Externalities

Exernalities

when the production or consumption of a good imposes an external cost or benefit on society (those not directly involved in the transaction) 

Production externality

drawn on supply curve, has to do with the impacts of the good as it is being made

Consumption externality

drawn on demand curve, has to do with the impacts of the good as it is being consumed

why do externalities create DWL?

because there is potential harm or benefit from a good being made/used, the market inaccurately predicts equilibrium — there is a different social equilibrium that needs to be considered!

negative externalities in production: social costs =

private costs + external costs (MCsocial = MCprivate + externality, Ssocial = Sprivate + externality)

negative externalities in consumption: social benefits = 

private benefits - external costs (MBsocial = MBprivate - externality, Dsocial = Dprivate - externality)

positive externalities in production: social costs =

private costs - external costs (MCsocial = MCprivate - externality, Ssocial = Sprivate - externality)

positive externalities in consumption: social benefits = 

private benefits + external benefits (MBsocial = MBprivate + externality, Dsocial = Dprivate + externality)

Which way do demand or supply shift when there is a positive externality? And a negative externality?

right, left

Intuition of externality DWL

all the units of the good where the cost to society is HIGHER than the benefit (they cause more harm than good)

Public solutions to externalities

tax or subsidy, price ceiling/floor, ban/quota, cap and trade

Pigovian tax or subsidy

tax or subsidy equal in size to the per unit amount of the negative or positive externality

What is the size of the tax DWL in comparison to the externality DWL?

They are equal in size! We trade one for the other

Private solutions to externalities

Coase Theorem, social shame, incentives, norms

Coase Theorem; conditions for this to work 

asserts that the real problem with externalities is a lack of property rights, and that if either group were given clear property rights and allowed to trade, they would reach social optimum; IF there are no transaction costs and contracts are enforceable