1. Externalities as Market Failures & the “Fixes”
Mod 74-75
Externalities as Market Failures
& the “Fixes”

2. But market failures can still happen.
MARKET INEFFICIENCY/FAILURES
Recall:
Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.
But market failures can still happen.

3. EXTERNALITIES AND MARKET INEFFICIENCY
An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.
Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

4. EXTERNALITIES AND MARKET INEFFICIENCY
An externality arises...
. . . when a person (or firm) engages in an activity that influences the well-being of a bystander and yet neither pays the cost nor receives any compensation for that effect.
Think of an externality as a spill-over or side effect of a transaction—affecting others NOT involved in the actual market transaction.

5. EXTERNALITIES AND MARKET INEFFICIENCY
When the impact on the bystander is harmful, we label it an external cost or a negative externality.
When the impact on the bystander is beneficial, we label it an external benefit or a positive externality.

6. EXTERNALITIES AND MARKET INEFFICIENCY
Negative Externalities
Pollution
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building

7. EXTERNALITIES AND MARKET INEFFICIENCY
Positive Externalities
Immunizations
Restored historic buildings
Research into new technologies

8. EXTERNALITIES AND MARKET INEFFICIENCY
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Why? B/c something “bad” is being produced but a firm is not having to pay for it!!
Positive externalities lead markets to produce a smaller quantity than is socially desirable.
Why? B/c something “good” is being produced but a firm is not being paid for it!!

9. NEGATIVE EXTERNALITIES
In analyzing Negative Externalities, we use an S & D graph of the market
We call the Demand curve the MSB (Marginal Social Benefit) curve
We call the Supply curve the MPC curve, representing the Private cost
To “treat” or “remedy” the negative externality, we show a shift in the Supply curve to show the lesser amount of Supply of this good that we want, and call that new Supply curve the MSC (Marginal Social Cost) curve

10. Aluminum as a Polluting good and the Social Optimum
Price of
Marginal Social
Cost--MSC
Aluminum
Cost of
pollution
Demand
Supply
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
Copyright © South-Western

11. Negative Externalities
Left alone, the market produces a greater quantity than is socially desirable.
So…we want to “fix” this market failure
The intersection of the demand curve and the new social-cost curve—the MSC curve—determines the optimal output level.
For a negative externality, the socially optimal output level is ALWAYS less than the market equilibrium quantity.
The social cost of the good is higher than the private cost of the good.

12. Aluminum as a Polluting good and the Social Optimum
Price of
Marginal Social
Cost--MSC
Aluminum
Cost of
pollution
Demand
Supply
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
Copyright © South-Western

13. SOLUTIONS TO NEGATIVE EXTERNALITIES
Internalizing an externality involves altering incentives so that people take account and bear the cost of the external effects of their actions.

14. PUBLIC POLICY TOWARD EXTERNALITIES
When negative externalities are significant there are two ways to “fix” the market failure:
Public Policy through Government action
Private solutions through use of the Coase Theorem

15. PUBLIC POLICY Through GOVERNMENT ACTION
There are 2 types of Government Actions:
command-and-control policies.
market-based policies.

16. GOVERNMENT PUBLIC POLICY TOWARD EXTERNALITIES
Command-and-Control Policies
Usually takes the form of regulations:
Forbid certain behaviors.
Require certain behaviors.
Examples:
Requirements that all students be immunized.
Laws on pollution emission levels
Limits on fish allowed to be caught

17. GOVERNMENT PUBLIC POLICY TOWARD EXTERNALITIES
Market-Based Policies
There are 2 types:
Pigouvian taxes are taxes enacted to correct the effects of a negative externality.

18. Pigouvian Taxes Pigouvian Tax Price of Pollution Demand for
pollution rights P
Pigovian
tax Q 1.
A Pigouvian
tax sets the
price of
pollution . . .
Quantity of 2.
. . . which, together
with the demand curve,
determines the quantity
of pollution.
Pollution
Copyright © South-Western

19. GOVERNMENT PUBLIC POLICY TOWARD EXTERNALITIES
Market-Based Policies
B.Cap and Trade permits allow the voluntary transfer of the right to create the negative externality from one firm to another—creating a market for the “right” to pollute!

20. Pollution Permits: An equivalent solution to taxation
Price of Q
Supply of
pollution permits
Pollution
Demand for
pollution rights P 2.
. . . which, together
with the demand curve,
determines the price
of pollution.
Quantity of 1.
Pollution
permits set
the quantity
of pollution . . .
Pollution
Copyright © South-Western

21. GOVERNMENT PUBLIC POLICY TOWARD EXTERNALITIES
EXAMPLE of CAP & TRADE PERMITS
Pollution Permits
allow the voluntary transfer of the right to pollute from one firm to another.
A market for these permits will eventually develop.
A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

22. Cap and Trade Endorsement
“We now believe that tradable permits are
the most straightforward system of reducing
emissions and creating the incentives necessary
for massive reductions.”   
Kert Davies, research director, Greenpeace USA
Wall Street Journal - August 23, 2005

23. COMPARING GOVERNMENT PUBLIC POLICY TOWARD EXTERNALITIES
Regulation vs Pigouvian Tax vs Tradeable Permits
If the EPA decides it wants to reduce the amount of pollution coming from a specific plant or industry, the EPA could…
tell the firm(s) to reduce pollution by a specific amount (Command/Control Regulation). This costs $ for admin of the agency and enforcement OR
levy a tax of a given amount for each unit of pollution the firm(s) emits (Pigovian Tax). This reduces number of firms in the market
create pollution permits that allow the voluntary transfer of the right to pollute from one firm to another. (Cap and Trade Permits). This creates a market for firms to continue in.

24. PRIVATE SOLUTIONS TO NEGATIVE EXTERNALITIES
Government action is not always needed to internalize a negative externality, or to solve the problem of externalities.

25. THE COASE THEOREM
The Coase Theorem (1960) is a proposition that if private parties can bargain over the allocation of resources, they can solve the problem of externalities on their own.
Cost/Benefit Analysis needs to include Transaction Costs
Transaction costs –the costs that parties incur in the process of agreeing to and following through on a bargain
Lawyer fees, surveying lands, monitoring equip, etc, are examples of transaction costs

26. WHEN THE COASE THEOREM FAILS
Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

27. EXTERNALITIES AND MARKET INEFFICIENCY
Positive Externalities
Immunizations
Restored historic buildings
Research into new technologies

28. POSITIVE EXTERNALITIES
In analyzing Positive Externalities, we use an S & D graph of the market
We call the Supply curve the MPC curve, representing the Private cost
We call the Demand curve the MPB (Marginal Private Benefit) curve
We show a shift in the Demand curve to show the greater amount of Demand of this good that we want, and call that new Demand curve the MSB (Marginal Social Benefit) curve

29. Education and the Social Optimum
Price of
Education
(Marginal Social
Benefit—MSB)
Supply
Demand
QOPTIMUM
QMARKET
Quantity of
Education
Copyright © South-Western

30. Positive Externalities
Left alone, the market produces a lesser quantity than is socially desirable.
The intersection of the supply curve—the MPC curve—and the social-value curve—the MSB curve—determines the optimal output level.
For a positive externality, the socially optimal output level is ALWAYS more than the market equilibrium quantity.
The social benefit or value of the good exceeds the private value of the good.

31. PUBLIC POLICY TOWARD EXTERNALITIES
When positive externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .
Subsidies.

32. Achieving the Socially Optimal Output
The government can internalize a positive externality by:
Providing a subsidy for the production of more of the desired good