In this chapter, look for the answers to these questions: § What is an externality? § Why do externalities make market outcomes inefficient? § What public policies aim to solve the problem of externalities? § How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? 0
EXTERNALITIES 1 Introduction § One of the principles from Chapter 1: Markets are usually a good way to organize economy activity. In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. § One type of market failure: externality , the uncompensated impact of one person’s actions on the well-being of a bystander. § Externalities can be negative or positive , depending on whether impact on bystander is adverse or beneficial.
EXTERNALITIES 2 Introduction § Self-interested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient. § Another principle from Chapter 1: Governments can sometimes improve market outcomes. In presence of externalities, public policy can improve efficiency.
EXTERNALITIES 3 Examples of Negative Externalities § Air pollution from a factory § The neighbor’s barking dog § Late-night stereo blasting from the dorm room next to yours § Noise pollution from construction projects § Health risk to others from second-hand smoke § Talking on cell phone while driving makes the roads less safe for others
EXTERNALITIES 4 0 1 2 3 4 5 0 10 20 30 Q (gallons) P $ The market for gasoline Recap of Welfare Economics Demand curve shows private value , the value to buyers (the prices they are willing to pay). Supply curve shows private cost , the costs directly incurred by sellers. The market eq’m maximizes consumer + producer surplus. $2.50 25
EXTERNALITIES 5 0 1 2 3 4 5 0 10 20 30 Q (gallons) P $ The market for gasoline Analysis of a Negative Externality Supply (private cost) External cost = value of the negative impact on bystanders = $1 per gallon (value of harm from smog, greenhouse gases) Social cost = private + external cost external cost
EXTERNALITIES 6 0 1 2 3 4 5 0 10 20 30 Q (gallons) P $ The market for gasoline Analysis of a Negative Externality D S Social cost The socially optimal quantity is 20 gallons. At any Q < 20, value of additional gas exceeds social cost. At any Q > 20, social cost of the last gallon is greater than its value to society. 25
EXTERNALITIES 7 0 1 2 3 4 5 0 10 20 30 Q (gallons) P $ The market for gasoline Analysis of a Negative Externality D S Social cost Market eq’m ( Q = 25) is greater than social optimum ( Q = 20). 25 One solution: tax sellers $1/gallon, would shift S curve up $1.
EXTERNALITIES 8 “Internalizing the Externality” § Internalizing the externality : altering incentives so that people take account of the external effects of their actions § In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs.
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- Externalities, Market failure, DICK, Externality