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Welcome to the

Presentation
Chapter Five
Externalities
Submitted To
:
Mrs. Shagufta
shaheen Submitted By :
Arafat Alam
Lecturer, Section : A,
Roll : 114,

Department of
Banking and
Insurance,
University of Dhaka.
What is an Externality?
An EXTERNALITY occurs when:

1) The activity of one entity directly


affects the welfare of another
entity
And
2) This affect is not depend on market
mechanism

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Theory - Externality Features
Externalities carry a variety of rarely
considered features:
1) EXTERNALITIES CAN BE PRODUCED BY
CONSUMERS AS WELL AS FIRMS
2) EXTERNALITIES ARE RECIPROCAL IN
NATURE
3) EXTERNALITIES CAN BE POSITIVE OR
NEGATIVE
4) PUBLIC GOODS CAN BE Viewed AS A
SPECIAL KIND OF EXTERNALITIES
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Math - Graphical Analysis of Externalities:
When an entity consumes a good with a negative
externality, he only equates marginal benefit
(MB) and his Private Marginal Cost (PMC) and
consumes at Q1.
SMC=PMC+MD

$
PMC Society, however,
experiences Marginal
MD
Damage (MD), and
therefore Social
MB Marginal Cost (SMC) is
Q* Q1 Q higher than PMC.
Efficient consumption therefore occurs where
SMC=MB, at point Q*. 6
Theory - Private Responses to
Externalities

1) Bargaining and The Coase Theorem


(assigning property rights)
2) Mergers
3) Social Conventions

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1) Assigning Property Rights
One way to privately deal with externalities
is for one party to be given OWNERSHIP
or PROPERTY RIGHTS of the market the
externality exists in.

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$ SMC

PMC

MD

MB

Q* Q1

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Private Responses to Externalities

1) Bargaining costs must be low


2) Resource owners must be able to
identify damages to their property and
legally prevent
3) Individuals may respond to the
externality by bargaining with each
other
4) The costs to the parties of bargaining
are low
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Theory - The Coase Theorem

*THE COASE THEOREM implies that once property


rights are established, no government intervention is
required to deal with externalities.
*The Coase Theorem works best in cases where
few parties are involved and the sources of
externalities are well-defined.
*Often many people are involved
*Often the externalities are poorly defined

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2) Private Response: Merger
One way to internalize an externality
is to combine involved parties. For
example, if one firms actions caused an
externality to another, the two firms
could merge (through buyout or a 3rd
party)

*Since everything happens within one firm,


one could argue it is no longer an
externality 12
3) Private Response: Social
Conventions
*Unlike firms, individuals cannot merge to
internalize externalities.
*Social conventions and moral precepts
encourage people to take Marginal Damage
into account

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Public Responses to Externalities
If private responses to externalities dont
work or dont occur, there are a variety
of ways the government can intervene,
including:

1) Taxes
2) Subsidies

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1) Public Response: Taxes

when actions with externalities have


SMC>PMC, one way to raise PMC is
through taxation

a PIGOUVIAN TAX is a per-unit tax on


output equal to the marginal damage at
the efficient level of output, Q*

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$ SMC PMC+Subsidy
PMC

MD

Subsidy Cost

Subsidy
MB

Q*

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2) Public Response: Subsidies

When actions with externalities have


SMC>PMC, another way to raise PMC is
through subsidy

a PIGOUVIAN SUBSIDY is a per-unit


subsidy on REDUCED output equal to the
marginal damage at the efficient level of
output, Q*
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$ SMC PMC+Subsidy
PMC

MD

Subsidy Cost

Subsidy
MB

Q*

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Public Responses to
Externalities
1. Emissions fee: A tax levied on each unit of
pollution
2. Cap and- trade: An alternative policy to an
emissions fee is for government to require two
person are submitted one government issued
permit for each unit of pollution they emit
3. Command and control regulation: Policies
that require a given amount of pollution
reduction with limited or no flexibility with
respect to how it may be achieved
Theory - Income Distribution Effects
Although government is responsible to
ensure efficiency in the case of
externalities, it is also responsible to
take into account the distribution effects
of its policies

In short, when dealing with externalities


the government has to ask:

1) Who benefits?
2) Who bears the cost 20
Theory - Positive Externalities
Although negative externalities are
most often discussed, positive
externalities can also lead to inefficiency

positive externality activity can be


made efficient by using a Pigouvian
subsidy

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$

MC

SMB=PMB+EMB

EMB PMB

Security
Q1 Q*

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Thank
you

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