Chapter 10

Externalities

Market Failure

Market failure is when the free market does not provide the best outcome for society.

Monopoly is a form of market failureMarket failure also comes from

externalities and public goodsThis chapter is about externalities; the

next chapter is about public goods.

What are Externalities?

Benefits or costs that are not considered by market buyers and sellers because they are not reflected in the relevant prices.

Positive vs. Negative Externalities

There are two types: positive and negative externalities.

A negative externality means that a cost is imposed on a third party (they didn’t take part in the transaction).

A positive externality means that a benefit is enjoyed by a third party (they didn’t take part in the transaction).

Externalities are Market Failure

An important point: Both negative and positive externalities represent market failure. (As we go through some examples later, you’ll see why).

This happens because of a lack of economic efficiency.

When does Economic Efficiency exist?

Efficiency exists when the price to consumers, reflecting marginal benefit, equals marginal cost; in other words, when a completely voluntary exchange between two parties creates no THIRD PARTY EFFECTS (No cost or benefit to a third party).

Negative Externalities

Air pollution is the classic example of a negative externality.

Say a tire factory produces air pollution. The factory doesn’t pay anything because of

the pollution. A cost is imposed on the surrounding

community (dirty air) even though some of those people don’t work at the factory or use the tires.

A Negative Externality is Market Failure

Since the factory doesn’t pay for the pollution it causes, the marginal social cost of the tires is larger from the firm’s private marginal costs.

Private marginal costs are paid by the producer.

The social marginal cost includes the cost to society from the externality.

A Negative Externality is Market Failure 2

Social welfare is maximized when marginal social benefit equals marginal social cost.

Social benefit means the sum of benefits to everyone, including both private benefits and external benefits.

Will the tire factory maximize social welfare?

A Negative Externality is Market Failure 3

The answer is no, the tire factory won’t maximize social welfare. Why not?

It will produce the amount of tires that maximizes profits, where MR=MC (but MC is just private, not social marginal costs).

What happens when External Costs are Ignored?Since the firm will not pay the cost of the

pollution, it will produce “too many” tires and cause too much pollution.

“Too many” tires does not mean a surplus.

A Graphical Representation

The following graphs show the short-run marginal cost curves and the long-run average cost curves for two firms; one pays private costs (typical) and the other pays both private and external costs (politically correct firm).

13

Private MC

P

Q

Social MC

QS QP

D

Why don’t the firms take care of this themselves, and just produce less tires OR produce the tires in a way the causes less pollution, if that’s possible?

They wouldn’t make as much money.

15

Private ATC

Long-run Average CostP

Q

Social ATC

PLR=LRPAC

QLR

How can the market failure be corrected?

One traditional way is to depend on the government.

The idea is that Government can step in and (somehow) take corrective action;

--which usually means imposing a tax or passing regulations. Passing a tax equal to the cost of the pollution per tire internalizes the externality.

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D

Using an Effluent Tax to Achieve Environmental EfficiencyP

Q

Social MC

Private MC

QS QC

PS

PC

tax

Results of Effluent Tax

Firm will produce less tires.The price of tires will go upIs this “fair”?Actually it is, because it’s the consumers’

“fault” that the tires are being produced.

What about Government Failure?

Government can fail, too. It might regulate too much, or make the taxes too high.

The government has an incentive to overestimate the tax because it gets the money!

Is the Efficient amount of Pollution typically Zero?No, the marginal social cost

of achieving one more unit of clean air is greater than the marginal social benefit

We would have to change everything to have zero pollution.

Emissions Auctions and Trading

Government-run auction that that allows firms to buy and sell the right to pollute. The price is determined by the free market.

Positive Externalities

A third-party receives a benefit even though they didn’t pay for it.

The marginal social benefit exceeds the private marginal cost. Therefore the good will be underproduced by

the free market There’s Market failure.

Positive Externalities 2

VaccinationsProperty ImprovementEducation

Coase Theorem

Coase wanted to explain why negative externalities occur.

It’s because of a lack of property rights.If you could own the air, air pollution would

not be an externality.

Coase Theorem 2

If property rights are well-defined and enforced, and transaction costs are low, the free market take care of any externalities.

Consider a lake with a factory on one side and a house on the other. If someone owns the lake, the free market will

make sure no externality exists.

Transaction Costs

The costs of negotiating and enforcing a contract

2 Interpretations of Coase Theorem

The free market (individualist) view:The vast majority of environmental problems

qualify for Coase Theorem solutions. The statist (big government) view:Only a small number of environmental

problems qualify for Coase Theorem solutions.