Externalities Chapter 10 EXTERNALITIES An externality is the

Externalities Chapter 10

EXTERNALITIES • An externality is the uncompensated impact of one person’s actions on another person – Both positive & negative externalities exist • All externalities cause markets to be inefficient – That is, markets do not maximize total surplus (welfare)

Negative Externalities – – – Automobile exhaust Cigarette smoking Barking dogs Loud stereos in an apartment building Noisy Students Neighbor’s poorly maintained property

Positive Externalties – – Immunizations Restored historic buildings Research into new technologies Neighbor’s well maintained property

MARKET INEFFICIENCY • Negative externalities lead markets to overproduce • Positive externalities lead markets to under-produce Supply Curve = Marginal Cost Curve Demand Curve = Marginal Benefit Curve MC = MB

Spillover Costs & Benefits • Spillover Costs- costs not captured by supply curve (MC) – Costs are understated • Spillover Benefits- benefits not captured by demand curve (MB) – Benefits are understated

Negative Externality: Pollution MSC Price of Aluminum External social Cost Supply = MCP (private Optimum P 1 (social cost) Equilibrium MC = MB cost) Spillover Cost Demand = MB (private 0 QOPTIMUM QMARKET value) Quantity of Aluminum

Positive Externality: Neighbor paints House Price External social benefit MC Optimum Equilibrium P 1 Spillover Benefit MSB MB 0 QMARKET QOPTIMUM Quantity

Solutions to Externalities • Internalizing an externality involves altering incentives • Government Methods – Taxes (corrective taxes), Subsidies – Patents – Laws (immunization laws, pollution laws) • Free market solution: – Trading pollution credits

Worksheet • Externalities

Taxing Negative Externalities Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output Total Cost = Total Benefit Total Cost = MSC (MCP + MCS)

Subsidizing Positive Externalities Fuel Efficient Cars Impose Subsidy = spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit

Day #2 • Practice Test

Factory A Factory B

Cap & Trade Analysis Goal: to reduce CO 2 emissions Pollution Credits Trading System S D