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Externalities

Chapter 10

Copyright © 2001 by Harcourt, Inc.

All rights reserved. Requests for permission to make copies of any part of thework should be mailed to:

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Market Failures: Externalities

u When a market outcome affectsparties other than the buyers andsellers in the market, side-effects arecreated called externalities.

u Externalities cause markets to beinefficient, and thus fail to maximizetotal surplus.

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An externality arises...

. . . when a person engages in anactivity that influences the well-being of a bystander and yet neitherpays nor receives any compensationfor that effect.

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Market Failures: Externalities

u When the impact on the bystander isadverse, the externality is called anegative externality.

u When the impact on the bystander isbeneficial, the externality is called apositive externality.

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u Automobile exhaust

u Cigarette smoking

u Barking dogs (loud pets)

u Loud stereos in an apartmentbuilding

Examples of NegativeExternalities

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u Immunizations

u Restored historic buildings

u Research into new technologies

Examples of PositiveExternalities

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The Market for Aluminum...

Quantity ofAluminum

0

Price ofAluminum

QMARKET

Demand(private value)

Supply(private cost)

Equilibrium

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QMARKET

Pollution and the SocialOptimum...

Quantity ofAluminum

0

Price ofAluminum

Demand(private value)

Supply(private cost)

Social cost

Qoptimum

Cost ofpollution

Equilibrium

Optimum

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Negative Externalities inProduction

The intersection of the demand curveand the social-cost curve determines theoptimal output level.

u The socially optimal output level is lessthan the market equilibrium quantity.

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Positive Externalities inProduction

When an externality benefits thebystanders, a positive externality exists.

uThe social costs of production are lessthan the private cost to producers andconsumers.

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Positive Externalities inProduction...

Quantityof Robots

0

Priceof Robot

QOPTIMUM

Demand(private value)

Supply (private cost)

Social cost

QMARKET

Value oftechnologyspillover

Equilibrium

Optimum

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Positive Externalities inProduction

The intersection of the demand curve andthe social-cost curve determines the optimaloutput level.

u The optimal output level is more than theequilibrium quantity.

u The market produces a smaller quantity thanis socially desirable.

u The social costs of production are less thanthe private cost to producers and consumers.

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Internalizing ProductionExternalities

u Taxes are the primary tools usedto internalize negativeexternalities.

u Subsidies are the primary toolsused to internalize positiveexternalities.

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Consumption Externalities...

Quantity ofEducation

0

Price ofEducation

QMARKET

Demand(private value)

Socialvalue

QOPTIMUM

(b) Positive Consumption Externality

Supply(private cost)

Quantityof Alcohol

0

Priceof Alcohol

QMARKET

Demand (private value)

Supply(private cost)

Social valueQ

OPTIMUM

(a) Negative Consumption Externality

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Externalities and MarketInefficiency

u Negative externalities in production orconsumption lead markets to produce alarger quantity than is sociallydesirable.

u Positive externalities in production orconsumption lead markets to produce alarger quantity than is sociallydesirable.

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Private Solutions toExternalities

Government action is notalways needed to solve theproblem of externalities.

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The Coase Theorem

The Coase Theorem states that if privateparties can bargain without cost over theallocation of resources, then the privatemarket will always solve the problem ofexternalities on its own and allocateresources efficiently.

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Why Private SolutionsDo Not Always Work

Sometimes the private solutionapproach fails because transaction

costs can be so high that privateagreement is not possible.

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Public Policy TowardExternalities

When externalities are significant andprivate solutions are not found,government may attempt to solve theproblem through . . .

ºcommand-and-control policies.

ºmarket-based policies.