Externalities

Externalities

Governments can sometimes improve market outcomes

Why do markets fail to allocate resources efficiently?

How can government policies improve market’s allocation?

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

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

Negative Externalities in Production Negative externalities in production or

consumption sometimes lead markets to produce a larger quantity than is socially desirable.

The Social Costs of production or consumption are greater than the private cost or private benefit by producers and consumers.

This leads to market failure.

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

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 loss is the fall in total surplus that results from a market distortion, such as tax or tariff.

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

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

• Pigovian taxes are enacted to correct the effects of the negative externalities

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

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)

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

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

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.

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

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

Should economics be used in the analysis of pollution?

Hint: People face tradeoffs and if clean environment is treated as a commodity ???