Chapter 10.

Externalities



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Definitions

  • externality: the uncompensated impact of one person's actions of the wellbeing of a bystander
  • internalizing the externality: altering incentives so that people take accoun of the external effects of their actions
  • Coase Theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own
  • Transaction costs: the costs that parties incur in the process of agreeing to an d following through on a bargain
  • corrective tax: a tax designed to induce private decisio makers to take account of the social costs that arise from a negative externality


Learning Objectives

  • relationship between externalities and market inefficiency
  • positive + negative externality
  • various solutions to externalities
  • public policies toward externalities




1.Types of externality

externality: the uncompensated impact of one person's action on the well-being of a bystander.
Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when there are externalities.
Altering incentives so that people take account of the external effects of their actions is called internalizing the externality

Examples of externalities

The pollution from automobile - negative externality
Newly researched technology - positive externality



1). negative externality

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At any given quantity, the height of the demand curve shows the willingness to pay of the marginal buyer.
At any given quantity, the height of the supply curve shows the cost of the marginal seller.
The social-cost curve is above the supply curve because it takes into account the external costs imposed on society producers.
This is inefficient is that the market equilibrium reflects only the private costs of production.
The negative externalities lead markets to produce a larger quantity than is socially desirable


2). Positive externality


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The demand curve does not reflect the value to society of the good. The social value is greater than the private value, the social value curve lies above the demand curve.
To move the market equilibrium closer to the social optimum, a positive externality requires a subsidy.
The positive externaltiies lead markets to produce a smaller quantity than is socially desirable

2. The types of private solutions

1) Problem of externalities can be solved by moral codes and social sanction, such as choosing not to litter.
2) Charity can solve the problem. People can voluntarily solve externalities by taking actions such as community service
3)The private party can solve the problem of externalities by relying on the self-interest of the relevant parties.
4)Interest parties who want to internalize externalities can contact each other. This is called coase theorem

Coase theorem
Private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient

For example, if Jane wants to have the barking dog removed, she can pay the owner. If Jane pays the owner $50 and if owner's value of the dog is $40, the owner will remove the dog. If owner's value of dog is $60, he won't remove the dog.

Why private solutions do not always work

1) Interest parties might fail because of transation cost. Transaction cost is the cost that parties incur in the process of agreeing to and following through on a bargain.

2) The bargain can just break down. The bargain may not work and cause conflicts such as labor strikes.

3) Reaching the bargain is even more difficult if the number of interest parties is large. Coordinating everyone is costly.

3. Public solutions

1) Command and Control Policy: regulation
The government can remedy an externality by making certain behaviors either required or forbidden. Government can create rules such as prohibiting factories from dumping pollutant into the nearby water.

2)Market based policy1: corrective tax and subsidies
The government can internalize the externality by taxing activities that have negative externalities and subsidizing activities that have negative externalities and subsidizing activities that have positive externalities.
The tax used to deal with negative externality is corrective tax.

Tax is just as effective as a regulation in reducing the overall level of pollution. It reducs pollution more efficiently becuase corrective tax allocates pollution to those factories that face the highest cost of reducing it.
Lastly, the tax gives the factories an incentive to develop cleaner technologies because a cleaner technology would reduce the amout of tax the factory has to pay.
The effect of corrective tax:
1. alter incentive of factories
2. move allocation of resources closer to the social optimum
3. raise revenue for the government
4. enhance economic efficiency


The supply for pollution right is perfectly elastic because firms can pollute as much as they want by paying the tax.

3) Market based policy 2: tradable pollution permits
Corrective tax, polluting firms must pay a tax to the government. With pollution permits, polluting firms must pay to buy the permit
Each firms that already own permits must pay to pollute, the opportunity cost of polluting is what they could have received by selling their permits on the open market.

The supply curve for pollution right is perfectly inelastic becuase the quantity of pollution is fixed by the number of permits


POSITIVE EXTERNALITY


NEGATIVE EXTERNALITY


EXAMPLE OF AN EXTERNALITY






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Review Questions

Externalities cause markets to
  1. fail to allocate resources efficiently
  2. cause price to be different than the equilibrium price
  3. benefit producers at the expense of consumers
  4. cause markets to operate more equitably

Negative externalities occurr when one person's actions

  1. cause another person to lose money in a stock market transaction.
  2. cause his or her employer to lose business reveal his or her preformance for foreign produced goods
  3. adversely affect the wellbeing of a bystander who is not party to the action.

Research into new technologies

  1. provides positive externlaities because it creates knowledge others can use.
  2. results in negative externalities because government funding for reseach causes less government spedning in other areas.
  3. causes too many resources to be used for the small benefits received by sociey
  4. should only be funded by the corporation which will receive the profits from the research

which of the following is an example of a positive externality

  1. a college student buys a new car when she graduates
  2. the mayor of a small town plants flowers in the city park
  3. local high school teachers have pizza delivered every friday for lunch
  4. an avid fisherman buys new fishing gear for his next fishing trip.

Many times the problems of extrenlaities are solved by each of the following except

  1. self-interest
  2. moral codes and social sanctions
  3. charity
  4. normal market adjustments

Answers10.jaks




Work Cited


image: http://thefilter.blogs.com/photos/uncategorized/petrol_tax1.jpg
video: http://www.youtube.com/watch?v=hvMAec06_Uo
video: http://www.youtube.com/watch?v=ha-ssoI6S0Q
video: http://www.youtube.com/watch?v=1FQyKMxv4mA
Image: http://www.econosseur.com/assets_c/2008/12/FieldtripEconomist-thumb-510x158.gif
questions: Mr. Ski