1. Chapter 10 Externalities

2. Externalities
Markets sometimes fail to allocate resources efficiently – some of these market failures are called externalities
An externality is when a person engages in an activity that influences the well-being of a bystander who neither pays nor receives any compensation for that effect

3. Negative vs. Positive If impact on bystander is adverse – negative
If impact on bystander is beneficial – positive
In both cases, equilibrium is not efficient when there are externalities

4. Negative Externalities
Externality causes cost to society to be larger than the cost to producers
Social cost includes private costs to producers plus the cost to bystanders affected by externality
Show this by putting social cost curve above the supply curve by the amount of the external cost

5. Negative Externality
Optimum quantity of production is where social cost curve intersects demand curve
Equilibrium quantity is larger than the socially optimal quantity, so… how do we fix this?

6. Internalizing the Externality
We can tax the producer in order to shift the supply curve upward by the size of the negative externality
This gives buyers & sellers an incentive to take into account the external effects of their actions; a smaller quantity will be consumed

7. Positive Externality
When there is a positive externality, like education, the demand curve does not reflect the value to society of the good
Social value curve is above the demand curve and optimum quantity level is where social value curve intersects supply curve

8. Internalizing the Externality
Positive externality requires a subsidy to move the demand curve to the right by the size of the externality (called social value curve)

9. Case Study: Technology Spillover
How could technology be a positive externality?
Tough to measure amount of technology spillover – debate on if government should encourage production of technology
Result is patent protection to encourage development of new ideas

10. Production vs. Consumption Externalities
Can be positive or negative for either… examples?
Production externalities move social cost curve up or down from supply curve (private cost curve)
Consumption externalities move social value curve up or down from demand curve (private value curve)

11. Private Solutions to Externalities
Don’t always need gov’t to intervene
Can be solved by moral codes/social sanctions
Charities can deal with externalities
Parties involved might enter into agreement that corrects the externality

12. Coase Theorem
Proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own
If the Benefits > Costs = efficient solution
Problem with private solutions: Transaction costs (either financially or logistically) > Benefits

13. Public Policies toward Externalities
2 major government options when there is an inefficient allocation of resources:
1. Command-and-Control Policies (Regulation)
What is the Problem? Inefficient?
2. Market Based Solutions
a. Tradable Pollution Permits
b. Taxes (Pigovian) + Subsidies
- Pigovian Tax – does not cause DWL , but tries to fix DWL
*Market Based Solutions – generally favored because: more efficient and lower cost to implement