The document discusses the nature of externalities, their impact on market efficiency, and potential solutions, including private and government interventions such as taxes and subsidies. It highlights the distinction between negative and positive externalities, illustrated through examples like aluminum production and technology spillovers. Additionally, it addresses consumption externalities, showing their effects in markets like alcohol and education.

1. ExternalitiesExternalities
Part IIPart II

2. • Learn the nature of an externality.
• See why externalities can make market
outcomes inefficient.
• Examine how people can sometimes solve
the problem of externalities on their own.
• Consider why private solutions to
externalities sometimes do not work.
• Examine the various government policies
aimed at solving the problem of
externalities.
• Learn the nature of an externality.
• See why externalities can make market
outcomes inefficient.
• Examine how people can sometimes solve
the problem of externalities on their own.
• Consider why private solutions to
externalities sometimes do not work.
• Examine the various government policies
aimed at solving the problem of
externalities.
In this Topic you will…In this Topic you will…

3. • The Market for Aluminum (cont’d)
–What quantity of aluminum should
be produced?
• Where the demand curve crosses the
social-cost curve.
• Below Qoptimum the value of the aluminum
to consumers exceeds rgw social
cost of producing it.
• Above Qoptimum the social cost of
producing additional aluminum
exceeds the value to consumers.
• The Market for Aluminum (cont’d)
–What quantity of aluminum should
be produced?
• Where the demand curve crosses the
social-cost curve.
• Below Qoptimum the value of the aluminum
to consumers exceeds rgw social
cost of producing it.
• Above Qoptimum the social cost of
producing additional aluminum
exceeds the value to consumers.
Negative Externalities inNegative Externalities in
ProductionProduction

4. Demand
(private value)
Supply
(private costs)
0
Equilibrium
Qmarket
Quantity of
Aluminium
Price of
Aluminium
Social costs
Qoptimum
Cost of
pollution
Optimum
Figure 10-2: Pollution and the SocialFigure 10-2: Pollution and the Social
OptimumOptimum

5. • The Market for Aluminum (cont’d)
– Reducing aluminum production and
consumption below the market
equilibrium level raises total economic
well-being.
• The Market for Aluminum (cont’d)
– Reducing aluminum production and
consumption below the market
equilibrium level raises total economic
well-being.
Negative Externalities inNegative Externalities in
ProductionProduction

6. 0 Quantity of
Aluminium
Price of
Aluminium
Social costs
Demand
(private value)
Poptimum
Qoptimum
Figure 10-3: Deadweight Loss of a NegativeFigure 10-3: Deadweight Loss of a Negative
Production ExternalityProduction Externality
Pmarket
Qmarket
a
b
HD + A + ED + A + E - H
A + B + C + HA + EE - (B + C + H)
- (A + B + C)DA + B + C + D
Total surplus
Producer surplus
Consumer surplus
ChangeAt QOptimumAt QMarket
D
A B C
E
F G
H

7. • The Market for Aluminum (cont’d)
– How the can social optimum of aluminum
production be achieved?
• 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.
– Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
– Pigovian taxes are taxes enacted to correct the
effects of negative externalities.
– In Figure 10-3, the Pigovian tax is equal to the
distance ab.
• The Market for Aluminum (cont’d)
– How the can social optimum of aluminum
production be achieved?
• 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.
– Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
– Pigovian taxes are taxes enacted to correct the
effects of negative externalities.
– In Figure 10-3, the Pigovian tax is equal to the
distance ab.
Negative Externalities inNegative Externalities in
ProductionProduction

8. • When an externality benefits the bystanders, a
positive externality exists.
– The social value of the good exceeds the
private value.
• Example:
• 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.
• When an externality benefits the bystanders, a
positive externality exists.
– The social value of the good exceeds the
private value.
• Example:
• 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.
Positive Externalities inPositive Externalities in
ProductionProduction

9. 0
Optimum
Quantity of
Robots
Price of
Robots
Demand
(private value)
Social costs
a
b
Qoptimum
Poptimum
Qmarket
Pmarket Equilibrium
Supply (private costs)Value of
technology
spillover
Deadweight
loss
Figure 10-4: Technology Spillovers and theFigure 10-4: Technology Spillovers and the
Social OptimumSocial Optimum

10. • The intersection of the supply curve and
the social-value curve determines the
optimal output level.
– The optimal output level is more than
the equilibrium quantity.
– The market produces a smaller quantity
than is socially desirable.
– The social value of the good exceeds
the private value of the good.
• The intersection of the supply curve and
the social-value curve determines the
optimal output level.
– The optimal output level is more than
the equilibrium quantity.
– The market produces a smaller quantity
than is socially desirable.
– The social value of the good exceeds
the private value of the good.
Positive Externalities inPositive Externalities in
ProductionProduction

11. • Internalizing Externalities: Subsidies
– Used as the primary method for
attempting to internalize positive
externalities.
• Internalizing Externalities: Subsidies
– Used as the primary method for
attempting to internalize positive
externalities.
Positive Externalities inPositive Externalities in
ProductionProduction

12. – Government intervention in the economy that
aims to promote technology-enhancing
industries
• Patent laws are a form of technology policy
that give the individual (or firm) with patent
protection a property right over its
invention.
• The patent is then said to internalize the
externality.
• The patent system gives firms a greater
incentive to engage in research and other
activities that advance technology.
– Government intervention in the economy that
aims to promote technology-enhancing
industries
• Patent laws are a form of technology policy
that give the individual (or firm) with patent
protection a property right over its
invention.
• The patent is then said to internalize the
externality.
• The patent system gives firms a greater
incentive to engage in research and other
activities that advance technology.
CASE STUDY:CASE STUDY: The Debate Over TechnologyThe Debate Over Technology
PolicyPolicy

13. • Some externalities are associated with
consumption.
• Figure 10-5 (a) shows a market with a
negative consumption externality such as
the market for alcoholic beverages.
• Figure 10-5 (b) shows a market with a
positive consumption externality such as
the market for education.
• Some externalities are associated with
consumption.
• Figure 10-5 (a) shows a market with a
negative consumption externality such as
the market for alcoholic beverages.
• Figure 10-5 (b) shows a market with a
positive consumption externality such as
the market for education.
Externalities in ConsumptionExternalities in Consumption

14. (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)
Qmarket Qoptimum
Qoptimum Qmarket
Figure 10-5: Consumption ExternalitiesFigure 10-5: Consumption Externalities