Externalities

Externalities

What is an externality? the uncompensated impact of one person's actions on

the well-being of a bystander (or 3rd party)Two Types of Externalities

Negative Externality If the impact on the bystander is adverse, it is called a

negative externality. Positive Externality

If the impact on the bystander is beneficial, it is called apositive externality.

Examples

Negative Externalities pollution from power plants exhaust from automobiles noise from airplanes or barking dogs

Positive Externalities restored historic buildings new technologies inoculations

Examples

How does an externality create a market failure? Supply and demand do not account for the external

effects on 3rd parties. If they did, equilibrium would change.

Price

Quantity

S (private cost)

D

Market for Aluminum

QMARKET

S (social cost: private cost + external cost)

ExternalCost

QOPTIMAL

Note: The market quantity isabove the optimal quantity.Society produces too much!(Society over-allocates resources to this activity)

Note: When considering the external costs, the last consumer at the equilibrium quantity is not willing to pay the costs to society for producing that same quantity.

Price

Quantity

S

D (private value)

Market for Flu Shots

QMARKET

D (private value + social benefit)

ExternalBenefit

Note: The market quantity is

Below the optimal quantity.

Society produces too little!

(Society under-allocates resources to this activity)

QOPTIMAL

Note: At the market equilibrium, there are still more Pareto Improvements to be made.

Correcting Externalities

Negative Externalities Society produces too much

Positive Externalities Society produces too little

With too much or too little, we have a market failure. What can be done? Public Solutions

Command & Control Policies, Market Based Solutions Private Solutions

Moral codes and social sanctions, Charities, Contracts

Correcting Externalities

Command and Control Policies In other words, government regulations

Many government regulations attempt to correct negative externalities by making the activity illegal. (example: against the law to dump poison into the city’s

water supply)

Correcting Externalities

Market based solutions In other words, government taxes and subsidies Usually considered to be a “corrective tax” or

“corrective subsidy”

Negative Externalities Pigovian taxes (ideally a corrective tax would be

imposed exactly equal to the external cost)Positive Externalities

Pigovian subsidy (ideally a corrective subsidy would be imposed exactly equal to the external benefit)

Price

Quantity

S (private cost)

D

Market for Aluminum

QMARKET

S (social cost: private cost + social cost)

QOPTIMAL

How large of a Pigouvian tax is required to correct this negative externality?

$50

$45

$40

Objections to the Economic Analysis of Pollution

"We cannot give anyone the option of polluting for a fee.“ -- Senator Edmund Muskie

Economists have little sympathy for this type of argument. To economists, good environmental policy begins by acknowledging the first of the Ten Principles of Economics in Chapter 1: People face trade-offs.

Consider transportation. All forms of transportation produce pollution, even horses! We should weigh the benefits and costs in determining policy toward externalities

Private Solutions to Externalities

Moral codes and social sanctions “Do unto others as you would have them do unto you”

Charities Appalachian Mountain Club, Appalachian Trail

Conservancy, Appalachian Voices, etc…

Contracts The parties involved my enter into a contract in an attempt

to make everyone agree to a situation in which they are all better-off.

Private Solutions to Externalities

Coase Theorem suggests that private market solutions to externalities can

be very effective in some circumstances

The Coase theorem says that private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient.

(Note: Coase Theorem generally requires bargaining with zero opportunity cost, such as not hiring a lawyer at $100 an hour)