Externalities Externalities and Solutionsand Solutions

Joyce JihJoyce JihVicky LiuVicky Liu[1[1stst hour] hour]

What is an What is an externality?externality?• The uncompensated impact of The uncompensated impact of

one person’s actions on the well-one person’s actions on the well-being of a bystander.being of a bystander.

• Arises when a person engages in Arises when a person engages in an activity that influences the an activity that influences the well-being of a bystander and well-being of a bystander and yet neither pays nor receives yet neither pays nor receives any compensation for that any compensation for that effect.effect.

• Results in market inefficiency or Results in market inefficiency or market failures.market failures.

• Two types: negative and Two types: negative and positive.positive.

Negative ExternalityNegative Externality•The impact on the bystander The impact on the bystander

is adverse.is adverse.•The social-cost curve includes The social-cost curve includes

external costs to affected external costs to affected bystanders.bystanders.

•The cost to society is larger The cost to society is larger than the cost to the than the cost to the suppliers. Difference suppliers. Difference between the two curves between the two curves reflects the cost of the reflects the cost of the externality.externality.

•The optimal quantity is where The optimal quantity is where the social-cost curve crosses the social-cost curve crosses the demand curve.the demand curve.

•Equilibrium quantity is larger Equilibrium quantity is larger than optimal quantity.than optimal quantity.

Negative Externality Negative Externality GraphGraph

Positive Positive Externalities Externalities

[a beneficial impact on the [a beneficial impact on the well-being of a bystander well-being of a bystander

who doesn’t pay or receive who doesn’t pay or receive any compensation for that any compensation for that

effect]effect]

AnalysisAnalysis• Demand curve doesn’t reflect value to Demand curve doesn’t reflect value to

society.society.• Social value>private value, social value Social value>private value, social value

curve is above the demand curve. curve is above the demand curve. • Optimal quantity is found where social-Optimal quantity is found where social-

value curve and supply curve intersectvalue curve and supply curve intersect• *Socially optimal quantity is greater *Socially optimal quantity is greater

than the quantity determined by the than the quantity determined by the private market*private market*

Positive Externality GraphPositive Externality Graph

EducationEducation• More educated population leads to More educated population leads to better government.better government.

• Productivity benefit of education not Productivity benefit of education not necessarily an externality; consumer necessarily an externality; consumer reaps benefits in form of higher wagesreaps benefits in form of higher wages

• If some of productivity benefits spill If some of productivity benefits spill over and benefit other people, this over and benefit other people, this would count as a positive externality as would count as a positive externality as well.well.

• Heavily subsidized through public Heavily subsidized through public schools and government scholarshipsschools and government scholarships

Restored Restored Historic Historic

BuildingsBuildings• People who walk or ride by them can People who walk or ride by them can enjoy their beauty and sense of enjoy their beauty and sense of history that the buildings providehistory that the buildings provide

• Building owners tend to discard Building owners tend to discard older buildings too quickly.older buildings too quickly.

• Local governments regulate Local governments regulate destruction of historic buildings by destruction of historic buildings by providing tax breaks to owners who providing tax breaks to owners who restore them.restore them.

Technology SpilloverTechnology Spillover• Creates knowledge that others can use.Creates knowledge that others can use.• Inventors can not capture the full Inventors can not capture the full

benefits of their inventions so they tend benefits of their inventions so they tend to devote too few resources to research.to devote too few resources to research.

• Industrial Policy: Some believe that Industrial Policy: Some believe that government should encourage government should encourage industries that yield largest spillovers. industries that yield largest spillovers. Others believe that there are no precise Others believe that there are no precise measurements and industries with most measurements and industries with most political clout will receive the most political clout will receive the most subsidies.subsidies.

Technology Technology Spillover: Spillover: Solutions Solutions • Government can Government can subsidize subsidize the the

production of the certain technology production of the certain technology [supply curve would shift down by the [supply curve would shift down by the amount of subsidy, therefore, amount of subsidy, therefore, increasing the equilibrium of robots. increasing the equilibrium of robots. Subsidy = value of technology spillover]Subsidy = value of technology spillover]

• Patent protection Patent protection give inventors give inventors exclusive use of their inventions for a exclusive use of their inventions for a period of time, which captures much of period of time, which captures much of economic benefit, give firms greater economic benefit, give firms greater incentive to engage in researchincentive to engage in research

Private SolutionsPrivate Solutions• Moral codes and social sanctions.Moral codes and social sanctions.

oPeople don't litter because it's the People don't litter because it's the wrong thing to do.wrong thing to do.

• Charities are funded with private Charities are funded with private donations.  donations.  oEducation and protecting the Education and protecting the environment have positive externalities.environment have positive externalities.

• Integrating different types of businesses.Integrating different types of businesses.oApple growers and beekeepers can Apple growers and beekeepers can work together to work together to produce the optimal produce the optimal quantity.quantity.

oContracts can also solve inefficiencies.Contracts can also solve inefficiencies.

Coase Coase TheoremTheorem• The proposition that if private parties can The proposition that if private parties can

bargain without cost over the allocation bargain without cost over the allocation of resources, they can solve the problem of resources, they can solve the problem of externalities on their own.of externalities on their own.

• Example: Dick, Jane, and SpotExample: Dick, Jane, and Spoto Dick's dog, Spot, barks and disturbs Dick's dog, Spot, barks and disturbs

Dick's neighbor, Jane.Dick's neighbor, Jane.o Dick's benefit from the dog and Jane's Dick's benefit from the dog and Jane's

cost from the barking determine the cost from the barking determine the efficient outcome reached.efficient outcome reached.

• Distribution of rights determines the Distribution of rights determines the distribution of economic well-being. distribution of economic well-being. 

Failure of Private Failure of Private SolutionsSolutions• Transaction costs - costs that Transaction costs - costs that

parties incur in the process of parties incur in the process of agreeing and following through agreeing and following through on a bargain.on a bargain.o e.g.: translators, lawyerse.g.: translators, lawyers

• Bargaining breaks down because Bargaining breaks down because both sides try to hold out for a both sides try to hold out for a better deal.better deal.

• Too many parties involved; Too many parties involved; impossible to please everyone.impossible to please everyone.

Government Government PoliciesPolicies

•Command-and-control Command-and-control policies regulate behavior policies regulate behavior directly.directly.

•Market-based policies Market-based policies provide incentives so that provide incentives so that private decision makers private decision makers will solve the problem on will solve the problem on their own.their own.

Pigovian TaxesPigovian Taxes• Taxes enacted to correct the effects of Taxes enacted to correct the effects of

negative externalities.negative externalities.•   For instance, the EPA could levy a tax on For instance, the EPA could levy a tax on

each factory of $50,000 for each ton of each factory of $50,000 for each ton of pollution it emits.pollution it emits.

• Pigovian taxes place a price on the right to Pigovian taxes place a price on the right to pollute.pollute.

• Economicists favor pigovian taxes because Economicists favor pigovian taxes because they encourage factories to reduce waste they encourage factories to reduce waste in order to pay less taxes, and therefore in order to pay less taxes, and therefore are better for the environment.are better for the environment.

• However, taxes create a deadweight loss.However, taxes create a deadweight loss.

Tradable Pollution Tradable Pollution PermitsPermits• Pollution permits allow factories to Pollution permits allow factories to

produce X amount of waste.produce X amount of waste.• Trades may be made.Trades may be made.

oExample: Factory A can sell its Example: Factory A can sell its right to pollute 100 tons to Factory right to pollute 100 tons to Factory B for $5 million.  B for $5 million.  

• Permits are more efficient when the Permits are more efficient when the demand curve for pollution is demand curve for pollution is unknown, therefore the EPA does not unknown, therefore the EPA does not know what size tax would achieve its know what size tax would achieve its goal level of pollution.goal level of pollution.

Comparison between Comparison between Pigovian Tax and Pigovian Tax and Pollution PermitsPollution Permits

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