1. LECTURE #9: MICROECONOMICS CHAPTER 10
Market Externalities
Solutions to Problems Caused by Externalities

2. Market Externalities
Uncompensated impact of one person’s actions on the well-being of a bystander
Positive Externalities = consumers or producers benefit
Education
Research activity
Negative Externalities = consumers or producers do not benefit
Pollution
Loss of Patent Protection
Increases in Cost – Less Quantity at every price level

3. Market Externalities Market Failure Impact on Welfare Economics
Decision maker - fails to account for externalities
Government intervention: protect the interests of bystanders
Impact on Welfare Economics
Increase in cost of goods, decrease in revenue to producers
Taxes imposed to repair effects of externalities
Reduced consumer and producer surpluses
Are reductions in surplus offset by economic value of increased welfare

4. Pollution and the Social Optimum
Price of
Aluminum
Social cost (private cost
and external cost)
External
Cost
Supply
(private cost)
Demand
(private value)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of Aluminum
In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET. 4

5. Education and the Social Optimum
Price of
Aluminum
Supply
(private cost)
Social value
(private value
and external benefit)
Optimum
Demand
(private value)
External
Benefit
QOPTIMUM
Equilibrium
QMARKET
Quantity of Aluminum
In the presence of a positive externality, the social value of the good exceeds the private value. The optimal quantity, QOPTIMUM, is therefore larger than the equilibrium quantity, QMARKET. 5

6. Solutions To Problems Caused By Externalities
Private Market Solutions
Moral codes
Social sanctions
Coase Theorem
private parties bargain on costs
Private solution to externality [problem]
Provide incentives
Corrective taxes and subsidies
Violation carries a price
Conformance obtains a [tax] benefit

7. Solutions To Problems Caused By Externalities
Public (Government) Solutions
Regulation
Making certain behaviors either required or forbidden
Cannot eradicate pollution
Taxation and Subsidies
Tradable [Pollution] Permits
Environmental Protection Agency (EPA)
Develop and enforce regulations protecting the environment
Dictates maximum level of pollution
Requires that firms adopt a particular technology to reduce emissions

8. Homework Questions for Review: 3, 4, 6 (4, 5, 6 - 4th Ed)
Problems and Applications: 1, 6, 12