Introduction to Externalities

1. Module Micro: Econ: 38 74 Introduction to Externalities • KRUGMAN'S • MICROECONOMICS for AP* Margaret Ray and David Anderson

2. Housekeeping & Homework • Factor exams graded. Review Wed. • Read Module 75 – 736-740 • Then read Module 75 pages 731-735, and Module 74.

3. What you will learnin thisModule: • What externalities are and the difference between positive and negative externalities. • Why externalities can lead to inefficiency in a market economy. • The importance of the Coase theorem, which explains how private individuals can sometimes find a solution to externalities.

4. External Costs • External Cost – an uncompensated cost that an individual or firm imposes on others • Also called a negative externality • Example – pollution from electrical utilities.

5. External Benefits • External Benefit – an uncompensated benefit that an individual or firm provides to others • Also called a positive externality • Example – flu shots.

6. Your Turn • Negative side – each pair comes up with one example of a negative externality. • Positive side – each pair comes up with one example of a positive externality.

7. Marginal Social Cost • How economists measure the total cost to society of one more unit. • Marginal Private Cost (MPC) • Marginal External Cost (MEC) • MPC + MEC = Marginal Social Cost (MSC)

8. Example – Electric Utility • Cost of coal $60 per ton = MPC • Health costs of pollution $40 per ton = MEC • MPC + MEC = Marginal Social Cost • $60 + $40 = $100

9. Marginal Social Benefit • How economists measure the total benefit to society of one more unit. • Marginal Private Benefit (MPB) • Marginal External Benefit (MEB) • MPB + MEB = Marginal Social Benefit (MSB)

10. Example – Flu Shots • Benefit per person (work days saved) $100 = MPB • Additional people that don’t get sick per immunization ($50) = MEB • MPB + MEB = Marginal Social Benefit • $100 + $50 = $150

11. Socially Optimal Output Marginal Social Benefit = Marginal Social Cost.

12. What happens to optimal output with externalities? • One desk partner takes question # 7a-b • The other # 4 a-c • Create supply and demand curve. Add in MSC or MSB curve. • How does the socially optimal output compare with market equilibrium? For positive externality vs. negative?

13. Negative Externalities MSC MPC Popt Pmkt D Under negative externalities the market produces more than the socially optimal quantity. Qopt Qmkt Price, MSC Qty steel

14. Positive Externalities S Popt Pmkt MSB MPB Under positive externalities the market produces less than the socially optimal quantity. Qmkt Qopt Price, MSB Qty education

15. Private Solutions to Externalities • The Coase Theorem – when externalities exist private bargaining between individuals/firms can result in an efficient solution provided there are: • Defined property rights • Low transaction costs • Generally limited number of negotiating parties Example: Neighbor’s barking dog.

16. Your Turn • Your and your partner come up with an externality case. • Each case should have two parties and an MEC or MEB. • We will swap partners and role play to see who can come up with a Coase solution.

17. Summary Positive vs. negative externalities MSC = MPC + MEC MSB = MPB + MEB Private markets lead to: • Overproduction if negative externalities • Underproduction if positive externalities Private solutions (Coase Theorem)

18. Exit Ticket • Do Problem #1 a-d • Identify MSC or MSB • How does market result compare with socially optimal result?

19. World of Externalities • Take note of each externality mentioned in the video. • Would a Coase solution work in these cases? Why? Why not? Nature and American Values - Economic Externalities B - Fall '10 - Video #8 - YouTube