Chapter+10+(Externalities)

CHAPTER 10 Externality

Externality is the uncompensated impact of one person’s actions on the well-being of a bystander. It rises a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is unfavorable, it is called a **negative externality** : if it is beneficial it is called a **positive externality**. media type="youtube" key="Jax-ZyL7DkI" height="344" width="425" //Source: http://kr.youtube.com/watch?v=Jax-ZyL7DkI//

Examples:  i. The release of dioxin into the environment. The paper firms won’t consider the cost of pollution they create and will give out too much pollution before the government takes action to stop them. ii. Barking dogs because they disturb neighbors. Dog owners do not pay the full cost of the barking of their dogs. Local governments make it illegal to “disturb the peace”.// i. Restored historic buildings because people who walk by it enjoy the beauty of them. The building owners don’t get all the benefit of restoring the buildings. Governments, therefore, regulate the destruction of these historical buildings. ii. Research into new technologies because it finds knowledge that other people can find useful. Inventors don’t get full benefits for their inventions. The federal government would deal with this problem by the patent system which gives only the inventors the ‘exclusive use’ temporarily. In each of these examples, some decision makers, such as inventors, do not know the external effects of their behaviors. So the government has to take action by influencing the behaviors to ‘protect the interest of bystanders.’ The market equilibrium is not efficient when there are externalities. The equilibrium fails to maximize the total benefit to society.
 * Negative externality:**
 * Positive externality:**

 Supply and demand curves have important information about costs and benefits. The demand curve shows the value to buye4rs, and the supply curve shows the costs of sellers. The equilibrium quantity maximizes the total value to buyers minus the total costs of sellers.
 * Welfare Economics: A Recap**
 * If there are no externalities, the market equilibrium is efficient. *

When there is a negative externality, such as pollution, the social cost of the good exceeds the private cost. __The optimal quantity is smaller than the equilibrium quantity.__ The reason for this inefficiency is that the market equilibrium shows only the private costs of production. In the market equilibrium, the marginal consumer values their product at less than the social cost of producing it. So, at equilibrium, the demand curve lies below the social-cost curve. Reducing the production and consumption of the product below the market equilibrium level would increase total economic well-being.  Q. How would the social planner achieve the optimal outcome?
 * Negative externalities **
 * It would be to tax the producers for each product sold. For example, aluminum producers would have each ton of aluminum sold, taxed.

Q. Effect of tax? : The tax would shift the supply curve for aluminum upward by the size of the tax. In the new market equilibrium, aluminum producers would produce the socially optimal quantity of aluminum. The use of such a tax is called: “Internalizing the externality ” because it gives the sellers and buyers an incentive to be aware of the external effects of their actions.


 * Internalizing the externality**: altering incentives so that people take account of the external effects of their actions.

 In the presence of positive externality, the social value of the good exceeds the private value. __The optimal quantity is larger than the equilibrium quantity.__ Education yields positive externalities. 1) A more educated population leads to more informed voters, which leads to a better government. 2) A more educated population means lower crime rates. 3) A more educated population encourages the development of technological advances, meaning higher productivity and wages for everyone.
 * Positive Externalities **

To move the market equilibrium closer to the social optimum, a positive externality requires a **subsidy**. For example, education is subsidized today through public schools and government scholarships. 
 * Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. *

Positive externality**: technology spillover**: the impact of one firm’s research and production efforts on other firms’ access to technological advance. For example: Industrial robots. Whenever a firm builds a robot, there is some chance that it will find a new and better design. This would benefit not only the firm but the society and will increase technological knowledge among people. The government can internalize the externality by __subsidizing__ the production of robots.
 * Technology spillovers, industrial policy and patent protection **


 * Industrial policy:** Government interference in the economy that tries to promote advancement in technology industries.

This law protects the rights of inventors by giving them a patent: an exclusive use of their inventions for some time. Q. How does the patent internalize the externality?  The patent gives the firm a ‘property right’ over its invention. So, if other firms wish to use the new technology, they would have to get permission for the inventing firm and pay a huge amount of money.  The goal of all remedies: __To move the allocation of resources closer to the social optimum.__ Colleges and universities receive gifts from corporations because education has positive externalities for the society. The government encourages this by a tax system that lets income tax deduction for charitable donations. For example, a contract between the apple grower and the beekeeper can solve the problem of too few trees and too few bees. The contract can identify the number of tress, the number of bees and the payment from one party to the other. 4) **The 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. This theorem states: the private economic actors can solve the problem of externalities among themselves. Whatever the initial distribution of rights, the parties can reach a bargain so that everyone can be better off and the outcome is efficient.
 * Patent protection:** A way to deal with technology spillovers.
 * Private Solutions to Externalities **
 * Type of private solutions:**
 * 1)** **Moral codes and social sanctions**
 * 2)** **Charities**
 * 3)** **A contract**

 Why? Because organizing everyone is expensive and costly. For example, with pollution, according to the Coase Theorem, if it is inefficient the factory and fishermen can reach a bargain in which the fishermen pay the factory not to cause pollution. If there are many fishermen, trying to coordinate all of them to bargain with the factory would be costly. media type="youtube" key="Unh9uJggjRg" height="344" width="425" Source: http://kr.youtube.com/watch?v=Unh9uJggjRg//
 * Why Private Solutions Do Not Always Work**
 * Sometimes the interested parties fail to solve an externality problem because of ‘**transaction costs’**: the costs that parties incur in the process of agreeing to and following through on a bargain.
 * Reaching an efficient bargain is difficult when the number of interested parties is high.
 * Public Policies toward externalities **

Command and Control Policies: Regulation A government can solve an externality by making some behaviors either required or forbidden. For example, dumping poisonous chemicals into the water supply is a crime. The external costs to society would exceed much more than the benefits to the polluter. The government would then carry out the command and control policy that prevents this act. Corrective Taxes and Subsidies Corrective taxes: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality. They are also called: Pigovian taxes.

Q. Why would economists prefer corrective taxes to regulations in order to deal with pollution? A. Because they can reduce pollution at a lower cost to society. For example, if there were two factories: a paper mill and a steel mill, each dumping 500 tons of glop into a river each year, and the EPA decides they want to reduce the pollution, there would be two solutions: Tax reduces pollution much more efficiently. The regulation requires each factory to reduce pollution by the same amount. But the corrective tax places a price on the RIGHT to pollute. Whatever the level of pollution the EPA chooses, they are able to achieve their goal at the lowest TOTAL cost using a tax.
 * 1) Regulation: The EPA could tell each factory to reduce its pollution to 300 tons of glop per year.
 * 2) Corrective tax: the EPA could levy a tax on each factory of $ 50,000 for each ton of glop it emits.
 * When there are externalities, society cares about the ‘well-being’ of the BYSTANDERS who are affected. Corrective taxes are therefore the incentives to account for the presence of externalities and so they move the allocation of resources closer to the social optimum.*

Pollution Permits An example of this is when the government could protect the environment by issuing a limited number of pollution permits. The end result of this policy is similar to imposing corrective taxes on polluters. Q. What are the similarities between pollution permits and corrective taxes? 1. Both of the firms pay for their pollution. 2. Both internalize the externality of the pollution by making it costly for firms to pollute.

__The equivalence of Corrective Taxes and Pollution Permits__ In corrective taxes, the EPA sets a price on pollution, and the demand curve determines the quantity of pollution. The supply curve is perfectly elastic (because firms can pollute as much as they want by paying the tax). In Pollution Permits, the EPA limits the quantity of pollution, and the demand curve determines the price of pollution. The supply curve for pollution rights is perfectly inelastic (because the quantity of pollution is fixed by the number of permits). The Price and quantity of pollution are the same in both cases. '


 * Quotas and Tariffs

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Sources

Books:** __The Principles of Microeconomics__ by: N. Gregory Mankiw of Havard University

http://www.eoearth.org/article/Externality http://en.wikipedia.org/wiki/Externalities http://library.thinkquest.org/26026/Economics/externality.html**
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