Externalities and Market Inefficiency
Chapter Introduction
This chapter introduces the concept of externalities, which occur when an individual's actions impact others not involved in the transaction. Externalities can lead to inefficiencies in market outcomes, warranting government intervention or private solutions.
Learning Objectives
In this chapter, four key aspects related to externalities are covered:
Learn the nature of an externality.
Understand why externalities contribute to market inefficiency.
Examine various government policies aimed at addressing externalities.
Survey how individuals might solve externality issues independently.
Explore reasons that private solutions may sometimes fail.
Externalities Overview
Example: Dioxin Emissions from Paper Manufacturing
Firms producing paper generate dioxin as a by-product, which poses health risks such as cancer and birth defects. Here, the release of dioxin represents a major societal issue due to the adverse impact on public health, unaccounted for in their market activities. Previous chapters discussed how efficient resource allocation is typically achieved through supply and demand, supported by Adam Smith's concept of the "invisible hand."
Market Failures and the Invisible Hand
Despite the effectiveness of markets, there are scenarios, particularly concerning externalities, where the invisible hand fails by allowing excess pollution due to profit motives unimpeded by social consequences. This introduces one of the critical principles of economics: the potential for government action to enhance market outcomes.
Definition of Externality
An externality is defined as a situation where an individual's actions affect a bystander without compensation. These can be classified into two major types:
Negative Externality: Adverse effects on third parties (e.g., pollution).
Positive Externality: Beneficial effects on third parties (e.g., education).
Implications of Externalities in Markets
Due to externalities, market participants (buyers and sellers) often neglect the effects of their actions on bystanders. For example, paper firms do not account for pollution costs in pricing, leading to excess emissions and an inefficient equilibrium. Therefore, the equilibrium market price doesn't reflect the true social costs.
Various Types of Externalities
Several practical examples illustrate both negative and positive externalities:
Automobile Emissions: The pollution from cars leads to smog and respiratory issues, a negative externality because drivers fail to include health costs in their purchasing habits. Solutions include government-set emission standards and gasoline taxes.
Barking Dogs: Dog owners might not realize that excessive barking disturbs neighbors, leading to conflicts. Local regulations like noise ordinances help mitigate this externality.
Research and Knowledge Spillovers: Technological advancements benefit society broadly, yet inventors face difficulties capturing these benefits, leading to underinvestment in research. Solutions include patent protection and research subsidies.
Carbon Emissions and Climate Change: Greenhouse gases lead to global warming and ecological changes that consumers don't fully account for in energy consumption. Governments combat this with carbon taxes.
Vaccinations: Vaccinating individuals against communicable diseases provides herd immunity, benefiting society at large. Individuals often undervalue this benefit when deciding on vaccination, presenting an opportunity for governmental intervention.
Market Inefficiency Due to Externalities
Concept of Welfare Economics
This section revisits the principles of welfare economics to show how externalities lead to inefficiencies. We'll analyze a specific market example, aluminum, to illustrate these principles. In market equilibrium, the intersection of supply (producer costs) and demand (consumer value) maximizes total surplus.
Negative Externalities in Production
Consider the case where aluminum production leads to pollution. Each unit's production incurs social costs beyond the private costs borne by producers, creating a social cost curve that lies above the supply curve. The true social optimum quantity of aluminum produced is less than that at market equilibrium due to this divergence, emphasizing inefficiencies caused by external costs neglected by producers.
Measuring Economic Well-Being
The introduced concept of deadweight loss elucidates the efficiency loss due to externalities. Total surplus decreases, represented graphically, when social costs exceed producer valuations at market equilibrium, which may incentivize the government to implement corrective measures, such as taxes aligned with the pollution costs.
Government Policies to Address Externalities
Command-and-Control Policies
The government often employs regulations (command-and-control policies) to manage externalities. Examples include banning the pollution of rivers or imposing production limits. These policies can be rigid and sometimes inefficient for various reasons, including variability in emission costs across firms.
Market-Based Policies
Corrective Taxes (Pigouvian Taxes): Taxes imposed on activities with negative externalities create economic disincentives for pollution-producing activities, thereby aligning individual incentives with social efficiency. In the case of aluminum, producers would face a tax equal to the external cost generated by their actions.
Subsidies for Positive Externalities: Conversely, for activities generating positive externalities, such as education, governments might provide subsidies incentivizing more consumption, aligning consumption levels closer to social optimality.
Tradable Pollution Permits: Alternatively, establishing a market for pollution rights allows firms the flexibility to buy or sell rights, efficiently allocating pollution within the economy based on how much firms value the right to produce pollutants.
The Coase Theorem
The Coase theorem posits that private negotiations can lead to efficient outcomes if transactions costs are low and property rights are well defined. In scenarios where negotiation fails due to high transaction costs or the large number of affected parties, government intervention becomes necessary.
Conclusion
This chapter elucidates the challenges posed by externalities in economic theory and practical policy-making. Market mechanisms alone often fail to account for third-party effects, necessitating government interventions through regulations, taxes, or allowances designed to internalize external costs. Markets can enhance overall welfare if redirected toward efficiency through purposeful policy.
Chapter Review
Key Concepts
Corrective Taxes: Taxes aimed at correcting market inefficiencies by aligning private costs with social costs.
Internalizing Externalities: Making individuals (e.g., producers) accountable for third-party costs associated with their activities.
Tradable Permits: Government-issued allowances for pollution that can be bought and sold to optimize environmental outcomes.
Coase Theorem: A principle suggesting that private parties can negotiate efficient outcomes without regulation if transaction costs are negligible.
Transaction Costs: Expenses incurred in the process of bargaining or forming contracts to internalize externalities.
Review Questions
Provide examples of negative and positive externalities.
Illustrate the effect of negative externalities on supply and demand curves using a diagram.
Discuss the advantages of corrective taxes over regulations in mitigating pollution.
What private mechanisms exist for addressing externalities without governmental intervention?