Chapter 10: Externalities

negative externality

the effect of someone’s decision/transaction creates negative effects on society

ex. steel factories emit pollution —> health and climate risks

social cost

used for (-) ex,

= private costs of steel producers + costs to bystanders harmed by the emissions

is the social cost curve above or below the supply curve

above the supply curve bc it has the supply curve cost which are the direct costs of the producers and then also adds the costs to bystanders harmed by the externality

**diff between these two curves = cost of pollution emitted

what does a negative externality due to market quantity?

the eq quantity > socially optimum quantity

**this leads to an inefficiency bc the market eq only takes into account private costs and not social costs as well

reducing steel production and consumption below market eq raises total economic well-being bc it gets rid of an inefficiency

negative externality graph details

social cost curve = higher supply curve

social cost curve = above supply curve

demand does not move

how can social planners fix negative externalities?

use a tax that is the same amt as the inefficiency bc that shifts the supply curve upward by the size of the tax —> now steel producers produce the socially optimal quantity of steel

“internalizes the externality”

this phrase means that the tax or subsidy gives buyers and sellers in the market an incentive to consider the external effects of their actions

ex. steel producers take into account literal costs of pollution and then the market price goes up and consumers of steel have an incentive to buy less

positive externalities

effect of something is positive on bystanders

i.e. education bc it leads to more informed voters = better gov for everyone, ,ower crime rates, leads to development of tech, etc.

positive externalities on a graph

demand curve does not reflect value to society of the good

social value > private value

social value = private value + benefit to society

optimal quant found @ social-value urve and supply curve intersect

social-value curve = like demand curve

socially optimal quantity > market quantity

**without outside intervention, the market yields too little of this product

how do govs fix positive externality

subsidies

negative and positive externalities and market quantities

negative externalities lead markets to produce a larger quantity than is socially desirable.

positive externalities lead markets to produce a lower quantity than is socially desirable.

gov can internalize the externality by taxing goods w/ neg externalities and subsidizing goods w/ pos externalities

command-and-control policies

regulate behavior directly

ex. all firms must reduce pollution by 30tons/day

market-based policies and the 2 types

provide incentives so that private decision makers choose to solve the problem on their own

(1) corrective taxes and subsidies

(2) tradable pollution permits

do economists prefer regulations or market-based policies?

market-based policies bc they’re much more efficient

problem w/ regulations

to make good regulations, gov needs to know details about specific industries and alternative technologies they could adopt but this info could be difficult for gov to obtain bc profit-seeking industries have no reason to share what they know, and typically have an incentive to conceal their information

corrective taxes

taxes enacted to deal w/ effects of negative externalities

aka pigovian taxes

ideal corrective tax = external cost from an activity w/ (-) externalities

corrective subsidies

subsidies enacted to handle positive externalities

aka pigovian subsidies

ideal corrective subsidy = external benefit from activity with (+) externality

why do economists prefer corrective taxes to regulations?

bc they can reduce pollution at a lower cost to society through taxes

ex. w/ regulation, companies don’t have further incentive to continue lowering pollution past a certain point and it costs some companies way more than others to lower pollution. however, w/ a tax, companies w/ lowest cost of reducing pollution will do it and have more of an incentive to do so

**the higher the tax, the larger the reduction in pollution

corrective taxes basically place a price on the right to pollute and therefore allocated pollution rights to factories that face the highest cost of reducing it

corrective taxes and incentives

most taxes distort incentives and move allocation of resources away from social optimum but corrective taxes give market participants the right incentives, therefore internalizing the externality and moving the allocation of resources closer to the social optimum.

corrective taxes raise gov rev and enhance economic efficiency

tradable pollution permits

EPA creates a new scarce resource: pollution permits and a market to trade these permits develops, which is governed by supply and demand

**invisible hand ensures the new market allocates the right to pollute efficiently - permits will end up in hands of those who value them most judged by their WTP

similarities between pollution permits and corrective taxes

firms pay for their pollution

• CT: pay tax to gov

• pollution permits: firms buy permits

objections to economic analysis of pollution

we shouldn’t put a price on clean air and water - protecting environment is a priority regardless of the cost

COUNTER: clean air and water obey law of demand - the lower the price of environmental protection, the more of it the public will want

private solutions to externalities

(1) moral codes & social sanctions: most people don’t litter bc it’s the wrong thing to do

(2) charities: gov encourages donations to things like universities or climate change organizations by offering an income tax deduction for donations

(3) integrating different types of businesses: apple grower and beekeeper next to each other benefit each other and if these two businesses became one, it would be easier to take advantage of the (+) ex

(4) negotiate a contract

coase theorem

if private parties can bargain over the allocation of resources at no cost, then the private market will always solve the problem of externalities and allocate resources efficiently

ex. emily has dog that brings her friendship (benefit) but barks really loud and disrupts ben (cost). they can come to an agreement in between her benefit and his cost

according to the coase theorem, does the initial distribution of rights maytter for the market’s ability to reach the efficient outcome?

no - two parties can reach the efficient outcome regardless of how rights are initially distributed

is the distribution of rights relevant?

yes, it determines the distribution of economic well-being

why private solutions don’t always work

(1) transaction costs: needing a translator or a lawyer to come to an agreement

(2) holding out for a better deal

(3) large # of interested parties: hard to coordinate w/ so many people

when private bargaining doesn’t work, what can be done?

gov can play a role