© 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY An externality is … –the...

© 2007 Thomson South-Western

EXTERNALITIES AND MARKET INEFFICIENCY

• An externality is …– the uncompensated impact of one person’s actions

on the well-being of a bystander.

• Externalities – cause markets to be inefficient– fail to maximize total surplus



• Negative externality – adverse impact on the bystander

• Positive externality– beneficial impact on the bystander



• Negative Externalities– Automobile exhaust– Barking dogs (loud

pets)– Industrial pollution



• Positive Externalities– Immunizations– Restored historic buildings– Research into new technologies


Costs and Benefits of Pollution• Marginal Social Cost (MSC) is …

– Additional cost imposed on

society when one more unit

is produced.

MSC is our S curve.


Costs and Benefits of Pollution• Marginal Social Benefit (MSB) is …

– Additional benefits received by

society when one more unit

is produced.

MSB is our D curve.


MSC and MCB of Pollution

Quantity ofPollution emitted (tons)

0

MSC and MSB of Pollution

MSB

MSC

QOPT

MSC = MSB


Costs and Benefits of Pollution

Will society, left unregulated, come to the optimal amount of pollution?

NO


The External Cost of Pollution

A power plant is located in the Ohio River Valley.

Who benefits?

Who pays the costs?

Benefits Costs

Producers Environment

Consumers Non-consumers


The External Cost of Pollution

External Costs are those ‘we’ pay when we are NOT benefitting from an externality. (Negative externality)


MSC, MSB in an Unregulated Market


0


MSB

MSC

QOPTQOPT

MSC = MSB

$1000

QMKT


PRIVATE SOLUTIONS TO EXTERNALITIES

• Government action is not always needed to solve the problem of externalities.

• Types of Private Solutions– Moral codes and social sanctions– Charitable organizations– Integrating different types of businesses– Contracting between parties


The Coase Theorem

• Coase theorem states a private solution may be found as long as …• property rights are clearly defined• Transactions costs are minimal

• Transaction costs are incurred when parties• agreeing to and • following through on a bargain


Why Private Solutions Do Not Always Work

• Transaction costs are too high • Communication costs• Legal costs• Delays in bargaining


PUBLIC POLICIES TOWARD EXTERNALITIES

• 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

• Corrective taxes

• Permits


Command-and-Control Policies: Regulation

• 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).


Market-Based Policy : Corrective Taxes

• Corrective taxes (Pigovian taxes) are taxes enacted to correct the effects of a negative externality.


Tax on Pollution


0


MSB

MSC

QOPTQOPT

$500

QMKT

tax


Tax on Pollution

• Tax ABOVE MSB curve• Cheaper for firms to ‘fix’ the problem• Pollution will be reduced to the socially optimal

amount• Financial incentive to ‘fix’ the problem


Market-Based Policy : Tradable Pollution Permits

• Tradable pollution permits • voluntary transfer of the right to pollute from one

firm to another • 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.

• Sam amount of pollution is reduced.


Positive Externalities

Positive Externality happens when …

• The production and consumption of a good also benefits 3rd parties.• Immunization• Home improvement


Private v. Social Benefits

Total Social Benefit =

Total Private Benefit + Total External Benefit mine + yours



Marginal Social Benefit =

Marginal Private Benefit (MPB) +

Marginal External Benefit (MEB)



Quantity ofHome Improvements

0

Price, MSB

MSB

MSC

QOPT

QOPT

P OPT

QMKT

P MSB

P MKT

Q MKT

MPB

MEB = MSB - MPB



Market Outcome:

• Equilibrium = MPB intersects QMKT

• MPB is ONLY for those who consume the G/S

• MPB + MEB = MSB• Society is willing to pay at this level• Market under produces which generate positive

externalities.

• QMKT is higher at PMSB

• Socially Optimal Outcome = MSB = MSC



Dead Weight Loss:

• How could we eliminate Dead Weight Loss?• Subsidy (Pigouvian subsidy)

• Voucher for home improvement goods

• Increases consumer willingness to pay


Subsidy Effect

Quantity ofHome Improvements

0

Price, MSB

MSB

S

QOPT

QOPT

P MKT

QMKT

P OPT

PCON

Q MKT

MPB

Subsidy


Private v. Social Costs

Total Social Cost =

Total Private Cost + Total External Costmine + yours



Marginal Social Cost =

Marginal Private Cost (MPC) +

Marginal External Cost (MEC)


Private v. Social Costs

Quantity ofElectricity

0

Price, MSC

MSB

MSC

P OPT

QMKT

P MKT

P FIRM

Q MKT

D

MPC



Market Outcome:

• Equilibrium = MPC intersects QMKT

• MPC is ONLY for those who incur the costs

• MPC+ MEC = MSC• Society is willing to pay at this level• Market over produces what generates negative

externalities.

• Socially Optimal Outcome = MSB = MSC



Dead Weight Loss:

• How could we eliminate Dead Weight Loss?• Tax (Pigouvian subsidy)

• Increases each firm’s MPC


Effect of a Tax

Quantity ofElectricity

0

Price, MSC

MSB

MSC

P OPT

QMKT

P MKT

P FIRM

Q MKT

D

MPC

Tax

Date post:	20-Jan-2016
Category:	Documents
Upload:	marian-barker
View:	212 times
Download:	0 times

© 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY An externality is … –the...

Documents