Lecture Slides 11 Externalities

Externalities Overview

• Externalities: Side effects (costs or benefits) from an economic activity affecting uninvolved parties (bystanders).

• They are not mediated by the market and can be either positive or negative.

Roadmap

• Identify externalities

• Assess the consequences of externalities

• Solutions to externalities

• Public goods

Efficient Markets vs. Market Failure

• Under ideal conditions, markets yield efficient outcomes when buyers and sellers are price-takers, well-informed, and affected parties are all at the bargaining table.

• Market failures include:

  • Government regulations that impede market forces (taxes, price floors)

  • Externalities that affect other parties.

  • Imperfect competition (firms exerting market power).

  • Issues like asymmetric information and irrationality.

What is An Externality?

• An externality is an unaccounted side effect impacting others.

• Can be Positive (benefits) or Negative (costs).

Negative Externalities

• Activities causing harm to bystanders (e.g., pollution from driving).

• External costs are not considered in some decisions:

  • Examples include secondhand smoke and increased illness chance during a pandemic.

• Bystanders affected can incur costs without compensation.

Positional Externalities

• Depend on relative performance:

  • Example: Your higher income makes another feel poor.

  • Actions like overfishing or increased competition in exams leading to disadvantage.

Positive Externalities

• Activities benefiting others without charge (e.g., vaccinations) with external benefits not reflected in prices.

• Examples include:

  • Vaccination: Protects the community from diseases.

  • Scientific discoveries: Broad benefits to society.

  • Beautiful gardens: Enhances neighborhood enjoyment.

Nature of Externalities

• Externalities reflect side effects not captured in the pricing mechanisms.

• A price change alone is not considered an externality; it’s a redistribution of wealth between buyers and sellers.

• Gentrification may appear as an externality because it impacts affordability but is not, as others are at the bargaining table.

Consequences of Externalities

• Negative Externalities: Decisions ignoring external costs can lead to overproduction and misallocation of resources.

• Positive Externalities: Benefits ignored lead to underproduction of helpful goods/services.

• Private Costs vs. Social Costs: Decisions should consider total social costs and benefits rather than just private ones.

Analyzing Externalities

1. Predict private outcome where supply equals demand.

2. Identify externalities involved: negative (supply not including all social costs) or positive (demand not reflecting benefits).

3. Evaluate what serves society's interests: where marginal social benefit equals marginal social cost.

Solutions to Externalities

1. Private Bargaining: Coase Theorem suggests that if bargaining is costless, private negotiations can solve externality issues.

   • Example: Street performers can be paid by businesses to perform year-round, creating mutual benefits.

2. Corrective Taxes and Subsidies: Implementing taxes equivalent to external costs can reduce negative externalities, while subsidies can enhance positive externalities.

3. Cap and Trade: Sets a cap on emissions or pollutant output, allowing trade of permits among firms to meet targets efficiently.

4. Laws, Rules, and Regulations: Regulations can minimize harmful externalities but may lack nuance, requiring flexibility to accommodate various private interests.

5. Public Goods Provision: Government can directly provide goods that are essential for society, covering gaps left by market underprovision.

6. Assign Property Rights: This solution can address the tragedy of the commons and ensure sustainable use of shared resources.

Key Takeaways

• Externalities impact uninvolved third parties and lead to market inefficiencies.

• Common examples include pollution (negative) and vaccinations (positive).

• Understanding and addressing externalities involves recognizing the broader implications of economic decisions.

• Effective solutions are varied and context-dependent, balancing the interests of all parties involved.