ExternalitiesExternality—the behavior of one agent (person or firm) affects another agent in a way that is external to markets.

negative externalities, e.g., chewing tobacco (disease and

soiling), alcohol (drunk driving), road salt (car damage), and antibiotics (disease resistantbacteria).

positive externalities, e.g., HPV vaccine (disease),

and education (better citizens).

Founded in 1879

19th & Early 20th Century Chewing Tobacco

The founders of Mail Pouch came up with the idea when they noticed that people liked chewing the clippings of stogie wrappers.

Mail Pouch paid barn owners $1 to $2 a year and painted the rest of the barn as well.

19th and Early 20th Century Chewing Tobacco

Quotes from Richard Kluger’s, Ashes to Ashes

Chewing Tobacco:

Messy: spit aimed at “ubiquitous cuspidor(s)” hit “carpets, walls, draperies, and trousers. ”

Dangerous: “spreader of tuberculosis and other contagions.”

“splendidly suited” to 19th Century outdoor life

In early 20th Century:

Early 20th Century Courthouse

Cuspidor

S

PMKT

QMKT

D

QCT

PCT(private cost)

Social Cost

Q*Efficient Q

external cost—the health and cleanup costs imposed on others from tobacco spit.

Market for Chewing Tobacco (CT), 1900

The Market for Chewing Tobacco

PCT

QMKT > Q*

QCT

SMKT

Social Cost

Dexternal cost

Market Failure: Negative externalities cause markets to

For each pouch of chewing tobacco produced, the social cost includes the private costs of producing the chewing tobacco plus the cost to those bystanders adversely affected by the spit from that pouch.

Q’producing Q’

Social cost of

Private cost of

producing Q’

Q* QMKT

produce a larger quantity than is

efficient.

PMKT

PCT

QMKTQ* QCT

Social Cost

Correcting the Market Failure

Changing incentives so people (or firms) take account of the external effects of their behaviors is called internalizing the externality.

SMKT

D

PMKT

PCT

QNTQT QCT

S

D

The government can internalize the externality by imposing a tax on chewing tobacco (assume that tobacco companies pay it).

STax(T)

external cost

tax

QT will equal Q* if the tax (per pouch) = the negative externality (per pouch).

MKTPT

S

D

QLJ

PLJ

(private cost)

Market for LoJack (LJ)

Social valuePMKT

External benefit (the value of in prob. that other cars will be stolen)

QMKTQ*

(private value)

Positive externalities cause markets to produce a smaller Q than is efficient.

DWL

Correcting the Market Failure

S

D

QLJ

PLJ

0

Social PMKT

External benefit

value

S

DQLJ

Subsidy

Ss

PLJ

PMKT

PS

0QMKT Q* QMKT QS

The government can internalize the externality by giving a subsidy to the producer of LoJack.

QS will equal Q* if the subsidy (per LoJack) = the positive externality (per LoJack).

Correcting the Market Failure

Alteratively, economists Ayres and Nalebuff “urge regulators to require insurers to give discounts to LoJack users.” Suppose the government requires insurers to give discounts of $200 to people who purchase LoJack.

S

D

QLJ

PLJ

0

Social PMKT

External benefit

value

S

DQLJ

$200

PLJ

PMKT

0QMKT Q* QMKT

D’

Q’

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