Externalities Spillover Costs Spillover Benefits Chapter 10 Market

Externalities Spillover Costs & Spillover Benefits Chapter 10 Market Failures Factory A (pages 203 -208) Factory B

Factory A Factory B

EXTERNALITIES • An externality is the uncompensated impact of one person or firm’s actions on another person/society – Negative externalities => have social costs – Positive externalities => have social benefits • All externalities are considered market failures (inefficient) – markets with externalities do not maximize total surplus (welfare) (MB ≠ MC) – Governments can correct externalities with taxes or subsidies MB ≠ MC Market Failure & DWL!

Spillover Costs (external) • Spillover Costs- external costs not included in supply curve (MC) – External costs exist with ALL negative externalities – MC is understated => which leads to overproduction (actual MC > MB) – MSC = MC + spillover cost (external cost) MSC MC = S -------- Firms only consider their “internal costs” when they produce goods/services Eso --------- Pso MC is a cost curve MB = D Labor, Inputs, Rent, etc…. . Qso Socially Optimal is when MSC = MB

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

Spillover Benefits • Spillover Benefits-external benefits not included in demand curve (MB) – External benefits exist with ALL positive externalities – MB is understated => which leads to underproduction (actual MB > MC) – MSB = MB + spillover benefit (external benefit) MC ------------ Pso Consumers only consider their “internal benefit” when they buy goods/services Eso MSB MB Qso Socially Optimal is when MSB = MC

Positive Externalities = External Benefits – – – Immunizations, flue shots Restored historic buildings Research into new technologies Neighbor’s or Firm’s well maintained property Volunteering, Charity

Internalizing Externalities • Internalizing an externality involves altering incentives to improve market outcomes (i. e. to increase total welfare) – Attempt to get the true MB = MC • Government Solutions – Taxes = spillover cost or Subsidies = spillover benefit – Laws (immunization laws, pollution laws) – Patents • Free market Solution: – Pollution credits => i. e. cap & trade policy

Internalizing Negative Externalities SUV’s have spillover costs = $2, 000 per SUV Large SUV Production MSC Eso Impose Tax producers = $2, 000 MC ----------- P 2 ------- Q 2 (exact size of spillover cost) Draw spillover cost wedge = $2, 000 -this shifts Supply Curve left Reach socialy optimal output (Eso) MB DWL eliminated Total Welfare is Maximized! DWL before tax

WORKSHEET: Internalizing Externalities Large SUV Production Electric Cars

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