WEEK 9 - Chapter 10: Externalities Flashcards
What is an externality?
The uncompensated impact of one person’s actions on the wellbeing of a bystander.
If the effect on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality.
Externalities come in many varieties, as do the policy responses that try to deal with the market failure.
What is market failure?
Situations where the market fails to achieve an efficient outcome, or where efficient, the outcome is deemed to be socially undesirable.
What is government failure?
Situations where the government fails to achieve an efficient outcome or redress a market failure, or where efficient, the outcome is deemed to be socially undesirable.
As always, there are trade-offs.
- Need to consider the costs and benefits of regulation (benefits cost analysis).
- Not every market failure warrants attention (some are trivial and can be ignored).
- Sometimes, the best policy may be to do nothing.
What happens in the presence of externalities?
In the presence of externalities, society’s interest in a market outcome extends beyond the wellbeing of buyers and sellers in the market; it also includes the wellbeing of bystanders who are affected.
Why is the market equilibrium inefficient with externalities?
Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient in the presence of externalities.
That is, the equilibrium fails to maximise the total benefit to society as a whole.
The release of dioxin into the environment, for instance, is a negative externality. Self-interested paper firms will not consider the full cost of the pollution created in their production processes, and consumers of paper will not consider the full cost of the pollution that results from their purchasing decisions. Therefore, the firms will emit too much pollution unless the government prevents or discourages them from doing so.
What is a market?
An institution that involves the exchange of goods and
services AND the rights (property rights) to use them.
Individuals with purely selfish motives mutually benefit from exchange.
Examples of market failure.
Markets may fail to produce sufficient quantities of certain goods
- eg. Police and fire protection)
- hence government provision/intervention is needed.
Markets may allocate too few resources to certain activities, producing too little of a good or service
- eg. R&D, education
- hence, compulsory primary & secondary schooling and compulsory immunisation.
Markets may allocate too many resources to certain activities, producing too much of a good or service
- eg. Too much pollution is generated, too much environmental devastation generated
- hence, need for interventions to curtail the activities that result in pollution.
Markets can provide many goods/services that are socially regarded as harmful:
- eg. drugs, sale of blood and body parts, slavery
- hence, the production of certain products is made illegal and, the distribution of certain products is restricted
Markets use prices to convey information, but some information is not provided in sufficient quantities or somebody in the market knows more than somebody else
- Drugs, certain foods, entertainment activities and products
- hence the need for health warnings, building codes, prevention of deceptive advertising
Negative externalities in production.
The demand curve reflects the value to buyers and the supply curve reflects the costs of sellers. The equilibrium quantity, QMARKET, maximises the total value to buyers minus the total costs of sellers. In the absence of externalities, therefore, the market equilibrium is efficient.
When there is a negative externality to production, the social cost of producing aluminium exceeds the private cost (S curve). The socially desirable quantity of aluminium, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET.
The vertical distance between these two curves reflects the cost of the externality emitted in producing the marginal unit – the difference between the private cost of the producer and the total cost to society for the marginal unit.
What is internalising an externality?
Altering incentives so that people take into account the external effects of their actions.
The use of such a tax is said to be internalising an externality because it gives buyers and sellers in the market an incentive to take into account the external effects of their actions.
The social planner achieve the optimal outcome through a tax. The tax would shift the supply curve upwards by the size of the tax. If the tax accurately reflected the social cost the new supply curve would coincide with the social-cost curve.
Positive externalities in production.
While some activities impose costs on third parties, others yield benefits. In markets with positive externalities the social cost of production is less than (to the right of) the private cost (S curve).
In the presence of a positive externality to production, the social cost of producing robots is less than the private cost. The socially desirable quantity of a good, QOPTIMUM, is therefore larger than the equilibrium quantity, QMARKET.
How can the government correct this market failure? In this case, the government can internalise the externality by subsidising the production of the good. If the government paid firms for each good produced, the supply curve would shift down by the amount of the subsidy and this shift would increase the equilibrium quantity of the good.
To ensure that the market equilibrium equals the social optimum, the subsidy should equal the value of the technology spillover.
Externalities in consumption.
The externalities we have discussed so far are associated with the production of goods. Some externalities, however, are associated with consumption.
The consumption of alcohol, for instance, yields negative externalities if consumers are more likely to drive under its influence, engage in antisocial behaviour and risk the lives of others.
Similarly, vaccination against a contagious disease such as measles or influenza yields positive externalities because it lowers the risk of catching the disease for everyone in the population, even those who are not vaccinated.
The analysis of consumption externalities is similar to the analysis of production externalities.
The demand curve no longer reflects the social value from the good.
Graphing the effect of negative externalities in consumption.
In this case, the social value is less than (to left of) the private value (D curve), and the socially optimal quantity is smaller than the quantity determined by the private market.
Graphing the effect of positive externalities in consumption.
In this case, the social value is greater than (to right of) the private value (D curve), and the socially optimal quantity is greater than the quantity determined by the private market.
How to fix externalities in consumption?
Once again, the government can correct the market failure by internalising the externality. To move the market equilibrium closer to the social optimum, a negative externality requires a tax and a positive externality requires a subsidy.
In fact, that is exactly the policy the government follows; alcoholic beverages are among the most highly taxed goods in our economy and vaccination is heavily subsidised through preschool programs and the medical system.
Private solutions to externalities.
We have discussed why externalities lead markets to allocate resources inefficiently, but have mentioned only briefly how this inefficiency can be remedied.
In practice, both private individuals and public policymakers respond to externalities in various ways.
All of the remedies share the goal of moving the allocation of resources closer to the social optimum.
The types of private solutions.
Moral codes and social sanctions.
- Consider, for instance, why most people do not litter.
- Although there are laws against littering, these laws are not vigorously enforced.
- Most people choose not to litter simply because it is the wrong thing to do.
Charities
- eg. Greenpeace, whose goal is to protect the environment, is a not-for-profit organisation funded by private donations.
- As another example, private individuals and corporations sometimes sponsor scholarships and prizes for university students, in part because education has positive externalities for society.
Integrating different types of business
- eg. consider an apple grower and a beekeeper located next to each other.
- each business confers a positive externality on the other – by pollinating the flowers on the trees, the bees help the orchard produce apples. At the same time, the bees use the nectar they get from the apple trees to produce honey.
Interested parties enter into a contract
- in the example above, a contract between the apple grower and the beekeeper can solve the problem of too few trees and too few bees.
- The contract can specify the number of trees, the number of bees and perhaps a payment from one party to the other.
- By setting the right number of trees and bees, the contract can solve the inefficiency that normally arises from these externalities and make both parties better off.
What is coase theorem?
The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
Why private solutions do not always work.
Despite the appealing logic of the Coase theorem, private individuals on their own often fail to resolve the problems caused by externalities.
The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement.
In the real world, however, bargaining does not always work, even when a mutually beneficial agreement is possible.
Sometimes the interested parties fail to solve an externality problem because of transaction costs.
What are transaction costs?
The costs that parties incur in the process of agreeing to, and following through on, a bargain.
If the benefit of solving a problem is less than the cost of the solving it, the parties might choose to leave the problem unsolved.
Public polices on externalities.
When an externality causes a market to reach an inefficient allocation of resources, the government can respond in one of two ways.
Command-and-control policies regulate behaviour directly.
Market-based policies provide incentives so that private decision makers will choose to solve the problem on their own.
Explain the following way the government can respond to externalities: Command-and-control policies (regulation)
The government can remedy an externality by either requiring or forbidding certain activities.
Eg. it is a crime to dump poisonous chemicals into the water supply. In this case, the external costs to society far exceed the benefits to the polluter.
The government therefore institutes a command-and-control policy that prohibits this act altogether. In most cases of pollution, however, the situation is not this simple. Despite the stated goals of some environmentalists, it would be impossible to prohibit all polluting activity.
Market-based policy 1: corrective taxes and subsidies.
Instead of regulating behaviour in response to an externality, the government can use market- based policies to align private incentives with social efficiency.
For instance, as we saw earlier, the government can internalise the externality by taxing activities (corrective tax) that have negative externalities and subsidising activities that have positive externalities.
Economists usually prefer corrective taxes over regulations as a way to deal with pollution because they can reduce pollution at a lower cost to society.
What is a corrective tax?
Taxes enacted to correct the effects of negative externalities are called corrective taxes.
An ideal corrective tax would equal the external cost from an activity with externalities and an ideal corrective subsidy would equal the external benefit from an activity with positive externalities.
Corrective taxes are unlike most other taxes. Most taxes distort incentives and move the allocation of resources away from the social optimum. The reduction in economic wellbeing – that is, in consumer and producer surplus – exceeds the amount of revenue the government raises, resulting in a deadweight loss.
Corrective taxes alter the incentives that the market participants face to account for the presence of externalities and thereby move the allocation of resources closer to the social optimum. Thus, while corrective taxes raise revenue for the government, they enhance economic efficiency.
