ECO 105 Ch.11 Market Failure #2: Externalities

Externalities

- Occur when benefits or costs associated with an economic activity are experienced by others not part of the original activity.
- Happened because of missing property right

Negative externalities

- Costs to society from your private choice that affect others, but that you do not pay.
- MSC>MC
- Price don't reflect all social costs and benefits, and markets fail to product efficient outcome.
- Too many products or service

Tragedy of the Commons

The overuse and depletion of a resource that no one can be excluded from because of missing property right

Efficient Pollution

Balances the additional environmental benefits of lower pollution with additional opportunity cost of reduced living standards
- Socially desirable amount of pollution is not zero.

Positive externalities

- Benefits to society from you private choice that affect others, but that others do not pay you for.
- MSB>MB
- Too few products and services
- Generate the problem of Free Rider

Free Rider

Those who consume products or service without paying

Rule for externalities

Marginal Social Cost = Marginal Social Benefit

Marginal Social Cost (MSC) [Negative Externalities] Supply Curve

Marginal Private Cost (MC) + Marginal External Cost [Price of preventing or cleaning up damage to others external to the original activity]

- Smart social quantity of output is at intersection of marginal social benefit and marginal social cost curves.

Marginal Social Benefits (MSB) [Positive externalities] Demand curve

Marginal Private Benefit (MB) + Marginal external Benefit [Price of value or savings to others externals to the original activity]

- Smart social quantity of output is at intersection of marginal social benefit and marginal social cost curves.

Gov's remedy market failure because of missing property right and business have incentives to ignore external costs by

1. Creating social property rights to the environment
2. Making polluting illegal
3. Penalizing Polluters

Emission Tax

Tax to pay for external costs of emissions

Internalize the externality

Transform external costs into costs the producer must pay to the gov

Carbon Tax

Emission tax on carbon-based fossil fuels

Smart Carbon Tax

Marginal external cost of damage from emission

Use of Carbon Taxes and Emissions Permits

Give pollution a price reflecting marginal external cost of damage, smart private choices become smart social choices

Cap-and-Trade system

- Limits quantities of emissions business can release into environment
- Gov auction off pollution permits to highest bidders
- Businesses can buy and sell emission permits
- Permit price becomes private cost to business reflecting marginal external cost of pollution
- Objection: Permit business to pollute

Differences between Carbon taxes and Cap-and-Trade system

- Carbon Tax set price of emission and the market adjust quantities
- Cap-and-Trade systems set quantities and the market adjusts price

Public Goods

- Provide external benefits consumed simultaneously by everyone; no one can be excluded
- Problems of free rider
- Positive externalities
- Eg. Lighthouse or national defence

Problems of freerider

- Market underproduce products and services with positive externalities
- no single price can coordinate smart individual choices and smart social choice
- Market-clearing price is too high for buyers to be willing to buy
- too low for sellers to be willing to supply

Public provision

Gov provision of product or services with positive externalities, financed by tax revenues

Subsidy

Payment to those creating positive externalities

Smart subsidy (value of marginal external benefit) and public provision

remove the disconnect between prices for buyers and sellers, leading to voluntary choice of output best for society