Chapter+10+-+Externalities+CDJ

= What is Externality? = Source: http://www.cartoonstock.com/directory/n/negative_externality.asp

– ** Externality ** is an impact of one person’s action on someone not directly involved.
There are two types of externalities: Negative externality – the impact on the bystander is **unfavorable**. Positive externality – the impact on the bystander is **beneficial**.

Here's a video about externality: media type="youtube" key="Jax-ZyL7DkI" height="344" width="425" Source: http://kr.youtube.com/watch?v=Jax-ZyL7DkI

Examples:
– Think about some daily events that would explain the concept of externality: As you walk on the sidewalk, you witness a group of __people smoking__. The smoke is a negative externality because although you are not directly harmed by seeing people smoking, you know that it is polluting the air that you breathe, thus increasing the risk of getting lung cancer (that sound a bit like an exaggeration, but we know that second hand smoking is harmful). – Okay, so we can think of many negative externalities in our daily lives. What about positive externalities? Take a look at this example: As you continue walking down the street, you see a __restored historic building__. The restored historic building is a positive externality because you can enjoy the beauty of the building and the sense of history as you walk by.

=Negative Externalities = Let's take a look at an example of aluminum factories. Aluminum factories emit pollution, which causes health risk for people who breathe the air. The ** cost to society ** of producing aluminum is **larger** than the ** cost to aluminum producers ** because the ** social cost ** includes __Private costs of aluminum producers + costs of bystanders who are affected by pollution.__ Take a look at the graph below:

source: textbook The equilibrium quantity of aluminum (Q market) is larger than the socially optimal quantity (Q optimum). Why? Market equilibrium reflects only the private costs of production. One to achieve the optimal outcome is to tax the aluminum producers. The tax would shift the supply curve for aluminum up by the size of tax, which would create a new supply curve that would coincide with social-cost curve. This usage of tax is called ** internalizing the externality **.

=Positive Externality = Basically, positive externality is the opposite of negative externality. When negative externalities lead markets to produce a //larger// quantity than is socially desirable, positive externalities produce a //smaller// quantity. One way to solve a problem for positive externality is by taxing goods that have negative externalities and subsidizing goods that have positive externalities.

Source: textbook

 =Private Solutions to Externalities =

Purpose : move the allocation of resources closer to the social optimum.
1. Moral Codes and social Sanctions : tells us to take account of how our actions affect other people. 2. Charities 3. Contract 4. The Coase Theorem : if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

Sometimes, private solutions don't work. Why? Interested party fails to solve an externality problem because of transaction costs : costs that parties incur in the process of agreeing to and following through on a bargain. Sometimes, bargaining simply breaks down. Reaching an efficient bargain is especially difficult when the number of interested parties is large. When private bargaining doesn't work, this is when the government plays a role.

=Public Policies Toward Externalities =

Command-and-Control Policies: Regula tion
A government can solve an externality by making some behaviors either required or forbidden. However, it is not as simple as this. It would be impossible to prohibit all polluting activities. Using environmental regulations would help controlling the quantities of pollution.

Market-Based Policy 1: Corrective Taxes and Subsidies
Corrective tax – a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality. Note: corrective tax is also known as Pigovian taxes.

source: textbook

Market-Based Policy 2: Tradable Pollution Permits
Polluti on Permits the initial allocation of pollution permits among firms does not matter from the standpoint of economic efficiency. source: textbook = =

Here's a powerpoint handout from the Mankiw website:

PODCAST & SUMMARY **
 * 

media type="file" key="econ1 4.m4a"

= Problems and Applications = 1. What is an example of negative and positive externality? 2. What is the difference between corrective taxes and pollution permits graphs?

Answers:
1. Possible answers for negative externality: pollution, loud neighbors, etc. Possible answers for positive exernality: education, renewed public park, etc 2. Corrective tax graph: price is fixed, Pollution permits: quantity is fixed