Principles of Microeconomics: Externalities

ECON 1051: Principles of Microeconomics - Externalities

Andres Cuadros-Meñaca, PhD.
University of Northern Iowa, Wilson College of Business

Roadmap

  • Objectives

  • Externalities in Our Daily Lives

  • Negative Externalities

  • Positive Externalities

Objectives

When you complete this section, you will be able to:

  • Explain why negative externalities lead to inefficient overproduction and how government actions can achieve a more efficient outcome.

  • Explain why positive externalities lead to inefficient underproduction and how government actions can achieve a more efficient outcome.

Externalities in Our Daily Lives

  • Definition of Externality:

    • An externality is a cost or a benefit that arises from:

    • Production that falls on someone other than the producer.

    • Consumption that falls on someone other than the consumer.

Types of Externalities

  1. Negative Externality:

    • A production or consumption activity that creates an external cost that affects third parties.

  2. Positive Externality:

    • A production or consumption activity that creates an external benefit to third parties.

Examples of Externalities in Our Daily Lives

Negative Production Externalities

  • Examples:

    • Power generation

    • Transportation

    • Noise pollution

Positive Production Externalities

  • Example:

    • Education

Negative Consumption Externalities

  • Examples:

    • Noisy parties

    • Plastic waste

Positive Consumption Externalities

  • Examples:

    • Vaccination

    • Restoration of native forests or historic buildings

Case Study: Starbucks Sustainability Programs

  • Location: Nariño, Colombia

  • Initiative to avoid contamination by reducing water consumption during coffee pulping.

Negative Externalities

Private Costs and Social Costs

  • Marginal Private Cost (MPC):

    • The cost of producing an additional unit of a good or service borne by the producer.

  • Marginal External Cost (MEC):

    • The cost of producing an additional unit of a good or service that falls on people other than the producer.

  • Marginal Social Cost (MSC):

    • The marginal cost incurred by society, including both the producer's cost and external costs; calculated as:

    • MSC = MPC + MEC

Relationship Between Cost and Output

  1. Example values:

    • Marginal Private Cost: $1.00 per gallon

    • Marginal External Cost: $1.25 per gallon

    • Marginal Social Cost: $2.25 per gallon

Production and Pollution: Market Dynamics

  • In an unregulated industry, the amount of pollution produced depends on market equilibrium prices and quantity produced.

  • When an external cost exists, the equilibrium signifies inefficient production levels (too much goods are produced).

Inefficiency with an External Cost

  1. Example scenario:

    • Equilibrium price: $1.00 per gallon

    • Quantity: 4 million gallons of paint per month

    • The efficient output is 2 million gallons, where the marginal social cost equals marginal benefit.

    • Deadweight Loss: Represented by the gray triangle, indicating inefficiencies due to pollution externality.

Solutions to Fix the Inefficiency

  • Ways to resolve inefficiencies associated with negative externalities:

    • Property Rights: Allocation of rights to manage resources.

    • Command-and-control Regulation: Legal limits on emissions or discharges.

    • Pollution Taxes: Taxes imposed on pollutants equivalent to the marginal external cost.

    • Cap-and-Trade Systems: Limitations on pollution allowed, with trading options for unused quotas.

Pollution Taxes Explained

  • A tax on polluting production that internalizes external costs.

  • If the tax equals the marginal external cost, firms are incentivized to act as though they bear those costs.

  • Effectiveness relies on the regulator having adequate industry knowledge, which can be challenging.

Inefficiency with an External Cost (Graphical Representation)

  • Pollution tax equals the marginal external cost.

  • Market equilibrium price: $1.50 per gallon with an efficient output of 2 million gallons.

  • Government revenue represented by the area of the purple rectangle.

  • Visual representation:

    • Price and cost ($ per gallon):

    • Efficient market equilibrium where marginal social cost equals marginal benefit.

Positive Externalities

Private Benefits and Social Benefits

  • Marginal Private Benefit (MPB): The benefit received by the consumer from an additional unit.

  • Marginal External Benefit (MEB): The benefit received by others who are not direct consumers of the good.

  • Marginal Social Benefit (MSB): Total benefit to society from consumption, calculated as:

    • MSB = MPB + MEB

Positive Externalities in Education

  • Example statistics with 15 million students attending college:

    • MPB: $10,000 per student

    • MEB: $15,000 per student

    • MSB: $25,000 per student

Inefficiency with an External Benefit

  • Deadweight Loss: Occurs when too few students enroll in college.

  • Scenario:

    • Market equilibrium: tuition of $15,000/year with 7.5 million students.

    • MSB exceeds marginal cost; the efficient number of students is 15 million.

Government Actions Addressing External Benefits

  1. Public Provision:

    • Production of a good/service by a public authority, funded primarily by government revenues.

  2. Private Subsidies:

    • Government payments to private producers to cover part of the production costs.

  3. Vouchers:

    • Tokens provided to households to purchase specified goods/services, incentivizing participation in areas like education.

Public Provision in Education

  • Example specifics:

    • With 15 million students, MSB equals marginal cost.

    • Tuition rate: $10,000/year, covering $15,000 of marginal costs per student through taxes.

Private Subsidies in Education

  • A subsidy of $15,000 per student shifts the supply curve, achieving efficient enrollment at 15 million students.

  • Price per student becomes $10,000, aligning marginal social benefit with marginal cost.

Vouchers Impact on Enrollment

  • With vouchers, buyers willingly pay a price reflecting MB plus voucher value.

  • Market equilibrium is efficient with 15 million students.

  • Tuition calculation includes the dollar price and voucher value.

Comparison: Subsidies vs. Vouchers

  • Delve into specific productivity and enrollment impacts based on subsidy and voucher implementations in educational settings.

References

  • Gregory Mankiw, Principles of Microeconomics, Tenth Edition, Cengage, 2024

  • Robin Bade and Michael Parkin, Foundations of Microeconomics, Ninth Edition, Pearson Education Inc., 2021