Econ 200 - Externalities Notes

Externalities

Warm-up Question

  • If the social cost is greater than the private cost in a particular market, the socially optimal equilibrium will exist at a quantity that is less than the private level.

Market Failures

  • Markets don’t always work well, leading to market failure.
  • Two types of market failures discussed:
    • Externalities
    • Public goods

What are Externalities?

  • Individuals make decisions by weighing their own costs and benefits.
  • Private benefit accrues directly to the decision-maker.
  • Private cost falls directly on an economic decision-maker.
  • Sometimes other people are affected by our decisions or have a stake in the outcomes.
  • External cost: a cost imposed without compensation on someone not involved in the decision-making.
  • External benefit: a benefit that accrues without compensation to someone not involved in the decision-making.

Abbreviations to Know

  • MB = Marginal Benefit
  • MC = Marginal Cost
  • Private MB and Private MC
    • "Private" refers to the market participants (the buyers and sellers).
    • Private MB = Demand
    • Private MC = Supply
  • Social MB and Social MC
    • Social MB is the benefit to society from consumption of a good/service.
    • Social MC is the cost to society from production of a good/service.

External Costs and Benefits

  • External costs and external benefits are collectively referred to as externalities.
  • Negative externality: external costs.
  • Positive externality: external benefits.

Four Types of Externalities

  • Negative production externality
  • Negative consumption externality
  • Positive production externality
  • Positive consumption externality

Examples of Externalities

  • Negative production externality: Burning coal to produce electricity.
  • Negative consumption externality: Smoking cigarettes.
  • Positive production externality: Bees.
  • Positive consumption externality: Flu shots
  • NETWORK externalities: Effect of additional user/participant on the value of good/activity.

Efficiency and Market Equilibrium

  • In the presence of externalities, total surplus is not maximized at the market equilibrium! (The market equilibrium is not efficient!)
  • Externalities cause a market failure.
  • With negative externalities, the market quantity is TOO MUCH.
  • With positive externalities, the market quantity is NOT ENOUGH.
  • Efficiency = Maximum Total Surplus

Negative Production Externality

  • Suppose a supplier causes a negative production externality during production.
  • Unregulated market produces where private MC = MB.
  • Social cost = private cost + external cost
  • Deadweight Loss (DWL) occurs if the externality is not considered.

Modeling Negative Externality from the Demand Side: Cigarettes

  • Cigarette consumption imposes an external cost of 1 on society.
  • If the consumers consider this cost, the demand curve would be lower.
  • Socially optimal level of consumption is less than privately optimal level.
  • Problem of “too much”

Example Question:

  • How much is the total cost of externality to society at the market equilibrium? (we assume we do not take into account the external effect)

Negative Externality from the Demand Side

  • Total external cost is 1 * 20B = $20B.

Consumer and Producer Surplus

  • How much is the consumer surplus plus producer surplus at market equilibrium (i.e. if we don’t consider the external effect)?

Total Social Surplus

  • How much is the total social surplus (consumer surplus + producer surplus - external cost) at the market equilibrium?

Social Surplus at Socially Optimal Equilibrium

  • How much is the social surplus (consumer surplus plus producer surplus) at the socially optimal equilibrium? (the demand will be social demand)