Lecture Slides 11 Externalities

Externalities Overview

Definition

Externalities are side effects, either positive or negative, that are caused by an economic actor and affect individuals or groups not directly involved in the transaction. These side effects can lead to market inefficiencies and are often not reflected in the costs borne by the parties involved in the transaction.

Ideal Market Conditions for Efficiency:

• Both buyers and sellers are price-takers: This means that no single buyer or seller has the power to influence prices, ensuring competitive market conditions.

• Equal information for buyers and sellers: Transparency in information allows informed decision-making, ensuring that all parties understand the ramifications of their transactions.

• All affected parties are present at the bargaining table: Effective negotiations can only take place when all stakeholders, including those impacted by externalities, are included in the decision-making process.

Roadmap for Understanding Externalities

1. Identify externalities: Recognize the positive or negative impacts affecting third parties.

2. Assess consequences of externalities: Evaluate how these externalities influence overall welfare, productivity, or societal costs.

Solutions to externalities:

There are several approaches to managing externalities:

• Public goods: Implementing government-funded programs that provide benefits to all and are non-excludable and non-rival in consumption.

Market Efficiency vs. Market Failure

• Market Failure: A situation where the allocation of goods and services is not efficient, commonly caused by:

  • Government regulations leading to unintended economic distortions (e.g., taxes).

  • Externalities that impact the welfare of third parties, thus affecting the free market's ability to allocate resources efficiently.

  • Imperfect competition where firms possess substantial market power deterring fair competition.

  • Issues like asymmetric information prevalent in market transactions.

Types of Externalities

Negative Externalities

• Definition: Activities that inflict harm on third parties who are not part of the transaction.

• Examples:

  • Driving: The pollution emitted from vehicles impacts air quality, creating health issues for individuals who do not drive.

  • Second-Hand Smoke: Individuals nearby are adversely affected by the inhalation of smoke from others' cigarettes, leading to health risks.

  • Pandemic Risks: During events like COVID-19, individuals not adhering to health guidelines (e.g., not wearing a mask) increase health risks for the surrounding community.

Positional Externalities

• Definition: Externalities that arise based on relative performance or position.

• Examples:

  • Higher Income Effects: Individuals earning higher incomes can unintentionally create feelings of inadequacy and competition among peers.

  • Sports Competitiveness: The use of performance-enhancing drugs can diminish fair competition, adversely affecting the integrity of sports for other athletes.

  • Overfishing: Depletion of fish stocks can harm the availability of resources for other fishermen or consumers.

Positive Externalities

• Definition: Activities that confer benefits to third parties not involved in a transaction.

• Examples:

  • Vaccination: By receiving vaccinations, individuals contribute to herd immunity, reducing disease spread in the wider community.

  • Scientific Discoveries: Innovations in research benefit society as a whole, advancing knowledge and technological progress.

  • Neighborhood Aesthetics: Well-maintained properties can boost local enjoyment and enhance property values in the vicinity.

Fiscal and Network Externalities

• Fiscal Externalities: The financial success of individuals or businesses can lead to increased taxes, which, in turn, enhance funding for public services that benefit society.

• Network Effects: The more individuals that buy or use popular products (like social media platforms), the more valuable those products become to users, creating a circular benefit.

Addressing Externalities

Assessing Consequences

• Negative Externalities: Often, individuals neglect the social costs that their actions impose on society, leading to adverse societal impacts.

• Positive Externalities: Conversely, individuals may underestimate the benefits that their actions bestow upon others, leading to under-participation in beneficial activities.

Analyzing Externalities Steps

1. Predict the private equilibrium outcome: Identify where supply meets demand in a market without external considerations.

2. Identify externalities: Investigate what social costs or benefits are absent from current market valuations.

3. Evaluate societal interests: Determine where marginal social benefits intersect with marginal social costs to achieve overall welfare.

Solutions to Externalities

• Private Bargaining: Potential solutions through negotiation can work effectively when transaction costs are low, enabling parties to reach agreements.

• Corrective Taxes/Subsidies: Government-imposed taxes on negative behaviors (e.g., pollution) or subsidies for positive externalities can alter economic behavior towards desired outcomes.

• Cap and Trade: Introducing systems that cap pollution levels and allow for trading of permits to achieve compliance effectively and efficiently.

• Laws and Regulations: Legislative measures can regulate negative externalities or encourage behaviors that generate positive outcomes for society.

• Government Provision of Public Goods: Ensuring that essential services like defense, education, and public health are made available to all, preventing market failures in their provision.

• Property Rights Assignment: Clearly defined property rights can help prevent the overuse of common resources, like fishing grounds or grazing lands, promoting sustainability and responsible usage.

Key Takeaways

• Externalities can lead to significant overproduction or underproduction within markets.

• Without proper regulation, negative externalities can result in excessive societal issues (for instance, pollution).

• Effective solutions are available but require proper implementation and commitment to address the underlying issues related to externalities.