Chapter 10: Externalities

In the presence of a negative externality, how would the benevolent social planner act.

He would put a tax on the producers by the amount that would shift the supply curve upward and leftward to meet the social optimum equilibrium quantity at which the social costs are accounted for. As a result of shifting the supply curve upwards and to the left, the equilibrium quantity has decreased, and the price to buyers has increased. This would increase efficiency.

Give examples of negative externalities.

- Pollution caused by the exhaustion from cars. (CO2 emissions) - Pollution caused by factories - The neighbours barking dog/late night parties in a small neighbourhood - Health risks from second-hand smoke - Noise pollution from construction projects

Give examples of positive externalities.

- Vaccinations against contagious disease (prevents you from catching and then passing down the disease) - Research and development (creates knowledge that others can use) - People going to university (increase the education level in the country, which can decrease crime rate, and elect better governments)

What are the three main topics in this chapter?

1. Externalities and market inefficiencies (what this means) 2. Public policies towards externalities 3. Private solutions towards externalities.

How do normal taxes and corrective taxes differ?

A normal tax aims to increase government revenue (such that they can provide public services, build roads, maintain communal services), however, most taxes distort incentives, causing a deadweight loss, meaning that due to a decrease in quantity demanded and supplied, economic well-being is compromised; the total surplus (consumer and producer surpluses) are not maximised; certain benefits of trade are not being realised. However, a corrective tax makes economies more efficient by altering incentives to facilitate the well-being of bystanders (those who are not directly involved in the market). When a negative externality is present, the impact of the actions of private individuals on bystanders is not compensated for. A corrective tax, though it decreases the quantity supplied and demanded, it addresses the effects on society as a whole. Additionally, corrective taxes raise government revenue as well.

Do economists prefer the use of regulations or corrective tax in the mitigation of pollution? Why?

A regulation is a command-and-control policy whereby the government is eligible to require or forbid the production of certain goods and services. A corrective tax is a market-based policy; a type tax that is designed to induce private decision-makers to take account of their social costs that arise from negative externalities, such that the level of consumption equals the social optimum. Economists have a preferential attitude towards corrective taxes when dealing with pollution. Why? Because with a corrective tax they can reduce pollution at a lower cost to society, and with greater efficiency. If you place a regulation on pollution (i.e. companies can only produce x amount of goods in y period of time), then the production of that good will always be limited to x. By taxing the right to pollute, factories may come up with more efficient ways to minimise pollution (i.e. by improving their technologies), and yet produce a high amount of the good, which would be higher than x.

What is meant by "internalising the externality"?

Altering the incentives of buyers or sellers such that they take account of the external effects of their actions. Premise: "people respond to incentives"

Define externality. Tell me about the two types of externalities.

An externality is a source of market failure, and is define as the uncompensated impact of one persons actions on the well-being of a bystander. When one person engages in an activity that influences the well-being of a someone else, but doesn't pay or receive compensation for that affect. Negative externality: when the uncompensated actions of an individual has an adverse affect on the well-being of a bystander. Positive externality: when the uncompensated actions of an individual is beneficial to the well-being of a bystander. Externalities occur when the decisions of buyers and sellers unintentionally affect societal members outside of the market.

What are the two main ways governments respond to externalities.

Command and control policies: - these regulate behaviour of supply and demand directly Market-based policies: - these provide incentives so the private decision-makers (buyers and sellers) choose to solve the problem on their own.

Which of the ten principles of economics is being explored in this chapter?

Governments can sometimes improve upon market outcomes.

Why is gasoline taxed so heavily?

Governments want to reduce certain negative externalities: - Congestion (Traffic) - Accidents (fatalities and injuries) - Pollution

What do corrective taxes and pollution permits have in common?

In both cases, firms pay for the right to pollute. In the context of a corrective tax, producers pay for pollution based on their output to governments. (a horizontal, perfectly elastic curve is set at a particular price, limits demand to a certain quantity) In the context of a tradable pollution permit, producers pay for the right to pollute on a separate market for pollution permits (to each other), hence they pay each other. (a vertical, perfectly inelastic curve is set at a given quantity, which halts demand at the "equilibrium" price).

A government intervention that aims to promote technology-enhancing industries is called?

Industrial policy.

Tell me about tradable pollution permits.

It is a deal between two companies that increases economic efficiency and makes the two companies better off. Two companies can choose to trade the right to pollution in exchange for money. Tradable pollution permits become a scarce resource, and consequently they potentially have their own market. The costs to society don't change. The level of pollution remains the same, except that the source of pollution changes from one company to the other.

How does a government subsidy for producers affect the supply curve?

It would shift the supply curve down and to the right (increase quantity supplied)

Is government intervention always necessary to internalise an externality?

No

Tell me about the social-cost curve.

Premise: due to the negative externality, the costs of production to society are greater than the costs of production to the producer. The social-cost curve (cost of production + social cost) takes into consideration 1. the costs of production to producers, and 2. the cost incurred to society due to production. On the supply-demand graph, the social cost curve is positioned parallel to—and above—the supply curve, by the amount of social cost. The social-cost curve sets a "new equilibrium" which now takes into consideration those bystanders who would be adversely affected by the previous equilibrium quantity.

The government is "designed for"...

Public (collective) action; solving problems of civilians.

So, what happens to quantity in the case that markets are modified to behave according to incentives, and the supply and demand curves adjust to become social-value and social-cost curves.

Social value curve = quantity increases, price increases Social cost curve = quantity decreases, price increases

What is meant by social value?

Social value is the goods value to society; by how much does the uncompensated impact of the actions of buyers benefit society/bystanders?

How can we internalise a positive externality?

Subsidies the good, cut taxes. By doing so, the "benevolent social planner" would shift the demand curve upwards and to the right by the amount that society values the good. This increases the social optimum.

Tell me about technology spillovers.

Technology spillover is a type of positive externality. The development of new technologies by one company, allows other companies to benefit from the use of the new technologies. Governments should usually subsidise the production of robots (or other technologies), so that other companies can make use of the advances, to make their processes more efficient. A subsidy given to producers will shift the supply curve down and rightward to create a larger quantity supplied and demanded. Economists debate on how large a technology spillover is.

Define property rights.

The ability of an individual to own and exercise control over scarce resources. "Ownership".

What is meant by social cost?

The cost of production to society; how much the uncompensated impact of the actions of producers adversely affects bystanders.

Tell me about the first market-based policy.

The first market-based policy is: corrective tax. Corrective tax (Pigovian tax; "Arthur Pigou") Tax is defined as a tax designed to induce private decision-makers to take account of their social costs that arise from a negative externality. Corrective subsidy, is a subsidy designed to induce private decision-makers to take account of the social value that arises from a positive externality.

How does price affect pollution.

The higher the price of the right to pollute (whether achieved through corrective taxes or tradable pollution permits), the less firms will pollute.

Tell me about command-and-control policies.

The main command-and-control policy is regulation. The government is eligible to require or forbid certain behaviours. So, when the social cost (detriment to society) of production exceeds the benefit of production to the producer, the government can choose to forbid the production of that product completely, or regulate the product to decrease the quantity produced and consumed. (EPA has the task of developing and enforcing regulations aimed at environmental protection.) For example, the government can put a maximum amount on how much pollution a factory emits by limiting the amount of goods produced per day.

Tell me about the (Ronald) Coase Theorem.

The proposition that economic efficiency can be increased if private businesses are able to negotiate without cost over the allocation of scarce resources, and the problem of externalities can thus be solved on their own without government intervention. Such a deal/negotiation would make everyone better off.

Tell me about the social-value curve.

The social-value curve is parallel to—and is found above—the demand curve. The social-value curve is calculated by the value to buyers + the external benefit to society. Shifting the demand curve upwards and to the right by the amount that society values the good, will shift the social optimum quantity up.

Tell me about (the types of) private solutions to externalities.

These solutions do not require government intervention. They are "private solutions", instigated by private decision-makers. 1. Moral codes, social rules (do not litter: "do what you would want others to do unto you") 2. charities and donations 3. integration of businesses (bee keeping business and a apple tree growing business: internalising the externality) 4. a contractual agreement between businesses

What is the goal of a public policy that aims to remedy a market inefficiency due to an externality?

To adjust supply and demand to meet the social optimum.

Why don't private solutions to externalities always work?

Two parties can not always reach a beneficial agreement. The Coase Theorem is thus very idyllic, and works only in the case that contending parties are able to reach an agreement over externalities. Factor that get in the way of negotiation among private decision-makers: 1. Transaction costs (the cost that parties incur when negotiating, i.e. fees to hire a lawyer) 2. Price wars and labor strikes 3. Coase Theorem rarely works when large groups of individuals are involved (in such a case, government intervention maybe necessary).

Under what circumstance is a tradable pollution permit more efficient to economic well-being than a corrective tax?

When the EPA (or government) does not know the demand curve for pollution.