Externalities

Econ 10

Holmes

Test volume

Big Idea

So far: non-shareable goods onlyHamburgers, T-shirts, etc.

You are studying for big test and your roomie listens to “Hate Tank”by Method of Destruction.

How much quality studying will you get done?

You get the idea...

External economies

When the consumption of a good affects people other than those consuming it, then we say that the good has “externalities” (or spillover effects).

In this case, your roomie’s “music” affects your ability to study. (Compare with your roomie eating a hamburger-you are not affected).

Note not necessarily negative: suppose neighbors like my roses.

Key features

• People do not incorporate the external costs (if negative) or external benefits (if positive) of the good.

• Thus, social welfare is not maximized when individuals make their own decisions.

Examples

• Pollution: firms “make too much” [Gary]

• Noise: w/out quiet hours, neighbors of MOD might never sleep

• Cigarettes: I lose my voice when you smoke

• etc.

Public Goods

Suppose you have a good that people cannot be prevented from enjoyingconsumption by one does not affect others’ consumption

Examples: public park, fireworks, concert in Central Park, etc.

How much can seller get? (How much would you pay to watch the sunset?) A: nothing.

These are called public goods.

NonexcludabilityNondepletability

Circus with a tent: private (excludable)Circus without a tent: public (nonexcludable) [Wrigley Field]

A continuum

Private Goods(all to consumer)

Public Goods(benefit to all)

HamburgersMassages

Education National DefenseFire Department

Education: higher wage, enjoy learning (ha!)more educated populace, more productive

Most goods lie somewhere in between...

Negative Externality

SteelP

Q

MC

D

100

$20

But there is an external cost to society: pollution adds $10 to each unit

SC

Where will firms go?Where is society best?

80

$23

DWL: loss due tooverproduction

Practice Problem

Compare and contrast DWL for monopoly and DWL for external economy.

Table

P MC D$10 100 400$20 200 350$30 300 300$40 400 250$50 500 200$60 600 150

SC

100200300

For steel...

Suppose external cost is $30. Apply excise tax techniques.

Market eq. (ME) will tend to $30, 300. SO is $50, 200.

Graph of example

SteelP

Q

MC

D

500

$30

But there is an external cost to society: pollution adds $30 to each unit

SC

Where will firms go?Where is society best?

200

$50

DWL: loss due tooverproduction

ME

SO

How can we get the ME to the SO?

What does this graph look like?

Suppose we imposed an excise tax of $30. Where would we end up?

Practice Problem: Why do we impose an excise tax on cigarettes? What should the tax be if the external cost is $.50/pack? What form does the external cost take?

What about a positive externality?

Suppose I grow roses and you enjoy looking at them (even though you don’t pay). The social benefit is thus greater than the private benefit.

Graph: positive

MC

D (private benefit)

Q

P

Social benefit SB

DWL

DWL is loss due to underproduction.

Table: Positive

P MC D$10 100 400$20 200 350$30 300 300$40 400 250$50 500 200$60 600 150

SB

400350300

SB: Social BenefitAt a SB of $40, $10 is private demand==> same D as at $10.

Education. Suppose education adds $30 in external benefit..

Graph:Positive

Q

P MC

D

300

$30

SB

SB has a higher Q for each P

400

$40

How do we convince private agents to act in public interest?

We need to make the private agents internalize the external benefit.How to accomplish?How did we do this with negative externalities?

Answer: Give subsidies.Examples:

Student LoansTax breaks for using natural gas in your carAwards for “best lawn”

Practice Problems•Define externality. Give an example of negative (positive) externalities, clearly stating the external cost (benefit).

•Define public good. What are the two key features of a public good? Why do government typically produce these? Discuss with examples.

•Sketch a graph of a positive (negative) good. Show ME, SO, and DWL. Discuss what DWL means in each case.

•Policy Relevance: Why do gov’ts offer cheap public transport?

PP, continued

Suppose we know that for cigarettes, the external cost per pack is $.75.

P MC D$0.75 3000 6000$1.00 3500 5000$1.25 4000 4000$1.50 4500 3000$1.75 5000 2000$2.00 5500 1000

1. Find the ME, SO.2. Sketch, including DWL.3. Discuss DWL.4. How can the gov’t make the SO the ME?