Lecture 6: Externalities Summary

Externalities Overview

• Definition: Uncompensated impact of one’s actions on another’s wellbeing.

  • Negative Externality: Adverse impact (e.g., pollution).

  • Positive Externality: Beneficial impact (e.g., vaccinations).

Market Failures

• Competitive markets can achieve efficient resource allocation.

• Market failure occurs when externalities are present, leading to inefficiencies (resources not allocated optimally).

• Other market failures: Public Goods, Asymmetric Information, Non-competitive Markets.

Negative Externalities in Production

• Example: Aluminium production causing pollution.

  • True cost = Private cost + Cost of negative externality = Social cost.

  • Optimal production (Qoptimum) occurs where social cost meets social value.

  • Market equilibrium (Qmarket) usually results in excessive production due to neglect of social costs.

  • Deadweight loss occurs between Qoptimum and Qmarket.

Solutions to Negative Externalities

• Internalizing the externality: Altering incentives (e.g., introducing a tax per unit produced) shifts supply curve to social cost.

Positive Externalities in Production

• Example: Industrial robots benefitting other sectors.

  • True cost of production is less than private cost, leading to underproduction in the market.

  • Deadweight loss occurs due to surplus left unaddressed.

  • Government may provide subsidies to encourage production to optimal levels.

Externalities in Consumption

• Negative: Excessive alcohol consumption, smoking.

• Positive: Vaccination, Education.

• Market fails due to discrepancies in social value vs. private value; solutions include taxation for negatives and subsidies for positives.

Private Solutions to Externalities

• Possible when individuals create incentives to reduce negative or promote positive externalities (e.g., moral codes, contracts).

• Coase Theorem: Private bargaining can efficiently resolve externalities if transaction costs are low.

Public Solutions to Externalities

• Implemented when private solutions fail; includes command-and-control regulations and market-based policies (e.g., Pigovian taxes, tradable permits).

• Taxes/subsidies align private incentives with social efficiency, potentially correcting market failures.

• Cap-and-trade policies create a market for pollution permits, allowing firms to buy/sell emission rights, fostering compliance with pollution caps.

General Lessons

• Negative externalities require taxation to reduce excessive production.

• Positive externalities require subsidies to stimulate increased production.