Externalities

1. Externalities

2. Externalities • Governments can sometimes improve market outcomes • Why do markets fail to allocate resources efficiently? • How can government policies improve market’s allocation?

3. Externalities • Market failure occurs as a result of • Market power • Externalities • Externality is the uncompensated impact of one person’s action on the well-being of a bystander • Adverse impact on the bystander is called a negative externality • Beneficial impact on the bystander is called a positive externality

4. Externalities and Market Inefficiency • Externalities cause markets to be inefficient, and thus fail. • Demand curve reflects the value to the buyers and supply curve reflects the cost to the seller • At market equilibrium, total surplus is maximized • In the absence of externalities, market equilibrium is efficient • Both decision-makers fail to take account of the external effects of their behavior

5. Negative Externalities in Production • Negative externalities in production or consumption sometimes lead markets to produce a larger quantity than is socially desirable. • The Social Costsof production or consumption are greater than the private cost or private benefit by producers and consumers. This leads to market failure.

6. Negative Externalities in Production • Due to the negative externality, social cost is greater than private cost • Social cost is the cost to the society of producing a product with a negative externality • The difference between social cost and private cost is the cost of the negative externality • The intersection between the demand curve and the social cost curve gives the optimum level of production

7. Negative Externalities in Production • In the presence of a negative externality: • Social cost> private cost • Optimum quantity < market equilibrium quantity • The reduction in production raises economic well-being • Economic well-being can be measured using the concept of deadweight loss • Deadweight lossis the fall in total surplus that results from a market distortion, such as tax or tariff.

8. Economic welfare • At market equilibrium, welfare is equal to the total surplus • Producer surplus is measured as amount received by the sellers- social cost to the society • At optimal quantity of production, consumer surplus is reduced but producer surplus increases • The dead weight loss of producing at market equilibrium level rather than at optimal level is equal to the area of the triangle formed by the social-cost curve and demand curve

9. Economic welfare • The dead weight loss is associated with the negative production externality • Pigovian taxes: • The government can internalize the externality by imposing a tax on the producer. The tax shifts private cost supply up to social cost supply and eliminates the deadweight loss. • Internalize an externality means to alter incentives so that people take account of the external effects of their actions • Pigoviantaxes are enacted to correct the effects of the negative externalities

10. Positive Externalities in Production • Social cost of production = Private cost - technology spillover • The optimal quantity is larger than the equilibrium market quantity • The positive externality can be internalized by imposing a Pigovian subsidy • Patents are an example of internalizing positive externalities

11. Externalities in Consumption • The analysis of consumption externalities is similar to that of production externalities • The demand curve does not reflect the value of the good from society’s point of view • Negative consumption externality (tax) • Positive consumption externality (subsidy)

12. Externalities : Conclusion • 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 smaller quantity than is socially desirable. • Government can internalize externalities by • Levying a tax on goods with negative externalities • Imposing a subsidy on goods with positive externalities

13. Private Solutions to Externalities • Is it possible for private actors to allocate resources at the social optimum level? • Types of private solutions: • Moral codes and social sanctions • Charities • Self-interest of involved/relevant parties • Integration of different types of business • Contracts

14. Private Solutions to Externalities • The Coase theorem proposes that if private parties can bargain without cost over the allocation of resources, they can solve the problems of externalities on their own. • The Coase theorem says that whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient.

15. Private Solutions to Externalities • Why private solutions do not always work? • Transaction costs are costs that parties incur in the process of agreeing and following through on a bargain • Coordination costs increase as the number of interested parties increase • Government is an institution designed for collective action

16. Public Policies Toward Externalities • Regulation- dictating maximum level/ adopting a particular technology • Pigovian taxes and subsidies • Pigovian taxes and subsidies are more efficient than regulation as they achieve the same result by conferring a lower cost on the society • Tradable pollution permits- limits the supply of pollution permits and the demand curve sets the price for pollution • Pigovian Tax- sets a price on pollution and the demand curve determines the quantity of pollution

17. Should economics be used in the analysis of pollution? • Hint: People face tradeoffs and if clean environment is treated as a commodity ???