underallocation Q
QFM
QOptimal 23

24. Market for Flu Shots
What should the government do to fix a negative externality? P
Subsidize the amount of the externality (Per Unit Subsidy)
S = MSC
D=MSB
=MPB
D=MPB Q
QFM
QOptimal 24

25. Positive Externalities and Consumption
(a) Positive Externality
(b) Optimal Pigouvian Subsidy
Price, marginal social benefit of flu shot
Price of flu shot
Marginal external benefit S S
Price to producers after subsidy P
MSB O O P
OPT
Optimal Pigouvian subsidy P E E
MKT
MKT
MKT
MSB of flu shots
Figure Caption: Figure 17-4: Positive Externalities and Consumption
Consumption of flu shots generates external benefits, so the marginal social benefit curve, MSB, of flu shots, corresponds to the demand curve, D, shifted upward by the marginal external benefit. Panel (a) shows that without government action, the market produces QMKT. It is lower than the socially optimal quantity of consumption, QOPT, the quantity at which MSB crosses the supply curve, S. At QMKT, the marginal social benefit of another flu shot, PMSB, is greater than the marginal benefit to consumers of another flu shot, PMKT. Panel (b) shows how an optimal Pigouvian subsidy to consumers, equal to the marginal external benefit, moves consumption to QOPT by lowering the price paid by consumers.
Price to consumers after subsidy D D Q Q Q Q
MKT
OPT
Quantity of flu shots
MKT
OPT
Quantity of flu shots

26. 2008 FRQ
2. Vaccinations for contagious diseases benefit the consumers as well as others in the community. Assume that vaccines are produced in a competitive market.
(a) Draw a correctly labeled graph of supply and demand, and
(i) label the market price “Pm ”, and label the market output “Qm ”.
(ii) label the socially efficient level of output “Qs”.
(iii) shade the area of the deadweight loss.
(b) Is marginal social cost greater than, less than, or equal to marginal social benefit at the market output?
(c) How will a tax on producers of the vaccines affect the deadweight loss that you identified in part (a) (iii) ?
Explain.

27. Question 2
6 points ( )
(a) 3 points:
• One point is earned for the correctly labeled graph with Qm and Pm correctly identified.
• One point is earned for correctly identifying QS.
• One point is earned for shading the area of the deadweight loss.
(b) 1 point:
• One point is earned for stating that the MSC is less than the marginal social benefit.
(c) 2 points:
• One point is earned for stating that the tax will increase the deadweight loss.
• One point is earned for the explanation that the tax raises the cost and causes output of vaccine to fall.