Principles of Microeconomics - Externalities

Externalities in Economics

Chapter Overview

  • Textbook: Mankiw, Principles of Microeconomics, Tenth Edition.

  • Chapter Focus: Externalities

    • Definition of externalities

    • Impact on market efficiency

    • Regulations, taxes, subsidies, and tradable permits

    • Private solutions to externalities

    • Coase theorem

Chapter Objectives

  • By the end of this chapter, you should be able to:

    • Describe the differences between positive and negative externalities.

    • Determine how negative externalities impact market efficiency.

    • Explain the impact of regulation on negative externalities.

    • Explain the impact of taxes on negative externalities.

    • Determine how positive externalities impact market efficiency.

    • Explain the impact of subsidies on positive externalities.

    • Explain the impact of tradable permits on negative externalities.

    • Explain how private solutions can correct for negative externalities.

    • Explain the application of the Coase theorem, given a scenario.

Understanding Externalities

Definition of Externality

  • Externality: The uncompensated impact of one person’s actions on the well-being of a bystander.

    • Negative Externality: An externality that harms a third party (e.g., pollution).

    • Positive Externality: An externality that benefits a third party (e.g., education).

Impact on Market Efficiency

  • Governments can improve market outcomes when externalities exist, as the well-being of bystanders must be included in society’s interest in market outcomes.

  • If externalities are present, market equilibria are not inherently efficient; societal well-being can be maximized through government intervention.

Review of Welfare Economics

  • Welfare Economics: Examines how the allocation of resources affects economic well-being.

    • Supply and demand curves are vital:

    • Demand Curve: Reflects the value to consumers.

    • Supply Curve: Reflects the cost to producers.

    • Market equilibrium maximizes the combination of producer and consumer surplus, effectively optimizing resource allocation.

Market Efficiency without Externalities

  • In a scenario with no externalities, the equilibrium quantity produced (denoted as $Q_{MARKET}$) is efficient, maximizing total value to buyers minus costs to sellers.

    • Social welfare is maximized when $Q_{MARKET}$ aligns with social costs.

Negative Externalities

Definition and Implications

  • Negative externalities occur when the cost to society exceeds the cost borne by producers, resulting in a social cost that surpasses private costs.

    • Social Cost: The total cost to society, including private costs and external damages suffered by third parties.

    • Social-Cost Curve: This curve lies above the supply curve, factoring in the external costs.

Example: Pollution

  • In cases like pollution, the social cost of production is higher than the private cost.

    • Equilibrium quantity ($Q{MARKET}$) exceeds the socially optimal quantity ($Q{OPTIMUM}$).

Solutions to Negative Externalities

Internalizing the Externality

  • Internalizing the Externality: Adjusting incentives so that market participants consider external effects when making decisions.

    • Implementing a tax on producers equates to the social cost.

    • The new supply curve aligns with the social-cost curve, yielding a new equilibrium that reflects socially optimal levels of production.

Positive Externalities

Definition and Characteristics

  • With positive externalities, the value derived from consumption may not be fully reflected in the demand curve.

    • Social-Value Curve: Lies above the demand curve, representing benefits to society beyond the individual consumer.

    • The socially optimal quantity of goods produced exceeds the equilibrium quantity determined by the market.

Correcting Positive Externalities

  • Governments can also correct positive externalities by providing subsidies for activities that confer communal benefits, effectively aligning private returns with social gains.

Public Policies towards Externalities

Command-and-Control Policies

  • Government regulations can mandate or prohibit certain behaviors to mitigate externalities (e.g., emissions standards).

    • Example: The EPA may set limits on pollution levels.

Market-Based Policies

  • Corrective Taxes (Pigovian taxes) incentivize producers to reduce negative externalities by aligning private costs with social costs.

    • An ideal corrective tax equals the external cost imposed on society.

    • Economists favor these taxes over regulation due to lower costs and increased efficiency.

Example of Carbon Tax

  • A proposed carbon tax of $20 per ton, increasing annually, could generate substantial federal revenue while addressing the negative externalities of carbon dioxide emissions.

Tradable Permits

  • Firms can buy and sell pollution permits, allowing for a market mechanism to regulate total pollution.

    • Firms that can reduce pollution at low costs will sell their excess permits to firms facing higher costs.

    • Outcome is efficient regardless of the initial distribution of permits.

Private Solutions to Externalities

Types of Private Solutions

  • Solutions can emerge from moral codes, charity actions, self-interest, and negotiations between affected parties.

  • Coase Theorem: Suggests that private economic actors can negotiate solutions to externalities, reaching efficient outcomes regardless of the initial allocation of rights.

Limitations of Private Solutions

  • Transaction Costs: The costs associated with the bargaining process that can prevent reaching agreements.

    • Coordination problems arise where many parties are involved, complicating resolution efforts.

Conclusion

  • The invisible hand of the market may fail to efficiently allocate resources in the presence of externalities. Government intervention can play a significant role in internalizing externalities and redirecting market forces to remedy market failures.