EEP 1/ECON 3 2015 Section 6 Externalities and Public Goods Qu Tang Chapter 10: Externalities I. Definition of externality: the uncompensated impact of one person’s actions on the well-being of a bystander. II. Externalities and Market Inefficiency A. Welfare Economics: A Recap • The demand curve for a good reflects the value of that good to consumers, measured by the price that the marginal buyer is willing to pay. • The supply curve for a good reflects the cost of producing that good. • In a free market, the price of a good brings supply and demand into balance in a way that maximizes total surplus (the difference between the consumers’ valuation of the good and the sellers’ cost of producing it). B. Negative Externalities Example: An aluminum firm emits pollution during production. • Because the supply curve does not reflect the true cost of producing aluminum, the market will produce more aluminum than is optimal. • This negative externality could be internalized by a tax on producers for each unit of aluminum sold. • Definition of internalizing an externality: altering incentives so that people take account of the external effects of their actions.
C. Positive Externalities Example: electric vehicle (reduce green house gas emissions and improve local air quality) III. Public Policies Toward Externalities A. When an externality causes a market to reach an inefficient allocation of resources, the government can respond in two ways: a) Command-and-control policies; b) Market-based policies. B. Command-and-Control Policies: Regulation C. Market-Based Policy 1: Corrective Taxes and Subsidies • Externalities can be internalized through the use of taxes and subsidies. • Definition of corrective tax: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality. These taxes are preferred by economists over regulation, because firms that can reduce pollution with the least cost are likely to do so (to avoid the tax) while firms that encounter high costs when reducing pollution will simply pay the tax. D. Market-Based Policy 2: Tradable Pollution Permits Tradable pollution permits and corrective taxes are similar in effect. In both cases, firms must pay for the right to pollute. a. In the case of the tax, the government basically sets the price of pollution and firms then choose the level of pollution (given the tax) that maximizes their profit. b. If tradable pollution permits are used, the government chooses the level of pollution (in total, for all firms) and firms then decide what they are willing to pay for these permits.
IV. Private Solutions to Externalities A. The Types of Private Solutions 1. Problems of externalities can sometimes be solved by moral codes and social sanctions.
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- Fall '12
- Pollution, Market failure, Externality, tradable pollution permits