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Externalities
Chapter 10
Copyright ? 2001 by Harcourt,Inc.
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Market Efficiency - Market Failures
Recall that,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.
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Market Failures,Externalities
?When a market outcome affects
parties other than the buyers and
sellers in the market,side-effects are
created called externalities.
?Externalities cause markets to be
inefficient,and thus fail to maximize
total surplus.
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An externality arises...
.,, when a person engages in an
activity that influences the well-
being of a bystander and yet neither
pays nor receives any compensation
for that effect.
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Market Failures,Externalities
?When the impact on the bystander is
adverse,the externality is called a
negative externality.
?When the impact on the bystander is
beneficial,the externality is called a
positive externality.
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?Automobile exhaust
?Cigarette smoking
?Barking dogs (loud pets)
?Loud stereos in an apartment
building
Examples of Negative
Externalities
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?Immunizations
?Restored historic buildings
?Research into new technologies
Examples of Positive
Externalities
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The Market for Aluminum...
Quantity of
Aluminum
0
Price of
Aluminum
QMARKE
T
Demand
(private value)
Supply
(private cost)
Equilibrium
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The Market for Aluminum and
Welfare Economics
The quantity produced and consumed
in the market equilibrium is efficient
in the sense that it maximizes the sum
of producer and consumer surplus.
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The Market for Aluminum and
Welfare Economics
If the aluminum factories emit
pollution (a negative externality),then
the cost to society of producing
aluminum is larger than the cost to
aluminum producers.
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The Market for Aluminum and
Welfare Economics
For each unit of aluminum produced,
the social cost includes the private costs
of the producers plus the cost to those
bystanders adversely affected by the
pollution.
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QMARKE
T
Pollution and the Social
Optimum...
Quantity of
Aluminum
0
Price of
Aluminum
Demand
(private value)
Supply
(private cost)
Social cost
Qoptimum
Cost of
pollution
Equilibrium
Optimum
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Negative Externalities in
Production
The intersection of the demand curve
and the social-cost curve determines the
optimal output level.
?The socially optimal output level is less
than the market equilibrium quantity.
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Achieving the Socially Optimal
Output
Internalizing an externality involves
altering incentives so that people
take into account the external
effects of their actions.
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Achieving the Socially Optimal
Output
The government can internalize an
externality by imposing a tax on
the producer to reduce the
equilibrium quantity to the socially
desirable quantity,
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Positive Externalities in
Production
When an externality benefits the
bystanders,a positive externality exists.
?The social costs of production are less
than the private cost to producers and
consumers.
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Positive Externalities in
Production
A technology spillover is a type of
positive externality that exists when a
firm’s innovation or design not only
benefits the firm,but enters society’s
pool of technological knowledge and
benefits society as a whole.
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Positive Externalities in
Production...
Quantity
of Robots
0
Price
of Robot
QOPTIMUM
Demand
(private value)
Supply (private cost)
Social cost
QMARKET
Value of
technology
spillover
Equilibrium
Optimum
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Positive Externalities in
Production
The intersection of the demand curve and
the social-cost curve determines the optimal
output level.
?The optimal output level is more than the
equilibrium quantity.
?The market produces a smaller quantity than
is socially desirable,
?The social costs of production are less than
the private cost to producers and consumers.
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Internalizing Externalities,
Subsidies
Government many times uses
subsidies as the primary method
for attempting to internalize
positive externalities.
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Technology Policy
Government intervention in the
economy that aims to promote
technology-enhancing industries is
called technology policy.
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Technology Policy
?Patent laws are a form of
technology policy that give the
individual (or firm) with patent
protection a property right over its
invention,
?The patent is then said to
internalize the externality.
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Internalizing Production
Externalities
?Taxes are the primary tools used
to internalize negative
externalities.
?Subsidies are the primary tools
used to internalize positive
externalities.
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Consumption Externalities...
Quantity of
Education
0
Price of
Education
Q
MARKET
Demand
(private value)
Social
value
Q
OPTIMUM
(b) Positive Consumption Externality
Supply
(private cost)
Quantity
of Alcohol
0
Price
of Alcohol
Q
MARKET
Demand
(private value)
Supply
(private cost)
Social value
Q
OPTIMUM
(a) Negative Consumption Externality
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Externalities and Market
Inefficiency
? Negative externalities in production or
consumption lead markets to produce a
larger quantity than is socially
desirable.
? Positive externalities in production or
consumption lead markets to produce a
larger quantity than is socially
desirable.
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Private Solutions to
Externalities
Government action is not
always needed to solve the
problem of externalities.
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Types of Private Solutions to
Externalities
?Moral codes and social sanctions
?Charitable organizations
?Integrating different types of
businesses
?Contracting between parties
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The Coase Theorem
The Coase Theorem states that if private
parties can bargain without cost over the
allocation of resources,then the private
market will always solve the problem of
externalities on its own and allocate
resources efficiently.
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Transactions Costs
Transaction costs are the costs
that parties incur in the process
of agreeing to and following
through on a bargain.
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Why Private Solutions
Do Not Always Work
Sometimes the private solution
approach fails because transaction
costs can be so high that private
agreement is not possible.
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Public Policy Toward
Externalities
When externalities are significant and
private solutions are not found,
government may attempt to solve the
problem through,,,
? command-and-control policies.
? market-based policies.
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Command-and-Control
Policies
?Usually take the form of regulations:
?Forbid certain behaviors.
?Require certain behaviors.
?Examples:
?Requirements that all students be
immunized.
?Stipulations on pollution emission levels set
by the Environmental Protection Agency
(EPA).
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Market-Based Policies
?Government uses taxes and
subsidies to align private incentives
with social efficiency.
?Pigovian taxes are taxes enacted to
correct the effects of a negative
externality.
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Examples of Regulation versus
Pigovian tax
If the EPA decides it wants to reduce the
amount of pollution coming from a specific
plant,The EPA could…
? tell the firm to reduce its pollution by a
specific amount (i.e,regulation).
? levy a tax of a given amount for each
unit of pollution the firm emits (i.e,
Pigovian tax).
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Market-Based Policies
?Tradable 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.
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The Equivalence of Pigovian
Taxes and Pollution Permits...
Quantity of
Pollution
0
Price of
Pollution
P
Q
Demand for
pollution rights
Pigoviantax
(a) Pigovian Tax
2.,..which,together
with the demand curve,
determines the quantity
of pollution.
1,A Pigovian
tax sets the
price of
pollution...
Quantity of
Pollution
0 Q
Demand for
pollution rights
Supply of
pollution permits
(b) Pollution Permits
Price of
Pollution
P
2.,..which,together
with the demand curve,
determines the price
of pollution.
1,Pollution
permits set
the quantity
of pollution...
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Summary
?When a transaction between a buyer and a
seller directly affects a third party,the effect
is called an externality.
?Negative externalities cause the socially
optimal quantity in a market to be less than
the equilibrium quantity.
?Positive externalities cause the socially
optimal quantity in a market to be greater
than the equilibrium quantity.
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Summary
?Those affected by externalities can
sometimes solve the problem
privately.
?The Coase theorem states that if
people can bargain without a cost,
then they can always reach an
agreement in which resources are
allocated efficiently.
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Summary
?When private parties cannot
adequately deal with externalities,
then the government steps in.
?The government can either regulate
behavior or internalize the externality
by using Pigovian taxes.
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Graphical
Review
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The Market for Aluminum...
Quantity of
Aluminum
0
Price of
Aluminum
QMARKE
T
Demand
(private value)
Supply
(private cost)
Equilibrium
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Pollution and the Social
Optimum...
QMARKE
T
Quantity of
Aluminum
0
Price of
Aluminum
Demand
(private value)
Supply
(private cost)
Social cost
Qoptimum
Cost of
pollution
Equilibrium
Optimum
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Positive Externalities in
Production...
Quantity
of Robots
0
Price
of Robot
QOPTIMUM
Demand
(private value)
Supply (private cost)
Social cost
QMARKET
Value of
technology
spillover
Equilibrium
Optimum
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Consumption Externalities...
Quantity of
Education
0
Price of
Education
Q
MARKET
Demand
(private value)
Social
value
Q
OPTIMUM
(b) Positive Consumption Externality
Supply
(private cost)
Quantity
of Alcohol
0
Price
of Alcohol
Q
MARKET
Demand
(private value)
Supply
(private cost)
Social value
Q
OPTIMUM
(a) Negative Consumption Externality
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The Equivalence of Pigovian
Taxes and Pollution Permits...
Quantity of
Pollution
0
Price of
Pollution
P
Q
Demand for
pollution rights
Pigoviantax
(a) Pigovian Tax
2.,..which,together
with the demand curve,
determines the quantity
of pollution.
1,A Pigovian
tax sets the
price of
pollution...
Quantity of
Pollution
0 Q
Demand for
pollution rights
Supply of
pollution permits
(b) Pollution Permits
Price of
Pollution
P
2.,..which,together
with the demand curve,
determines the price
of pollution.
1,Pollution
permits set
the quantity
of pollution...