Econ 321 Lecture Notes 4-Externalities

Externalities
Externality: A spillover effect associated with production or consumption that extends to a third party outside the market. In other words, an external effect that generates costs or benefits to the third party. Positive externality. (big brake lights, smoke alarms) Negative externality. (pollution)
NEGATIVE EXTERNALITY Refined Petroleum Market MSC= MPC + MEC MPC: Marginal Private Cost MPD: Marginal Private Benefit MEC: Marginal External cost MSC: Marginal Social Cost Yellow shaded area is the social welfare loss due to the externality.

S=MPC p p
e p

MEC

D=MPB q
e

POSITIVE EXTERNALITY MARKET FOR SMOKE ALARMS S=MPC Since the smoke alarm owners dont care about the external benefits market is going to yield aless than efficient amount of smoke alarms. Yellow triangle is the social welfare loss due to positive externality.

MEB D=MPB
p e

MSB=MPB + MEB

Econ 321 Lecture Notes 4-Externalities

Public Policy toward Negative Externalities A) PIGOVIAN TAXES Government imposes a tax on negative externality creating agents. (generally producers)
Refined Petroleum Market

MSC= MPC + MEC

S=MPC p p
e p

If we put a tax on petroleum at the amount of external costs we will be able to make the marginal social cost to be equal to the marginal private cost. Thus the market will yield efficicent amount of petroleum.

T=MEC D=MPB q
e

Problems a) Difficult to estimate the external cost. (what is the external cost of water pollution) b) Difficult to determine who is responsible for the cost. (who is responsible for air pollution) c) What should be taxed is not always clear. (putting scrubbers lowers the externality but not the quantity)

B) COMMAND AND CONTROL REGULATIONS Government directly regulates the producers production technology. Government requires certain steps to be taken by producers. Example: Catalytic converters on cars, scrubbers on factories. In the short run both Pigovian taxes and regulation give the same results. However, with regulation (decreased output level) the firms are going to make profits while with taxes no profits or even losses. Thus the firms prefer regulation over taxes. Regulatory solution approximates corrective tax solution in short run Does not give incentive to further reduce externality Corrective tax solution gives incentive to reduce externality when cost effective Difficult to apply in real world Negative political pressure

Econ 321 Lecture Notes 4-Externalities

C) MARKETABLE POLLUTION RIGHTS They are established by giving firms to right to generate certain amount of pollution. (or any other negative externality). These rights can be bought or sold like any other commodity. They have three desirable characteristics: 1) Can reduce the inefficiencies due to externality 2) Can reduce the pollution in a cost effective manner 3) Have less political opposition than taxes or regulation.

Public Policy toward Positive Externalities SUBSIDY: A negative tax that correct for the positive externality. A perfect subsidy should be equal to the magnitude of the externality. For example vaccines in our country like in most other countries are subsidized by the government. (I.e. they are generally provided free, even though the marginal cost is not zero)

Excess Burden and Excess Benefit When there is a positive externality, should we subsidize this market? Efficiency tells us we should; however when we do that we also have to keep in mind that, we have to raise the subsidy money from other markets with taxes. And we know that taxes create inefficiencies. Thus while we are correcting for an inefficiency, we should not create a bigger one. This is called excess burden, but it doesnt say all subsidies should be eliminated but the excess burden effect should be kept in mind. A similar effect is relevant for negative externalities, when there is negative externality a Pigovian tax might eliminate inefficiency. However, it also raises some revenue, government can lower the tax rates on other markets since it had collected money from this market. Thus with a Pigovian tax, we can lower the inefficiencies in multiple markets. This is called excess benefit.

Irrelevant Externalitites When there are externalities, there are inefficiencies and government can improve the welfare of the society eliminating those inefficiencies. However not all externalities create inefficiencies. 1) Pecuniary Externalities: When a new Migros is opened next to Kiler, it will have a negative effect on Kiler. Their sales will go down and probably average price level also goes down. This is under the definition of negative externality. However, this effect work through market system and doesnt cause any inefficiency and thus not requires government action.

Econ 321 Lecture Notes 4-Externalities

2) Inframarginal Externalities: Sometimes externalities exist but they are not effective on the margin. For example people who are wealthy would vaccinate their children for tuberculosis even if wasnt subsidized by the government. (namely not free). It is true each vaccinated children will have a positive externality on other children but this doesnt affect the decisions on the margin. So there is no inefficiency and no need for government action. However the externality might not be inframarginal for the poor segment of the society, in this case there is need for government action.

Private Actions to Correct an Externality a) Coase Theorem: In the absence of transactions costs, the allocation of resources will be independent of the assignment of property rights. This means that when there is nothing to stop a potentially profitable trade from taking place, the trade will take place and resources will be allocated to their highest valued uses. Example: Confectioner and doctor Income effect Transactions cost, small number of individuals. b) Mergers: If a single individual or firm owns the both parties (the one which causes the externality and the one which is exposed the externality) the problem is automatically solved since the owner will try to maximize the value of its asset.