0123450102030Q(gallons)P$The market for gasolineAnalysis of a Negative ExternalityDSSocial costThe socially optimal quantity is 20 gallons.The socially optimal quantity is 20 gallons.At any Q< 20, value of additional gas exceeds social cost. At any Q< 20, value of additional gas exceeds social cost. At any Q> 20, social cost of the last gallon isgreater than its value to society.At any Q> 20, social cost of the last gallon isgreater than its value to society.25
From the previous slide:“At any Q < 20, value of additional gas exceeds social cost.” For example, at Q = 10, the value to buyers of an additional gallon equals $4, while the social cost is only $2. Therefore, total surplus (society’s well-being) would increase with a larger quantity of gas. “At any Q > 20, social cost of the last gallon is greater than its value.” For example, at Q = 25 (the market equilibrium) the last gallon cost $3.50 (including the external cost) but the value of it to buyers was only $2.50. Hence, total surplus would be higher if Q were lower. Only at Q = 20 is society’s welfare maximized.
0123450102030Q(gallons)P$The market for gasolineAnalysis of a Negative ExternalityDSSocial costMarket eq’m (Q= 25)is greater than social optimum (Q= 20).25One solution: tax sellers $1/gallon,would shift Scurve up $1.
“Internalizing the Externality”Internalizing the externality: altering incentives so that people take account of the external effects of their actionsIn our example, the $1/gallon tax on sellers makes sellers’ costs = social costs.When market participants must pay social costs, market eq’m = social optimum. (Imposing the tax on buyers would achieve the same outcome; market Qwould equal optimal Q. Recall: tax incidence and the allocation of resources is the same whether a tax is imposed on buyers or sellers.)
Examples of Positive ExternalitiesBeing vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you. R&D creates knowledge others can use.People going to college raise the population’s education level, which reduces crime and improves government.And, especially important in an election year: a better educated population makes more informed voting decisions and elects higher quality lawmakers and leaders.
Positive ExternalitiesIn the presence of a positive externality, the social valueof a good includesprivate value– the direct value to buyersexternal benefit– the value of the positive impact on bystandersThe socially optimal Qmaximizes welfare:At any lower Q, the social value of additional units exceeds their cost.At any higher Q, the cost of the last unit exceeds its social value.