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Understanding Externalities and Market Inefficiency

Explore the impact of both positive and negative externalities on market efficiency, causes of overproduction and underproduction, spillover costs and benefits, and solutions such as taxes, subsidies, laws, and trading pollution credits.

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Understanding Externalities and Market Inefficiency

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  1. Externalities Chapter 10

  2. EXTERNALITIES • An externalityis the uncompensated impact of one person’s actions on another person • Both positive & negative externalities exist • All externalities cause markets to be inefficient • That is, markets do not maximize total surplus (welfare)

  3. Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs • Loud stereos in an apartment building • Noisy Students • Neighbor’s poorly maintained property

  4. Positive Externalties • Immunizations • Restored historic buildings • Research into new technologies • Neighbor’s well maintained property

  5. MC = MB MARKET INEFFICIENCY • Negative externalities lead markets to overproduce • Positive externalities lead markets to under-produce Supply Curve = Marginal Cost Curve Demand Curve = Marginal Benefit Curve

  6. Spillover Costs & Benefits • Spillover Costs-costs not captured by supply curve (MC) • Costs are understated • Spillover Benefits-benefits not captured by demand curve (MB) • Benefits are understated

  7. Supply = MCP External social Cost (private cost) Optimum Spillover Cost Equilibrium MC = MB Demand = MB (private value) QOPTIMUM QMARKET Negative Externality: Pollution MSC (social cost) Price of Aluminum P1 Quantity of 0 Aluminum

  8. External social benefit MC Optimum Equilibrium Spillover Benefit MB QOPTIMUM QMARKET Positive Externality: Neighbor paints House Price P1 MSB Quantity 0

  9. Solutions to Externalities • Internalizing an externality involves altering incentives • Government Methods • Taxes (corrective taxes), Subsidies • Patents • Laws (immunization laws, pollution laws) • Free market solution: • Trading pollution credits

  10. Worksheet • Externalities

  11. Taxing Negative Externalities Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output Total Cost = Total Benefit Total Cost = MSC (MCP + MCS)

  12. Subsidizing Positive Externalities Fuel Efficient Cars Impose Subsidy=spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit

  13. Day #2 • Practice Test

  14. Factory A Factory B

  15. Cap & Trade Analysis Goal: to reduce CO2 emissions Pollution Credits Trading System S D

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