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Externalities
Chapter 10
EXTERNALITIES• An externality is the uncompensated impact of one
person’s actions on another person– Both positive & negative externalities exist
• All externalities cause markets to be inefficient– That is, markets do not maximize total surplus (welfare)
Negative Externalities
– Automobile exhaust
– Cigarette smoking
– Barking dogs
– Loud stereos in an apartment building
– Noisy Students
– Neighbor’s poorly maintained property
Positive Externalties – Immunizations– Restored historic buildings– Research into new technologies– Neighbor’s well maintained property
MARKET INEFFICIENCY
• Negative externalities lead markets to overproduce
• Positive externalities lead markets to under-produce
Quantity ofAluminum
0
Price ofAluminum
EquilibriumEquilibrium
Demand(marginal benefit)
Demand(marginal benefit)
Supply(marginal cost)
Supply(marginal cost)
QMARKETQMARKET
MC = MB
Supply Curve = Marginal Cost Curve
Demand Curve = Marginal Benefit Curve
Spillover Costs & Benefits
• Spillover Costs- costs not captured by supply curve (MC)– Costs are understated
• Spillover Benefits- benefits not captured by demand curve (MB)– Benefits are understated
Negative Externality: Pollution
Equilibrium MC = MB
Quantity ofAluminum
0
Price ofAluminum
Demand = MB (private value)
Supply = MCP (private cost)
MSC (social cost)
QOPTIMUM
Optimum
QMARKET
SpilloverCost
External social Cost
P1
Positive Externality: Neighbor paints House
Quantity0
Price
MB
MC
QMARKET
External social benefit
EquilibriumOptimum
QOPTIMUM
Spillover Benefit
MSB
P1
Solutions to Externalities
• Internalizing an externality involves altering incentives
• Government Methods– Taxes (corrective taxes), Subsidies
– Patents
– Laws (immunization laws, pollution laws)
• Free market solution: – Trading pollution credits
Worksheet
• Externalities
Taxing Negative Externalities
Impose Tax = spillover cost Shifts Supply Curve left
Reach social optimal output
Total Cost = Total Benefit
Total Cost = MSC (MCP + MCS)
Equilibrium MC = MBEquilibrium MC = MB
Aluminum0
Price ofAluminum
Demand = MB(private value)
Demand = MB(private value)
Supply = MC(private cost)
Supply = MC(private cost)
MSC (social cost)
QOPTIMUMQOPTIMUM
OptimumOptimum
QMARKETQMARKET
External social Cost External
social Cost
Subsidizing Positive Externalities
Impose Subsidy = spillover benefit Shifts demand curve right
Reach social optimal output
Total Cost = Total Benefit
Quantity0
Price
MBMB
MCMC
QMARKETQMARKET
External social benefit
External social benefit
EquilibriumEquilibriumOptimumOptimum
QOPTIMUMQOPTIMUM
Spillover BenefitSpillover Benefit
MSB
Fuel Efficient Cars
Day #2
• Practice Test
Factory A Factory B
Cap & Trade Analysis
D
S
Goal: to reduce CO2 emissions
Trading SystemPollution Credits