Busa 201 Ch. 10 externalities

Externalities cause markets to be inefficient,

and fail to maximize total surplus.

Pigovian taxes

are taxes enacted to correct the effects of a negative externality.

Transactions Costs

are the costs that parties incur in the process of agreeing to and following through on a bargain.

When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .

-command-and-control policies. -market-based policies.

PRIVATE SOLUTIONS TO EXTERNALITIES

Government action is not always needed to solve the problem of externalities. Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties

Industrial Policy

Government intervention in the economy that aims to promote technology-enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality.

Market-Based Policies

Government uses taxes and subsidies to align private incentives with social efficiency.

Examples of Regulation versus Pigovian Tax

If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could... tell the firm to reduce its pollution by a specific amount (i.e. regulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).

Positive Externalities examples

Immunizations Restored historic buildings Research into new technologies

negative externality examples

Negative Externalities Automobile exhaust Cigarette smoking Barking dogs (loud pets) Loud stereos in an apartment building

Why Private Solutions Do Not Always Work

Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

negative externalities: Achieving the Socially Optimal Output

The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

negative externalities figure

The intersection of the demand curve and the social-cost curve determines the optimal output level. --The socially optimal output level is less than the market equilibrium quantity.

positive externalities: The intersection of the supply curve and the social-value curve determines the optimal output level.

The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good.

The Market for Aluminum

The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers. For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

When an externality benefits the bystanders, a positive externality exists.

The social value of the good exceeds the private value.

Examples of Regulation versus Pigovian Tax - Market-Based Policies

Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. A market for these permits will eventually develop. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

Internalizing Externalities: Subsidies

Used as the primary method for attempting to internalize positive externalities.

Command-and-Control Policies

Usually take the form of regulations: -Forbid certain behaviors. -Require certain behaviors. Examples: Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

Summary

When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. Those affected by externalities can sometimes solve the problem privately. The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. When private parties cannot adequately deal with externalities, then the government steps in. The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

The Coase Theorem

is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

the impact on the bystander is adverse, the externality is called a

negative externality Negative externalities lead markets to produce a larger quantity than is socially desirable.

the impact on the bystander is beneficial, the externality is called a

positive externality Positive externalities lead markets to produce a smaller quantity than is socially desirable.

externality

refers to the uncompensated impact of one person's actions on the well-being of a bystander.

A technology spillover is a type of positive externality that exists

when a firm's innovation or design not only benefits the firm, but enters society's pool of technological knowledge and benefits society as a whole.