Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities Chapter 10 © 2002 by...

Principles of Microeconomics : Ch.10 Second Canadian Edition

Externalities

Chapter 10

© 2002 by Nelson, a division of Thomson Canada Limited


Overview

Externalities and Market Inefficiency

Private Solutions to ExternalitiesPublic Policies toward

Externalities


Market Efficiency: Chapter 7Under the assumptions of perfect

competition and no externalities, the economic well-being of a society is measured as:

The sum of consumer and producer surplus!

The invisible hand is powerful but not omnipotent, which leads to market failure.


Market Failure

If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.– Externalities cause markets to be

inefficient, and thus fail.


Externality — DefinedThe uncompensated

effects that the production or consumption of goods have on third parties.

The impact of one person’s actions on the well-being of a bystander!


Externality — Effect on Society In the presence of

externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . .

… the well-being of third parties are considered.


External Benefits — Positive Externalities

The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods.

The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.


External Costs — Negative Externalities

The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods.

The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.


Negative ExternalityAutomobile exhaustCigarette smoking

Positive ExternalityImmunizationsRestored historic buildings

Identify Some Negative and Positive Externalities


Externalities and Market Inefficiency - Negative Externalities

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 and Market Inefficiency - Graphical Example

Assume that the production process emits pollution — negative externality.

The cost to society of production is larger than the cost to the producer.

The Social Cost includes the private costs plus the costs to those bystanders adversely affected by the pollution.

Reflects in a new Supply Curve. . .



SupplyPrivate Cost

DemandPrivate Value

Q Market

Market output before accounting

for externality.

Price



DemandPrivate Value

Q Market

Supply

Social C

ost

Supply Private Cost

Price



DemandPrivate Value

Q Market

Supply

Social C

ostCost ofPollution -DecreasesSupply

Supply Private Cost

Price



The optimum outputaccounts for the

externality.

Q Optimum

Supply

Social C

ost

Q Market

Supply Private Cost

Price



The optimum outputaccounts for the

externality.

Supply

Social C

ostMarketOver-ProducesProduct

Q OptimumQ Market

Supply Private Cost

Price

Shaded area is dead weight loss from over-production



The intersection of the demand curve and the social-cost curve determines the optimal output level - less than equilibrium quantity.

Attainment of the Optimal OutputThe 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.


Externalities and Market Inefficiency - Positive Externalities

Positive externalities in production or consumption sometimes lead markets to produce a smaller quantity than is socially desirable.

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

This leads to market failure.


Positive Externalities and Market Inefficiency - Graphical Example

SupplyPrivate Cost

Q Market

DemandPrivate Value

Price


SupplyPrivate Cost

DemandPrivate Value

QMarket

Market output before accounting

for externality.


Price


SupplyPrivate Cost


Value of TechnologySpillover

Q Optimum

DemandPrivate Value

Q Market

Price


SupplyPrivate Cost


DemandPrivate Value

MarketUnder-ProducesProduct

Q Market Q Optimum

Price

Shaded area is dead weight loss from under-production



The intersection of the demand curve and the social-cost curve determines the optimal output level — more than equilibrium quantity.

Attainment of the Optimal OutputThe government can internalize the

externality by subsidizing the production — paying the producer to produce more than the equilibrium and eliminating the

dead weight loss.


Government Policy Toward Externality

In situations where market failure occurs because of externalities, the government will attempt to internalize the externality by:

imposing a tax on goods with a negative externality.– implementing a subsidy on goods with a

positive externality.


Quick QuizGive an example of a

negative externality and a positive externality.

Explain why market outcomes are inefficient in the presence of externalities.


Overview



Externalities


Private Solutions to ExternalitiesGovernment action is not always

needed to solve a problem of externalities.

Alternative private solutions:– Moral codes and social sanctions.

– Charitable organizations focused on dealing with an externality.

Examples of private solutions. . .


Private Solutions to ExternalitiesCoase Theorem:

– If private parties can bargain to their mutual advantage without cost, then the private market will always solve the problem of externalities and allocate resources efficiently.

– Private bargaining can internalize the external effects, resulting in efficient solutions.


Failure of Private Solutions Approach

Sometimes the private solutions approach will fail because:– The transaction costs can be so high that

private agreement is not possible.Transaction costs are the costs that parties

must incur to agree and follow through on a bargain.


Quick QuizGive an example of a

private solution to an externality.

What is the Coase theorem?

Why does the private solutions approach often fail?


Overview



Externalities


Public Policy Toward ExternalitiesWhen externalities are significant and

when private solutions are not possible or incomplete, government may attempt to solve the problem by:

Command-and-Control policies – Market-Based policies


Command-and-Control Policies

Usually in the form of regulations: – making certain behaviour forbidden

– making certain behaviour requiredExamples:

– All students must be immunized

– Stipulating levels of pollution emissions


Government use of taxes and subsidies to align private incentives with social efficiency.– Pigovian Taxes: designed to reflect the

social costs of a negative externality and internalize the external cost to the offending entity.

Market-Based Policies


Market-Based PoliciesTradable Pollution Permits: the

voluntary transfer of the right to pollute from one firm to another. – Pollution permits which results in a new

market for these permits.

– Firms that can reduce pollution most easily will be willing to sell their permit, for whatever they can get.


Externalities — ConclusionUncompensated effects that the

production or consumption of goods have on third parties are called externalities.– Negative externalities: results in market

equilibrium beyond the social optimum.

– Positive externalities: results in market equilibrium short of social optimum.


Externalities — Conclusion

Solutions to externalities can be accomplished:– through private agreements

– through government intervention


Overview


Private Solutions to Externalities Public Policies toward

Externalities

Principles of Microeconomics : Ch.10 Second Canadian Edition Externalities Chapter 10 © 2002 by...

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