Chapter 10Externalities

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

Externalities

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

Negative vs. Positive

◦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

Negative Externalities

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?

Negative 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

Internalizing the 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

Positive Externality

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

Internalizing the Externality

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

Case Study: Technology Spillover

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)

Production vs. Consumption 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

Private Solutions to Externalities

Proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own

Problem with private solutions: Transaction costs (either financially or logistically)

Coase Theorem

2 major government options when there is an inefficient allocation of resources:

1. Command-and-Control Policies (Regulation)

2. Tradable Pollution Permits

Public Policies toward Externalities