1. Externalities Spillover Costs & Spillover Benefits
Chapter 10 Market Failures (pages )
Factory B
Factory A

2. Factory A
Factory B

3. EXTERNALITIES = Market Failures
An externality is the uncompensated impact of one person or firm’s actions on another person/society
Both negative externalities & positive externalities exist
All externalities are considered market failures (inefficient)
That means markets with externalities do not maximize total surplus (welfare)
Governments can correct externalities with taxes or subsidies

4. Negative Externalities = External Costs
Automobile exhaust & pollution
Cigarette smoking
Barking dogs
Loud stereos in an apartment building
Noisy Students
Neighbor’s poorly maintained property

5. Spillover Costs (external)
Spillover Costs- external costs not included in supply curve (MC)
External costs exist with ALL negative externalities
MC is understated => which leads to overproduction (actual MC > MB)
MSC = MC + spillover cost (external cost)
MB = D
MC = S
MSC
MC is a cost curve
Firms only consider their “internal costs”
when they produce goods/services
Labor, Inputs, Rent, etc…..

6. Positive Externalities = External Benefits
Immunizations, flue shots
Restored historic buildings
Research into new technologies
Neighbor’s or Firm’s well maintained property
Volunteering, Charity

7. Spillover Benefits
Spillover Benefits-external benefits not included in demand curve (MB)
External benefits exist with ALL positive externalities
MB is understated => which leads to underproduction (actual MB > MC)
MSB = MB + spillover benefit (external benefit) MB MC
MSB
Consumers only consider their “internal benefit” when they buy goods/services

8. Internalizing Externalities
Internalizing an externality involves altering incentives to improve market outcomes (i.e. to increase total welfare)
Government Solutions
Taxes = spillover cost
Subsidies = spillover benefit
Laws (immunization laws, pollution laws)
Patents
Free market Solution:
Pollution credits => i.e. cap & trade policy

9. WORKSHEET: Internalizing Externalities
Electric Cars
Large SUV Production

10. Internalizing Negative Externalities
Large SUV Production
SUV’s have spillover costs = $2,000 per SUV
MSC
Impose Tax producers = $2,000
(exact size of spillover cost)
Draw spillover cost wedge = $2,000
-this shifts Supply Curve left
Reach socialy optimal output (Eso)
DWL eliminated
Total Welfare is Maximized! MC Q2 P2
Eso
DWL before tax MB

11. Subsidizing Positive Externalities
Assume these cars have external benefits
Electric Cars MC
Impose Subsidy = $5,000 spillover benefit
Shifts demand curve right MB => MSB
Reach socialy optimal output
DWL eliminated & Total Wefare maximized
Initial DWL
Eso
MSB MB
MB = MB private benefit MSB = MB private benefit + social benefit

12. WORKSHEET: Internalizing Externalities
Electric Cars
Large SUV Production

13. Switzerland & Garbage
35 Liter Swiss Trash Bag

14. Bottled Water
What is the real cost?
Start 20 minutes in…

15. Internalizing Negative Externalities
Impose Tax = spillover cost
This puts a price on “external costs”
Reach socialy optimal Q2
MSC = MCp + MCs (internal & external)
Bottled Water
MSC MC Q2 P2 E2 MB