Chapter 10 Externalities Chp 1

Principles of Micro Chapter 10: Externalities We Will Learn:      what an externality is why externalities can make market outcomes inefficient. how people can sometimes solve the problem of externalities on their own. why private solutions to externalities sometimes do not work. the various government policies aimed at solving the problem of externalities Introduction   Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market But market failures can still happen. Externalities and Market Inefficiency  1. 2. externality: the uncompensated impact of one person’s actions on the well-being of a bystander. - If the effect on the bystander is adverse, there is a negative externality. - If the effect on the bystander is beneficial, there is a positive externality Externalities and Market Inefficiency  An externality arises... . . . when a person engages in an activity that influences the wellbeing of a bystander and yet neither pays nor receives any compensation for that effect. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. Externalities and Market Inefficiency  Negative Externalities      Automobile exhaust Cigarette smoking Barking dogs (loud pets) Loud stereos in an apartment building Positive Externalities    Immunizations Restored historic buildings Research into new technologies Welfare Economics: A Recap  The Market for Aluminum The quantity produced and consumed in the market equilibrium is efficient (it maximizes the sum of producer and consumer surpluses).  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.  Welfare Economics: A Recap  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 Pollution and the Social Optimum Price of Aluminum Social cost Cost of pollution Supply (private cost) Optimum Equilibrium Demand (private value) 0 QOPTIMUM QMARKET Quantity of Aluminum Negative Externalities  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. 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. internalizing an externality: altering incentives so that people take account of the external effects of their actions. Positive Externalities  When an externality benefits the bystanders, a positive externality exists.   The social value of the good exceeds the private value. technology spillover is a type of positive externality that exists when a firm’s innovation not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. Education and the Social Optimum Price of Education Supply (private cost) Social value Demand (private value) 0 QMARKET QOPTIMUM Quantity of Education 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. Positive Externalities   Internalizing Externalities: Subsidies  the primary method for attempting to internalize positive externalities. Industrial Policies: government intervention in the economy that aims to promote technology-enhancing industries  Patent laws: 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.