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Externalities

Learn about externalities and market inefficiencies without regulation, Coase theorem, government intervention strategies, and examples of externalities as costs and benefits.

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Externalities

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  1. Externalities Today: Markets without ownership usually lead to inefficient outcomes

  2. Market failures • Previously • Monopolies • Cartels • Today: Ending Unit 4 • Externalities • Next week: Beginning Unit 5 • Applications of externalities

  3. Today • Externalities • Inefficiencies without regulation • The Coase theorem • Optimal amount of externalities • Some ways to reach more efficient solutions when externalities are present • Examples

  4. Externalities: Definition • External cost (benefit) • “A cost (benefit) of an activity that falls on people other than those who pursue the activity” (F/B p. 348) • What else is going on? • There is often no formal market for the cost or benefit in question • Private negotiation typically must occur to increase efficiency

  5. A market without regulation • Without regulation, consumers and producers only look at private costs and private benefits in order to decide on production and consumption

  6. A market without regulation • Notice that production of each unit of good leads to external costs external cost per unit

  7. What is efficient? • To find efficiency, we need to have no further possibilities to have beneficial exchange of a good or service • Social costs and benefits lead to overall efficiency • Too much is produced to be efficient, since social costs and benefits determine efficiency

  8. A market without regulation • Where is Social MB equal to Social MC? external cost per unit (= Social MB)

  9. A market without regulation • Where is Social MB equal to Social MC? Quantity E, Price B external cost per unit (= Social MB)

  10. A market without regulation • Production above quantity E results in lower efficiency, since Social MB is less than Social MC Private market forces will produce up to quantity F external cost per unit (= Social MB)

  11. A market without regulation • Deadweight loss shaded • These units produced have Social MC greater than Social MB external cost per unit (= Social MB)

  12. Why do we see inefficiencies? • Often, negotiation is costly • Example: A polluter in the Los Angeles metro area • Who owns the air? (Polluter or residents?) • If the polluter owns the air, the firm will not care about the residents • If the residents own the air, it is prohibitively costly to negotiate with every person affected by pollution

  13. Costly negotiation • Negotiation is typically costly • Remember, time is worth something • Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

  14. Coase theorem • The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur • People can negotiate costlessly • The right can be purchased and sold • Given the above conditions, efficient solutions can be negotiated Ronald Coase

  15. Coase theorem • Notice that the Coase theorem addresses efficiency • To get to efficiency, the quantity of most goods and services produced is still positive • Example: It is not efficient to get rid of all pollution • If all pollution was gone, we could not live (since we exhale CO2)

  16. Coase theorem and costly negotiation • Since negotiation is typically costly, we need government intervention to increase efficiency • Taxes • Quotas

  17. Government intervention • The government can estimate costs of negative externalities at relatively low cost • Based on these external costs, they can set a tax or quota to reduce the amount of the externality to an efficient level

  18. A market with regulation: Tax • The government can set a tax equal to the external cost per unit With tax equal to distance of vertical arrow: The efficient solution is achieved external cost per unit (= Social MB)

  19. A market with regulation: Marketable permits with resale • An alternative to a tax is to sell or distribute marketable permits • To be effective, these permits must be able to be sold and resold • Sale of permits guarantees that producers with lowest private MC can get permits

  20. A market with regulation: Marketable permits to sell • Quantity of permits available: E • Low-cost producers will buy permits if they do not have them external cost per unit (= Social MB)

  21. A market with regulation: Marketable permits to sell • Market price for the good will be B, since E units are being produced external cost per unit (= Social MB)

  22. Remember • I have gone through the case where externalities are costs • Externalities can be either costs or benefits, however • When there are positive externalities, subsidies can help to increase efficiency

  23. Examples of externalities as costs • Particulate matter and gases released from driving cars • Freeway noise • Washing you car in your driveway, followed by hosing the soap off • Soap goes into storm drains, polluting the ocean

  24. Examples of externalities as benefits • Planting flowers in your front lawn • Scientific research • Finding information that is useful to a group of people • Example: One person finds the fastest route for a trip that many people will be taking; everyone can use this information to their benefit

  25. Examples of externalities:Cost or benefit? • Christmas decorations • A fan blowing in a warm office building • Use of perfume or cologne

  26. An algebraic example • Suppose Private MC equals production  MC = Q • Let Demand be denoted by P = 100 – Q • Let External Cost be $10 per unit

  27. An algebraic example MCSocial = Q + 10 • Translate equations and External Cost to our graphical example MC = Q external cost per unit of $10 P = 100 – Q

  28. An algebraic example:Private equilibrium • Inefficient equilibrium w/o controls: Set Q = 100 – Q  Q = 50 (quantity F) MC = Q P = 100 – Q

  29. An algebraic example:Socially optimal equilibrium MCSocial = Q + 10 P = 100 – Q • Socially optimal equilibrium: Set • Q + 10 = 100 – Q  Q = 45 (quantity E)

  30. An algebraic example: Price MCSocial = Q + 10 • Inefficient equilibrium, P = Q  P = 50 • Socially optimal equilibrium, P = Q + 10  P = 55 MC = Q Price B = 55 external cost per unit of $10 Price C = 50 P = 100 – Q Recall E = 45 and F = 50

  31. This concludes basic externality theory • Upcoming applications… • Wednesday • Congestion in cities and on highways • Friday • Tragedy of the Commons • Environmental and safety regulation

  32. Summary • When external costs or benefits enter a market, private equilibrium is usually inefficient • A tax or quota can be set to lead to efficient equilibrium when a negative externality occurs • Subsidies can improve efficiency with positive externalities

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