Download Externalities

Externalities
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By the end of this Section you should
be able to:
► Define
and describe an externality (both +
and -) and its effects of social welfare.
► Evaluate 3 of the possible solutions for an
externality:
 Private Solution
 Pigouvian Tax
 Tradable Permit Market
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Externalities
► An
externality is an uncompensated impact of one
person’s actions on the well-being of a bystander.
► Externalitites can be + (a benefit for the
bystander) or – (a cost for the bystander).
► Examples:




Pollution from manufacturing
Exhaust from automobiles
Knowledge to everyone from scientific discoveries
Sprinklers in your yard hitting the clean laundry set out
to dry by your next door neighbor
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Recall a Competitive Equilibrium
Supply = Marginal Cost
Price
P*
Demand = Marginal Benefit
Q*
Quantity
► If
the market is producing at Q*,P* then
social welfare is maximized.
► This assumes there is no externality.
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Two Types of Externalities
► Type
1: Negative Externality
 A negative externality exists when production or
consumption activity creates an external cost.
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What happens when there is a
Negative Externality
► When
there is a negative externality, there
exists a marginal external cost.
 Marginal External Cost – the cost of producing
an additional unit of output or service that falls
on people other than just the producer.
► Marginal
Cost + Marginal External Cost =
Marginal Social Cost.
 Marginal Social Cost – the marginal cost
occurred by the entire society.
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Negative Externality’s effect on the
Competitive Equilibrium
Price
Marginal Social Cost = Marginal Cost + Marginal External Cost
Supply = Marginal Cost
Psc*
P*
Demand = Marginal Benefit
Qsc*Q*
►
►
►
Quantity
When there exists an externality, the marginal cost/supply
curve is shifted to reflect the cost of producing to everyone.
The market is then not producing at the equilibrium anymore as
the equilibrium is now Qsc*, Psc*.
Producing at Q*, P* instead of Qsc*, Psc* causes a DWL.
 Because it does not take into account total social cost.
 MSC>MB so there is a loss in total surplus.
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Two Types of Externalities
► Type
2: Positive Externality
 A positive externality exists when production or
consumption activity creates an external
benefit.
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What happens when there is a
Positive Externality
► When
there is a positive externality, there
exists a marginal external benefit.
 Marginal External Benefit – the benefit of an
additional unit that other people (other than
those enjoying the output or service) enjoy.
► Marginal
Benefit + Marginal External Benefit
= Marginal Social Benefit.
 Marginal Social Benefit – the marginal benefit of
consumption of a good or service to society.
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Positive Externality’s effect on the
Competitive Equilibrium
Price
Supply = Marginal Cost
Psb*
P*
Demand =
Marginal
Benefit
Q*
►
►
►
Qsb*
Marginal Social Benefit =
Marginal Benefit + Marginal
External Benefit
Quantity
When there exists an externality, the marginal benefit/demand
curve is shifted to reflect the benefit of producing to everyone.
The market is then not producing at the equilibrium anymore as
the equilibrium is now Qsb*, Psb*. Producing there maximizes
surplus.
Producing at Q*, P* instead of Qsb*, Psb* causes a DWL.
 Because it does not take into account total social benefit.
 There exists under production so total surplus is subtracted from.
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How to solve for an externality:
“Solving” for an externality is how we get the market to
produce at equilibrium.
There exists many solutions, we will examine 3 of them.
Private Solution: have the effected parties work out their
problems between them selves.
Coase Theorem: if private parties can bargain without
cost over the allocation of resources they can solve the
problem of externality on their own.
►
►
1.
►

Requirements for the Coase Theorem to work:
1.
2.
►
Property rights are defined.
Small number of people negotiating.
Examples: Sprinkler and laundry, loud party and sleeping
neighbors, etc.
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How to solve for an externality:
2. Pigouvian Tax: A tax enacted on producers that
produce a negative externality.



Causes firms to pay for the right to pollute
Internalizes the social cost and shifts the supply curve
of the firm so that it equals the Marginal Social Cost.
Problem: hard to enforce.
How it works: a tax is put on each ton of
emissions due to production of a good.
►


The tax is equal to the marginal external cost.
So the Marginal Social Cost is equal to the Marginal
MSC = MC + tax
MEC
Price
Cost
MC
tax
MB
Quantity
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How to solve for an externality:
3. Tradable Permits: Government issued permits that
allows them to pollute to a certain limit. Firms
then buy and sell the permits amongst
themselves.
 The firms for which it is cheap to decrease pollution
now have an incentive to decrease pollution as much as
possible and make money selling permits.
 In addition the firms for which it is expensive for them
to decrease pollution can buy permits from other firms.
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Comparison between Pigouvian Tax
and Tradable Permits
Price of
Pollution
Pigouvian Tax
Price of
Pollution
Tradable Permit
Supply of Permits
P
P
Demand for
Pollution Rights
Q
Quantity of
Pollution
A pollution tax sets the price of
pollution per ton of emissions with which
the demand curve sets the Q of pollution
demanded.
Demand for
Pollution Rights
Quantity of
Pollution
A permit market sets the
quantity of pollution with which
the demand curve sets the P of
pollution.
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