Session 8 externalities

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Session 8 externalities

  1. 1. Session 8 Externalities © 2002 by Nelson, a division of Thomson Canada Limited Lectured by Prof. Dr. Ferdinand D. Saragih, MA
  2. 2. <ul><li>Learn the nature of an externality. </li></ul><ul><li>See why externalities can make market outcomes inefficient. </li></ul><ul><li>Examine how people can sometimes solve the problem of externalities on their own. </li></ul><ul><li>Consider why private solutions to externalities sometimes do not work. </li></ul><ul><li>Examine the various government policies aimed at solving the problem of externalities. </li></ul>In this chapter you will… Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  3. 3. <ul><li>Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. </li></ul><ul><li>But market failures can still happen! </li></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  4. 4. <ul><li>If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities . </li></ul><ul><ul><li>Externalities cause markets to be inefficient, and thus fail. </li></ul></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  5. 5. <ul><li>An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander. </li></ul><ul><li>Externalities cause markets to be inefficient, and thus fail to maximize total surplus. </li></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  6. 6. <ul><li>In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . . </li></ul><ul><li>… the well-being of third parties are considered . </li></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  7. 7. <ul><li>Positive Externality </li></ul><ul><ul><li>The uncompensated benefits that are received by individuals who are not directly involved in the production or consumption of goods. </li></ul></ul><ul><ul><li>The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them. </li></ul></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  8. 8. <ul><li>Negative Externality </li></ul><ul><ul><li>The uncompensated costs that are imposed upon individuals who are not directly involved in the production or consumption of goods. </li></ul></ul><ul><ul><li>The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them. </li></ul></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  9. 9. <ul><li>Negative Externality </li></ul><ul><li>Automobile exhaust </li></ul><ul><li>Cigarette smoking </li></ul><ul><li>Positive Externality </li></ul><ul><li>Immunizations </li></ul><ul><li>Restored historic buildings </li></ul>EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  10. 10. <ul><li>The Market for Aluminum </li></ul><ul><ul><li>The demand curve for aluminum reflects the value to consumers of aluminum as measured by the prices they are willing to pay. </li></ul></ul><ul><ul><li>The supply curve for aluminum reflects the costs of producing aluminum. </li></ul></ul><ul><ul><li>Q market : the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. </li></ul></ul>Welfare Economics: A Recap Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  11. 11. Figure 10-1: The Market for Aluminium Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 0 Quantity of Aluminium Price of Aluminium Demand (private value) Supply (private costs) Equilibrium Q market
  12. 12. <ul><li>The Market for Aluminum (cont’d) </li></ul><ul><ul><li>If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers. </li></ul></ul>Welfare Economics: A Recap Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  13. 13. <ul><li>The Market for Aluminum (cont’d) </li></ul><ul><ul><li>For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution. </li></ul></ul>Negative Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  14. 14. <ul><li>The Market for Aluminum (cont’d) </li></ul><ul><ul><li>What quantity of aluminum should be produced? </li></ul></ul><ul><ul><ul><li>Where the demand curve crosses the social-cost curve. </li></ul></ul></ul><ul><ul><ul><li>Below Q optimum the value of the aluminum to consumers exceeds social cost of producing it. </li></ul></ul></ul><ul><ul><ul><li>Above Q optimum the social cost of producing additional aluminum exceeds the value to consumers. </li></ul></ul></ul>Negative Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  15. 15. Figure 10-2: Pollution and the Social Optimum Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page Supply (private costs) 0 Quantity of Aluminium Price of Aluminium Demand (private value) Equilibrium Q market Social costs Q optimum Cost of pollution Optimum
  16. 16. <ul><li>The Market for Aluminum (cont’d) </li></ul><ul><ul><li>Reducing aluminum production and consumption below the market equilibrium level raises total economic well-being. </li></ul></ul>Negative Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  17. 17. Figure 10-3: Deadweight Loss of a Negative Production Externality Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 0 Quantity of Aluminium Price of Aluminium Social costs Demand (private value) H D + A + E D + A + E - H A + B + C + H A + E E - (B + C + H) - (A + B + C) D A + B + C + D P optimum Q optimum P market Q market a b Total surplus Producer surplus Consumer surplus Change At Q Optimum At Q Market D A B C E F G H
  18. 18. <ul><li>The Market for Aluminum (cont’d) </li></ul><ul><ul><li>How the can social optimum of aluminum production be achieved? </li></ul></ul><ul><ul><ul><li>Tax the producers of aluminum thus shifting the private supply curve up by the amount of the tax so that it coincides with the social-cost curve. </li></ul></ul></ul><ul><ul><li>Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. </li></ul></ul><ul><ul><li>Pigovian taxes are taxes enacted to correct the effects of negative externalities. </li></ul></ul><ul><ul><li>In Figure 10-3, the Pigovian tax is equal to the distance ab . </li></ul></ul>Negative Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  19. 19. <ul><li>When an externality benefits the bystanders, a positive externality exists. </li></ul><ul><ul><li>The social value of the good exceeds the private value. </li></ul></ul><ul><li>Example: </li></ul><ul><li>A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. </li></ul>Positive Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  20. 20. Figure 10-4: Technology Spillovers and the Social Optimum Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 0 Quantity of Robots Price of Robots Demand (private value) Supply (private costs) Optimum Social costs a b Q optimum P optimum Q market P market Equilibrium Value of technology spillover Deadweight loss
  21. 21. <ul><li>The intersection of the supply curve and the social-value curve determines the optimal output level. </li></ul><ul><ul><li>The optimal output level is more than the equilibrium quantity. </li></ul></ul><ul><ul><li>The market produces a smaller quantity than is socially desirable. </li></ul></ul><ul><ul><li>The social value of the good exceeds the private value of the good. </li></ul></ul>Positive Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  22. 22. <ul><li>Internalizing Externalities: Subsidies </li></ul><ul><ul><li>Used as the primary method for attempting to internalize positive externalities. </li></ul></ul>Positive Externalities in Production Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  23. 23. <ul><ul><li>Government intervention in the economy that aims to promote technology-enhancing industries </li></ul></ul><ul><ul><ul><li>Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. </li></ul></ul></ul><ul><ul><ul><li>The patent is then said to internalize the externality. </li></ul></ul></ul><ul><ul><ul><li>The patent system gives firms a greater incentive to engage in research and other activities that advance technology. </li></ul></ul></ul>CASE STUDY: The Debate Over Technology Policy Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  24. 24. <ul><li>Some externalities are associated with consumption. </li></ul><ul><li>Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages. </li></ul><ul><li>Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education. </li></ul>Externalities in Consumption Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  25. 25. Figure 10-5: Consumption Externalities Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page (a) Negative Consumption Externalities (b) Positive Consumption Externalities Price of Alcohol Quantity of Alcohol 0 0 Social value Demand (private value) Supply (private cost) Quantity of Education Price of Education Social value Demand (private value) Supply (private cost) Q market Q optimum Q optimum Q market
  26. 26. <ul><li>Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient. </li></ul><ul><li>People can develop private solutions. </li></ul><ul><ul><li>Moral codes and social sanctions </li></ul></ul><ul><ul><li>Charitable organizations </li></ul></ul><ul><ul><li>Integrating different types of businesses </li></ul></ul><ul><ul><li>Contracting between parties </li></ul></ul>PRIVATE SOLUTIONS TO EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  27. 27. <ul><li>The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. </li></ul><ul><li>Private bargaining can internalize the external effects, resulting in efficient solutions. </li></ul>The Coase Theorem Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  28. 28. <ul><li>In the real world bargaining does not always work. </li></ul><ul><ul><li>Transactions Costs </li></ul></ul><ul><ul><ul><li>Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain. </li></ul></ul></ul><ul><ul><li>Bargaining breaks down. </li></ul></ul>Why Private Solutions Do Not Always Work Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  29. 29. <ul><li>When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . </li></ul><ul><ul><li>Command-and-control policies that regulate behaviour directly. </li></ul></ul><ul><ul><li>Market-based policies that provide incentives so that private decisions makers will choose to solve the problem on their own. </li></ul></ul>PUBLIC POLICIES TOWARDS EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  30. 30. <ul><li>Command-and-Control Policies </li></ul><ul><ul><li>Usually take the form of regulations: </li></ul></ul><ul><ul><ul><li>Forbid certain behaviors. </li></ul></ul></ul><ul><ul><ul><li>Require certain behaviors. </li></ul></ul></ul><ul><ul><li>Examples: </li></ul></ul><ul><ul><ul><li>Requirements that all students be immunized. </li></ul></ul></ul><ul><ul><ul><li>Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). </li></ul></ul></ul>PUBLIC POLICIES TOWARDS EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  31. 31. <ul><li>Market-Based Policies </li></ul><ul><ul><li>Government can internalize an externality by using taxes and subsidies to align private incentives with social efficiency. </li></ul></ul><ul><ul><li>Pigovian taxes are taxes enacted to correct the effects of a negative externality. </li></ul></ul>PUBLIC POLICIES TOWARDS EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  32. 32. <ul><li>Why are gasoline taxes so common? </li></ul><ul><li>They are a Pigovian tax aimed at correcting three negative externalities: </li></ul><ul><ul><li>Congestion </li></ul></ul><ul><ul><li>Accidents </li></ul></ul><ul><ul><li>Pollution </li></ul></ul><ul><li>The tax makes the economy work better. </li></ul>CASE STUDY: Why Is Gasoline Taxed So Heavily? Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  33. 33. <ul><li>Market-Based Policies </li></ul><ul><ul><li>Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. </li></ul></ul><ul><ul><li>A market for these permits will eventually develop. </li></ul></ul><ul><ul><li>A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. </li></ul></ul>PUBLIC POLICIES TOWARDS EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  34. 34. <ul><li>Market-Based Policies </li></ul><ul><ul><li>Reducing pollution using permits is quite similar to imposing a Pigovian tax. </li></ul></ul><ul><ul><li>In both cases it is the firm who pays its pollution. </li></ul></ul><ul><ul><li>With Pigovian taxes, polluting firms must pay the government. </li></ul></ul><ul><ul><li>With pollution permits, polluting firm must pay to buy the permit. </li></ul></ul><ul><ul><li>See Figure 10-6 for an illustration of the similarities. </li></ul></ul>PUBLIC POLICIES TOWARDS EXTERNALITIES Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  35. 35. Figure 10-6: The Equivalence of Pigovian Taxes and Pollution Permits. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page (a) Pigovian Tax (b) Pollution Permits Price of Pollution Quantity of Pollution 0 Quantity of Pollution 0 Pigovian Tax P 1. A Pigovian sets the price of pollution… 2. … which together with the demand curve, determines the quantity of pollution… Demand for pollution rights Q Supply of pollution permits 1. … Pollution permits set the quantity of pollution… Q 2. … which together with the demand curve, determines the price of pollution… Demand for pollution rights P
  36. 36. <ul><li>When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. </li></ul><ul><li>Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. </li></ul><ul><li>Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. </li></ul>Summary Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  37. 37. <ul><li>Those affected by externalities can sometimes solve the problem privately. </li></ul><ul><li>The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. </li></ul><ul><li>When private parties cannot adequately deal with externalities, then the government steps in. </li></ul><ul><li>The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits. </li></ul>Summary Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page
  38. 38. The End Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page

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