Externalities

• • • • The effect of a market action on someone outside of the market A transaction spillover A cost or benefit not transmitted through prices affecting someone who did not agree to the action that caused the effect It is a market failure – Negative Externality • Hurts someone outside of the market – Positive Externality • Helps someone outside of the market

• • • Example of negative externalities – Exhaust from cars – A loud barking dog – An unmowed yard Examples of positive externalities – Vaccinations – Education – Research in to new technologies Producers/consumers do not take into account their externalities (ie external) – So government should correct the market failure

• • • • Externalities cause inefficient allocation of resources Remember at efficient point cost = benefit In other words value to consumers = cost to producers if no externality – That is where supply cross demand If an externality exists than true benefit (value) or cost is not reflected in the demand/supply curves

• • Remember – View Supply Curve now as cost curve to society (if no externality) – View Demand Curve as benefit to society (if no externality) – We care about society wide gains (benefits/cost) Differentiate fairness from efficiency – Doesn’t matter who pays the cost, it is a cost that should matter when finding efficient point – Doesn’t matter who gains, it is a benefit that should be included when finding efficient point

Market for Coal Supply (private cost) Market Equilibrium Demand (private value) Q’

• • • • • But there exists an externality Production of coal pollutes local watersheds So actual Social Cost is greater than cost of production – Remember welfare is about economy wide effects, the total to all, not how its split up Social Cost – Cost of production plus – Cost to clean water ways Social cost above the supply curve

Market With Negative Externality Social cost (private cost plus external cost) Supply (private cost) Optimum/Efficient Point External Cost Original Market Equilibrium Demand (private value) Q* Q’

• • • In the presence of a negative externality the optimum point is a quantity lower than the market produces on its own Governments role is to step in and correct the market failure to maximize welfare How – Tax producers equivalent to the cost of the externality – This raises the supply curve to the level of private cost plus external cost

Tax as Fix To Externality Social cost (private cost plus external cost) Supply (private cost) Efficient Point = New Eq. With Tax Tax = External Cost This is NOT a DWL. The Tax does not make the market Inefficient, it fixes an inefficiency. Demand (private value) Q* Q’

Positive Externality

• • • • • When there is a positive externality it means the market is not making enough of the good.

The market is inefficient There is a benefit which is not incorporated in the demand curve Actual benefit curve to society is above the demand curve To correct the market failure the government should subsidize the market

Market with Positive Externality Optimal/Efficient Point Private cost = social cost (no negative externality) Original Market Equilibrium External Benefit Social Benefit = Private Benefit + external benefit Private Benefit Q’ Q*

• • • • Government should place a subsidy on the good equal to the external benefit This will increase the market to the efficient level This does not lead to inefficiency like a subsidy on a “good” market does It fixes an inefficiency due to the market failure that is the externality

Market Correction Thru Subsidy Original Market Equilibrium Optimal/Efficient Point Private cost = social cost (no negative externality) These units produce are NOT inefficient Subsidy = External Benefit Social Benefit = Private Benefit + external benefit Private Benefit Q’ Q*

• • Externalities are Market Failures – Markets with negative externalities produce more than the efficient amount – Markets with positive externalities produce less than the efficient amount – Why? Because the market (supply/demand curves) don’t internalize the external cost/benefit Taxes/Subsidies correct the failure, they bring us to the efficient point – Taxes shrink the market – Subsidies expand the market

Focus on Pollution

• • • How to deal with pollution?

Maybe “command and control” – Government tells companies exactly what to do to limit pollution (like what type of inputs to use, or what type of process) – Not efficient Maybe use a market based approach (that is provide an incentive) – Taxes – Cap and Trade

Pollution Market

• • • • • Pollution is a byproduct of almost every type of market action Without it there could be no production of the stuff we like to consume So we want to think of there being a market for pollution We want to think of the demand/supply curve in terms of benefits/cost Again still looking for efficient point

Value Value of Pollution at efficient level Market For Pollution Emissions Cost Curve: The cost of the pollution. We have to live with bad side effects. Efficient Point (costs = benefits) Efficient Emission Level Benefit Curve: The value of Polluting. Allows us to produce things Emissions

• • • • • There is no natural market for pollution Given no natural market then the price of pollution is zero Producers will emit pollution till the benefit curve hits the horizontal axis This is more emissions than is efficient (negative externality so more in market than should be) Government has to create the market, or create the price to reach efficient level – Problem of having the information to know what the benefit/cost curves look like, because need

these to find efficient price or efficient quantity

• • • • • • • Can do this two ways Price the pollution – That is tax pollution at the level of the EQ point Limit the pollution level – That is Cap the emissions at the level of the EQ pt Tax or Cap should be set at efficient level – How to find these? Ask and economist.

Either way leads to same outcome Tax – Government prices pollution and market finds level of emissions Cap and Trade – Government sets pollution level and market finds price of polluting (Like a market with perfectly inelastic Supply Curve)

Tax Equivalence Resulting Price/Quantity the same under both Tax Cap and Trade Market finds price of permit Market decide Quantity Cap

• • • • • Notice the efficient level of pollution is not zero We do “want” some pollution – it allows us to make the things we want But we want an efficient level of pollution – Costs = Benefits Government must create market because it does not naturally exist The Tax or Cap-and-Trade does not distort the market, it fixes the market failure