Ch.10+Externalities+YD

So far, we have discussed how the supply and demand leads the market into the equilibrium. One of the Ten Principles of Economics says that markets are usually a good way to organize economic activity. But why does it say //usually//? It's because of this idea of **externalities**. This explains why governments can sometimes improve market outcomes, one of the Ten Principles of Economics.


 * Externality** occurs when a person participates in an activity that influences the non-participants in some ways, yet those non-participants pay nor receive any compensation for that effect. It is easier to understand this concept with examples.

If you smoke tobaccos, the people around you are going to suffer from second-hand smoking. You are the one smoking, and the people around you are bystanders. When the impact on the bystander is adverse like in this case, it is called a **negative externality**.

If there's a negative externality, there should be a positive externality. **Positive externality** is when the impact is beneficial for the bystanders. For example, if you invent a new machine that allows people to transport instantly to anywhere, the people who didn't invent the machine can benefit from the machine.

Negative Externalities
Let's take aluminum factories as an example.

According to the things we have learned, supply and demand curves determine the equilibrium point. However, this equilibrium point only considers the cost to the buyers and the seller, not the bystanders who are influenced by this market.

Let's suppose that aluminum factories emit pollutions. Everytime the factory produces aluminum, a certain amount of smoke enters the atmosphere. Because this pollution creates a health risk for those walking down the street, it is a negative externality.

How does negative externality affect the market?

In negative externalities, the cost to society of producing aluminum is larger than the cost to the aluminum prioducers. Social cost includes the private cost of the aluminum producers plus the costs to those bystanders affected adversely by the pollution. The graph below shows the social cost of producing aluminum. Since the MSC, or the Marginal Social Cost is greater than the MPC, Marginal Private Cost, the new supply curve is above the original.



With the new supply curve that takes into account the negative externality of producing aluminum, we can find the socially optimum point.

Originally, equilibrium price was P1, and quantity Q1. When the social cost is added, socially optimum price is P2 and quantity Q2. Notice that the quantity goes down. It is logical to think that the socially optimum point would want to reduce the quantity in the market because it causes negative effects in the society. The price goes up because the people in the market should pay for the pollution they cause in the society.

How can the government interfere to reach this socially optimum point?

The government can tax every aluminum produced. The tax will shift the supply curve upward, and will raise the price and reduce the quantity. the use of such a tax is called **internalizing the externality** because it gives the people in the market to take into account the externalities.

Positive Externalities
Unlike negative externalities, positive externalities bring about benefits on the bystanders. In positive externalities, social value is greater than the private value. The graph belowe shows the market when the positive externalities are taken into account.

Because the society values the product higher, social demand is above the private demand. The socially optimum point is the ideal equilibrium in the graph. Notice that the quantity is higher and price is higher than the original equilibrium. It is logical to think that the market should increase the quantity if the good has positive influence in the society. Also, producers should receive more (higher price) for producing something beneficial.

Government can subsidy to internalize the positive externality. For example, governments pay for the public schools because education is a positive externality.

Private Solutions To Externalities
Now, we'll discuss how private individuals respond to the externalities to move the allocation of resources closer to the social optimum. Government interference is not always necessary to solve problems.

One way the problems of externalities are solved is with moral codes. For example, most people do not turn on the radio with max volume on at 3am in the morning. Everybody knows that it is morally wrong to do that, because that will disturb neighbor's sleep. This moral code stops people from doing such a thing.

Charities, merging of firms, and signing of contracts can all solve problems with externalities.

The Coase Theorem
This economist named Ronald Coase came up with this theorem called the Coase theorem. It suggests that private markets can be very effectie in dealing with externalities.

For example, let's say your dog D-Wade barks like crazy all night. You're neighbor Lebron suffers from the noise every night. You benefit from owning D-Wade, but D-Wade has negative externality on LeBron. LeBron can offer to pay you to get rid of D-Wade. If LeBron offers you greater amount of money than the benefit you receive from owning D-Wade, you will accept the offer. By bargaining, they will eventually settle their problem. As a result, the outcome becomes efficient in the end.

Like this, any two groups with externality problems can bargain to reach optimum point.

However...
The Coase theorem is not always very efficient. This is because of the transaction costs, the costs that parties incue in the process of ahreeing to and following through on a bargain. In case of D-Wade and LeBron example above, they have to discuss and bargain for a long time to reach agreement. they are wasting time and energy by doing this.

Command and Control Policies: Regulation
Governments can regulate the quantity produced in the market to internalize the externalities.

Corrective Taxes and Subsidies
Governments can enact taxes to deal with negative externalities. These taxes are called corrective taxes.

Many prefer corrective taxes to regulations for several reasons.

First of all, both policies are as effective. However, corrective taxes can reduce production more efficiently. Different factories have different costs to reduce their production. Regulation reduces the production by the same amount for all the factories. Therefore, it will cost more for some factories to reduce the production. However, corrective taxes put incentives to reduce the production. Therefore, factories with less cost will reduce more, while other factories will reduce less and pay more taxes.

Another reason is that regulation causes no incentives for the factories to produce less. Corrective taxes put more taxes if they produced more. Therefore, corrective taxes is better for the environment.


 * __Key Concepts__**
 * externality**: the effects of a person's actions on a bystander
 * internalizing the externality**: solving the problem of externality by making either the buyers or the suppliers take account of the effects on bystanders
 * Coase theorem**: the proposition that if the private market can distribute resources without using money, then, there will be no externalities
 * transaction costs**: costs that are made as people bargain
 * corrective tax**: tax that makes suppliers to take account of the negative effects on bystanders

Questions 1. What is the effect called that affects the bystander? 2. What is the theorem called that proposes that private market should distribute resources without using money

Answers 1. externality 2. Coase theorem