Externalities

1. EXTERNALITIES
Externality: a by-product of a
transaction that affects someone
not immediately involved in the
transaction

2. EXTERNALITIES
Positive externality: a party not
immediately involved in the transaction
benefits from the transaction
Classic example: orchard owner lives
next door to a bee keeper
•Fruit trees make bees more product
•Bees pollinate tree blossoms

3. EXTERNALITIES
Negative externality: a party not immediately
involved in the transaction is harmed by the
transaction
Classic example: Automobile use generates
sulfur dioxide that pollutes the air
•Asthma sufferers
•Homeowners (paint, metal)
•Tree owners

4. Negative Externality Application
Hog Production:
• Water quality
• Air quality
• Land Prices

5. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
$105
$5
External cost + private MC
Marginal Social Cost = Private Marginal Cost plus External Cost

6. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
External cost + private MC
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand
$102
45000
Overproduction and
underpriced relative
to social optimum of
45000 hogs

7. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
External cost + private MC
= social marginal cost
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand = marginal
value
$102
45000
Overproduction:
Value of last hog is
$100, social cost of
production is $105.
$105

8. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
External cost + private MC
= social marginal cost
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand = marginal
value
$102
45000
Overproduction:
Value of last hog is
$100, social cost of
production is $105.
$105
Deadweight
loss from
overproduction

9. How can we attain the social
optimum?
• Tax producers to shift supply curve left
• Tax consumers to shift demand curve to
the left
• Set quota on output to limit supply to
45000 hogs

10. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
External cost + private MC
= private MC + tax
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand
$102
45000
Impose $5 tax on
producers, generate
efficient solution
$105
$5
$97

11. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand
45000
Impose $5 tax on
consumers, generate
efficient solution
$95
$5 $97

12. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
External cost + private MC
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand
$102
45000
Impose hog quota of
45000

13. Supply = private MC
Hogs
$
Negative Externality: Hog Production
50000
$100
External cost + private MC
Marginal Social Cost = Private Marginal Cost plus External Cost
Demand
$102
45000
Tradeable pollution
permits = pollution
consistent with 45000
hogs
$97
$5
PERMIT VALUE =
P – Private MC

14. Positive Externality Application
Live music venue creates foot traffic for
nearby establishments
• Restaurant sales
• Retail sales

15. Supply = private MC
Ticket sales
$
Positive Externality: Music Venue
1000
$7
$10
$3
Private MC – social benefit
Marginal Social Cost = Private Marginal Cost minus External Benefit

16. Supply = private MC
Ticket sales
$
Positive Externality: Music Venue
1000
$7
$10
$3
Private MC – social benefit
= social marginal cost
Marginal Social Cost = Private Marginal Cost minus External Benefit
Demand =
marginal value
$8.50
800
Underproduction
and overpriced
relative to social
optimum of 1000

17. Supply = private MC
Ticket sales
$
Positive Externality: Music Venue
1000
$7
$10
$3
Private MC – social benefit
= social marginal cost
Marginal Social Cost = Private Marginal Cost minus External Benefit
Demand =
marginal value
$8.50
800
Last unit sold
valued at $8.50 but
only costs $5.50 to
produce
Deadweight loss
from under-
production
$5.50

18. How can we attain the social
optimum?
• Subsidize music producers to shift supply
curve rightward
• Subsidize consumers to shift demand
curve to the right

19. Supply = private MC
Ticket sales
$
Positive Externality: Music Venue
1000
$7
$10
$3
Private MC – social benefit
= Private MC - subsidy
Marginal Social Cost = Private Marginal Cost minus External Benefit
Demand =
marginal value
$8.50
800
Provide $3 subsidy
per ticket to music
producer

20. Supply = private MC
Ticket sales
$
Positive Externality: Music Venue
1000
$7
$10
$3
Marginal Social Cost = Private Marginal Cost minus External Benefit
Demand
$8.50
800
Provide $3 subsidy
per ticket to
consumer
Demand = marginal
value + subsidy

21. Externalities
• Imply that the competitive equilibrium will
not result in the social optimum
• Imply that the competitive equilibrium will
result in a dead weight loss
• Create a role for government intervention