© 2007 Thomson South-Western
EXTERNALITIES AND MARKET INEFFICIENCY
• An externality is …– the uncompensated impact of one person’s actions
on the well-being of a bystander.
• Externalities – cause markets to be inefficient– fail to maximize total surplus
© 2007 Thomson South-Western
EXTERNALITIES AND MARKET INEFFICIENCY
• Negative externality – adverse impact on the bystander
• Positive externality– beneficial impact on the bystander
© 2007 Thomson South-Western
EXTERNALITIES AND MARKET INEFFICIENCY
• Negative Externalities– Automobile exhaust– Barking dogs (loud
pets)– Industrial pollution
© 2007 Thomson South-Western
EXTERNALITIES AND MARKET INEFFICIENCY
• Positive Externalities– Immunizations– Restored historic buildings– Research into new technologies
© 2007 Thomson South-Western
Costs and Benefits of Pollution• Marginal Social Cost (MSC) is …
– Additional cost imposed on
society when one more unit
is produced.
MSC is our S curve.
© 2007 Thomson South-Western
Costs and Benefits of Pollution• Marginal Social Benefit (MSB) is …
– Additional benefits received by
society when one more unit
is produced.
MSB is our D curve.
© 2007 Thomson South-Western
MSC and MCB of Pollution
Quantity ofPollution emitted (tons)
0
MSC and MSB of Pollution
MSB
MSC
QOPT
MSC = MSB
© 2007 Thomson South-Western
Costs and Benefits of Pollution
Will society, left unregulated, come to the optimal amount of pollution?
NO
© 2007 Thomson South-Western
The External Cost of Pollution
A power plant is located in the Ohio River Valley.
Who benefits?
Who pays the costs?
Benefits Costs
Producers Environment
Consumers Non-consumers
© 2007 Thomson South-Western
The External Cost of Pollution
External Costs are those ‘we’ pay when we are NOT benefitting from an externality. (Negative externality)
© 2007 Thomson South-Western
MSC, MSB in an Unregulated Market
Quantity ofPollution emitted (tons)
0
MSC and MSB of Pollution
MSB
MSC
QOPTQOPT
MSC = MSB
$1000
QMKT
© 2007 Thomson South-Western
PRIVATE SOLUTIONS TO EXTERNALITIES
• Government action is not always needed to solve the problem of externalities.
• Types of Private Solutions– Moral codes and social sanctions– Charitable organizations– Integrating different types of businesses– Contracting between parties
© 2007 Thomson South-Western
The Coase Theorem
• Coase theorem states a private solution may be found as long as …• property rights are clearly defined• Transactions costs are minimal
• Transaction costs are incurred when parties• agreeing to and • following through on a bargain
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Why Private Solutions Do Not Always Work
• Transaction costs are too high • Communication costs• Legal costs• Delays in bargaining
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PUBLIC POLICIES 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
• Corrective taxes
• Permits
© 2007 Thomson South-Western
Command-and-Control Policies: Regulation
• 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).
© 2007 Thomson South-Western
Market-Based Policy : Corrective Taxes
• Corrective taxes (Pigovian taxes) are taxes enacted to correct the effects of a negative externality.
© 2007 Thomson South-Western
Tax on Pollution
Quantity ofPollution emitted (tons)
0
MSC and MSB of Pollution
MSB
MSC
QOPTQOPT
$500
QMKT
tax
© 2007 Thomson South-Western
Tax on Pollution
• Tax ABOVE MSB curve• Cheaper for firms to ‘fix’ the problem• Pollution will be reduced to the socially optimal
amount• Financial incentive to ‘fix’ the problem
© 2007 Thomson South-Western
Market-Based Policy : Tradable Pollution Permits
• Tradable pollution permits • voluntary transfer of the right to pollute from one
firm to another • 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.
• Sam amount of pollution is reduced.
© 2007 Thomson South-Western
Positive Externalities
Positive Externality happens when …
• The production and consumption of a good also benefits 3rd parties.• Immunization• Home improvement
© 2007 Thomson South-Western
Private v. Social Benefits
Total Social Benefit =
Total Private Benefit + Total External Benefit mine + yours
© 2007 Thomson South-Western
Private v. Social Benefits
Marginal Social Benefit =
Marginal Private Benefit (MPB) +
Marginal External Benefit (MEB)
© 2007 Thomson South-Western
Private v. Social Benefits
Quantity ofHome Improvements
0
Price, MSB
MSB
MSC
QOPT
QOPT
P OPT
QMKT
P MSB
P MKT
Q MKT
MPB
MEB = MSB - MPB
© 2007 Thomson South-Western
Private v. Social Benefits
Market Outcome:
• Equilibrium = MPB intersects QMKT
• MPB is ONLY for those who consume the G/S
• MPB + MEB = MSB• Society is willing to pay at this level• Market under produces which generate positive
externalities.
• QMKT is higher at PMSB
• Socially Optimal Outcome = MSB = MSC
© 2007 Thomson South-Western
Private v. Social Benefits
Dead Weight Loss:
• How could we eliminate Dead Weight Loss?• Subsidy (Pigouvian subsidy)
• Voucher for home improvement goods
• Increases consumer willingness to pay
© 2007 Thomson South-Western
Subsidy Effect
Quantity ofHome Improvements
0
Price, MSB
MSB
S
QOPT
QOPT
P MKT
QMKT
P OPT
PCON
Q MKT
MPB
Subsidy
© 2007 Thomson South-Western
Private v. Social Costs
Total Social Cost =
Total Private Cost + Total External Costmine + yours
© 2007 Thomson South-Western
Private v. Social Benefits
Marginal Social Cost =
Marginal Private Cost (MPC) +
Marginal External Cost (MEC)
© 2007 Thomson South-Western
Private v. Social Costs
Quantity ofElectricity
0
Price, MSC
MSB
MSC
P OPT
QMKT
P MKT
P FIRM
Q MKT
D
MPC
© 2007 Thomson South-Western
Private v. Social Benefits
Market Outcome:
• Equilibrium = MPC intersects QMKT
• MPC is ONLY for those who incur the costs
• MPC+ MEC = MSC• Society is willing to pay at this level• Market over produces what generates negative
externalities.
• Socially Optimal Outcome = MSB = MSC
© 2007 Thomson South-Western
Private v. Social Benefits
Dead Weight Loss:
• How could we eliminate Dead Weight Loss?• Tax (Pigouvian subsidy)
• Increases each firm’s MPC
© 2007 Thomson South-Western
Effect of a Tax
Quantity ofElectricity
0
Price, MSC
MSB
MSC
P OPT
QMKT
P MKT
P FIRM
Q MKT
D
MPC
Tax
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