242topic6

242topic6 - Topic 6 Externalities and Public Goods An...

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Topic 6: Externalities and Public Goods An externality is created when the actions of participants in a private market affect the well being of someone not directly associated with that market. Consider the market for paper. Paper creates a byproduct in its production called dioxin. Dioxin affects innocent bystanders by causing cancer and birth defects. This is a negative externality in production because the paper firm doesn’t consider this cost to society when making production decisions. Since these negative externalities affect innocent by-standers, the cost to society is greater than the cost to firms. Price, $ S (Social Cost) S (Private Cost) D(Private Value) Q E Q* Quantity of Paper Consider the market for historic buildings and homes. These buildings and homes create positive externalities in consumption because bystanders value historic homes – their beauty and sense of history. Thus, society’s value of the homes is greater than that to the owners of the buildings. Price, $ S (Private and Social Cost) D (Social Value) D (Private Value) Q* Q E Historic Homes and Buildings Consider alcohol, which creates a negative externality in consumption where the value to society is less than the value to consumers (because of car wrecks, injuries to others, and violence). Price, $
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S (Private and Social Cost) t D (Private Value) D (Social Value) Q E Q* Alcohol But, we can achieve the efficient market outcome by taxing consumption of alcohol. This explains why alcohol is one of the most highly taxed goods. Consider education, which creates a positive externality in consumption. That is, education’s value to society is greater than the value to private consumers. More education equates with a better informed populace, better government, better behavior, and better citizenship. Price, $ S (Private and Social Cost) S D (Social Value) D (Private Value) Q* Q E Education We can internalize the externality by subsidizing education. This explains why education is one of the most highly subsidized goods. Now, go back to the first two examples. What could the government do to internalize the externality created by the consumption of historic homes and buildings? What could the government do to internalize the externality created by the production of paper? Actually, there are three options: The Environmental Protection Agency (EPA) could: 1. Prohibit pollution all together by setting quotas (q = 0). 2. Regulate paper quantity to be q = q E . 3. Tax paper production. Economists prefer the tax. This is because: 1. The tax raises revenue. 2
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2. With regulations, firms have no incentive to reduce Q below the regulated level. With taxes, factories have incentives to develop better/cleaner technologies. 3.
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242topic6 - Topic 6 Externalities and Public Goods An...

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