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Unformatted text preview: -1-1Chapter 4Negative Externalities and PolicyContents:General OverviewProduction ExternalitiesPolicy 1: Externality TaxPolicy 2: Output-reduction SubsidyPolicy 3: StandardsElasticity Effects on Magnitude of ExternalitiesImperfect Competition and Externality PolicyConsumption ExternalitiesExternalities from Cigarette SmokingThe Economics of Illicit DrugsGeneral OverviewAn externality can only exist when the welfare of some agent, or group of agents,depends on an activity under the control of another agent. Under these circumstances, anexternality arises when the effect of one economic agent on another is not taken into accountby normal market behavior. Externalities are a type of market failure. When an externality exists, the prices in amarket do not reflect the true marginal costs and/or marginal benefits associated with thegoods and services traded in the market. A competitive economy will not achieve a Paretooptimum in the presence of externalities, because individuals acting in their own self-interestwill not have the correct incentives to maximize total surplus (i.e., the invisible hand ofAdam Smith will not be pushing folks in the right direction). Because competitivemarkets are inefficient when externalities are present, governments often take policy actionin an attempt to correct, or internalize, externalities.Externalities may be related to production activities, consumption activities, or both.Production externalities occur when the production activities of one individual impose a costor benefit on other individuals that are not transmitted accurately through a market. Let usfirst examine production externalities, for example, air pollution from burning coal, groundwater pollution from fertilizer use, or food contamination and farm worker exposure to toxicchemicals from pesticide use. We will then analyze the case of consumption externalities,which occur when the consumption of an individual imposes costs or benefits on otherindividuals that are not accurately transmitted through a market.Production ExternalitiesTo motivate the concept of a production externality, consider the followingexamples:A farmer takes irrigation water out of a river before it reaches a wildlife refuge.The farmers actions reduce the flow of water reaching the wetland, whichreduces the amount of wetland acreage available to waterfowl. Consequently,fewer birds are attracted to the refuge, which decreases the utility ofbirdwatchers. If farmers had to account for the value of the lost utility tobirdwatchers (i.e., there was a price associated with a reduction in birds), theywould probably reduce the amount of irrigation water they pumped from theriver.A more common example is the case of a firm polluting an air or water source as aby-product of production. Examples here include, the production of refrigeratorsusing CFCs, a coal-burning electricity plant (NOxand SOx), or a paper mill, which-2-2dumps chlorine bleach into a river as a by-product of producing white office paper.dumps chlorine bleach into a river as a by-product of producing white office paper....
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This document was uploaded on 02/03/2011.
- Spring '09