Principles of Microeconomics - Externalities
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Transcript of Principles of Microeconomics - Externalities
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Externalities
Dr. Katherine Sauer
Principles of Microeconomics
ECO 2020
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In the eastern part of the Pacific Ocean, there is a floating garbage
patch that is twice the size of Texas.
https://reader009.{domain}/reader009/html5/0508/5af1441b301ba/5af
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Plastic
Consumers get the benefit of buying things that contain plastic,
and they have to pay for that benefit.
Producers get the benefit of selling an item that people want, and
they incur the costs of producing it.
But,there are *extra* costs to society as a whole.
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When you drive your car, you are emitting carbon dioxide, a known
greenhouse gas, into the air.
http://www.boxoid.org/?p=86
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Gasoline
Consumers get the benefit of driving their cars, and they have to
pay for the cost of gasoline.
Producers get the benefit of producing/selling gasoline, and they
have to incur the cost of producing it.
But,
there are *extra* costs to society as a whole.
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Education
Consumers (students) get benefits like a higher future salary and
an increase in skills and experience, and must pay the cost in the
form of tuition.
Producers (colleges) get benefits like selling a service that
consumers want but also must incur the costs of production.
But,
there are *extra* benefits to society as a whole.
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Historic buildings allow a glimpse into the past.
http://www.downtowndenver.com/Business/DevelopmentandPlanning/denverunionstation/tabid/316/Default.aspx
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Historic Buildings
The owner of the building gets the benefit from owning the
building, and incurs the cost of renovation / upkeep.
But,
there are *extra* benefits to society as a whole.
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The Market Outcome
Recall:
The Demand curve represents the value (benefit) to consumers.The Supply curve represents the production cost.
Market equilibrium is efficient (it maximizes total surplus).
In reality, sometimes the total benefits are not reflected in the demand
curve and the total costs are not reflected in the supply curve.
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I. Externalities are the uncompensated impact of ones actions on the
well-being of abystander or society as a whole.
ex: factory emissions, barking dogs, flu shots, flower gardens
Externalities can be positive or negative.
Positive externalities mean that the third party has in some
way benefited.
Negative externalities mean that the third party has in someway been harmed.
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Note: If a party engages in an activity that harms/benefits
themselves, that is not part of the externality.
ex: You smoke cigarettes. (benefit to you)
- You pay for cigarettes. (cost to you, not an externality)
- You spend money on gum and mouthwash. (cost to you,
not an externality)
- You will probably face some health issues in the future.
(cost to you, not an externality)
-You smoke around a non-smoker and it bothers them.
(negative externality)
-You eventually end up with Medicare paying your healthcosts. (negative externality)
-You die younger than a non-smoker and stop drawing
Social Security. (positive externality)
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A. Negative Externalities
Ex: pollution from the production of coal-fired electricity
- you pay for electricity and get its benefits
- the power plant incurs production costs and receives
payment for the electricity it sells
- pollution from the power plant harms the environment and
bothers people
The social cost of coal-fired electricity is greater than the privatecost of coal-fired electricity.
social cost = production costs + externality costs
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Price
Quantity of Megawatts
Supply
(private
cost)
Demand
(private
benefit =
social benefit)
Qm
Pm
The market outcome
will be where supply
and demand are equal.
The market ignores
externalities.
The private cost plus theexternality cost is the
true cost to society of
the action.
The socially optimaloutcome is a lower
quantity and higher
price.
Social Cost
externality costs
Pso
Qso
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B. Positive Externalities
Ex: K-12 education (in many nations it is not free)
- student pays for education and gets its benefits
- school incurs production costs and receives payment for
services
- society as a whole benefits by having more educated
residents
The social benefits of education are greater than the private benefitsof education.
social benefit = private benefit + externality benefit
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Price
Quantity
Supply(private
cost =
social
cost)
Social
Benefit
Qso
Pso
The market outcome will
be where supply and
demand are equal.
The market ignores
externalities.
The private benefit plusthe externality benefit is
the true benefit to society
of the action.
The socially optimaloutcome is a higher
quantity and higher
price.
Demand (private benefit)
external benefit
Qm
Pm
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II. Public Policy: Government responses to externalities
If the market ignores externalities, then perhaps there is reason
for the government to step in.
Two common types of government responses to externalities:
1. command and control
2. market based
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1. Command and Control = regulate the behaviordirectly
Ex: laws against dumping untreated water into riversEx: must attend school until you are 16
2. market based =provide incentives so people/firms choose to
change behaviorEx: gasoline tax
Ex: flu shot subsidies
Market based solutions allow the externality to be internalized.
- alter the incentives so that people/firms take the
external effects of an action into account
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Price
Quantity of
Megawatts
Supply
(private
cost)
Demand
(private
benefit =
social benefit)
Qm
Pm
Anegative externality can
be internalizedby imposing
a corrective tax on the
good.
Recall, a tax shifts the
supply curve to the left by
the amount of the tax.
If the tax was set at the
same amount as the
externality cost, the supply
curve would then coincidewith the social cost curve.
Now the market outcome is
socially optimal.
Social Cost
externality costs
Pso
Qso
a. Internalizing a negative externality
tax
= supply + tax
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Price
Quantity
Supply(private
cost and
social
cost)
Social Benefit
Qso
Pso
Apositive externality
can be internalizedby
subsidizing the good.
A subsidy can be used to
shift the demand curve
to the right.
If the subsidy was set at
the same amount as the
externality benefit, the
demand curve would
then coincide with thesocial benefit curve.
Now the market outcome
is socially optimal.
Demand
(private benefit)
external benefit
Qm
Pm
b. Internalizing a positive externality
subsidy
= demand +
subsidy
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III. Private Solutions (non-government solutions)
We do not necessarily need government involvement to correct
externalities.
Types of private solutions:
1. moral codes
ex: the Golden Rule
2. nonprofits and charities
ex: Sierra Club, UniversityAlumni Foundation
3. self-interest / contracts
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How well does the private sector do when dealing with
externalities?
- depends on how well property rights are defined
- depends on ease of bargaining (how many parties?)
- depends on transaction costs
The Coase Theorem: If property rights are well-defined and if
private parties can bargain costlessly, then the private market willsolve the externality problem.
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Chapter Summary:
When a transaction between a buyer and seller affects a third
party, that effect is called an externality.
If an activity yields negative externalities, the socially optimalquantity in a market is less than the equilibrium quantity.
If an activity yields positive externalities, the socially optimal
quantity is greater than the equilibrium quantity.
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Governments use various policies to remedy the inefficiencies
caused by externalities.
- regulation
- corrective taxes- subsidies
In certain situations, people can solve externality issues
without government intervention.