Microeconomics Dr.

Katie Sauer

Externalities (ch 10) Example 1: Plastic Consumers get the benefit of buying things that contain plastic, and they have to pay for that benefit. Producers get the benefit of selling an item that people want, and they incur the costs of producing it. But, there are *____________________* costs to society as a whole.

Example 2: Gasoline Consumers get the benefit of driving their cars, and they have to pay for the cost of gasoline. Producers get the benefit of producing/selling gasoline, and they have to incur the cost of producing it. But, there are *____________________* costs to society as a whole.

Example 3: Education Consumers (students) get benefits like a higher future salary and an increase in skills and experience, and must pay the cost in the form of tuition. Producers (colleges) get benefits like selling a service that consumers want but also must incur the costs of production. But, there are *____________________* costs to society as a whole. Example 4: Historic Buildings The owner of the building gets the benefit from owning the building, and incurs the cost of renovation / upkeep. But, there are *____________________* costs to society as a whole. The Market Outcome Recall: The Demand curve represents the value (benefit) to consumers. The Supply curve represents the production cost. Market equilibrium is efficient (it maximizes total surplus). In reality, sometimes the total benefits are not reflected in the demand curve and the total costs are not reflected in the supply curve.

I. Externalities are the uncompensated impact of ones actions on the well-being of a bystander. ex:

Microeconomics Dr. Katie Sauer

Externalities can be positive or negative. Positive externalities mean that the third party has in some way benefited. Negative externalities mean that the third party has in some way been harmed. Note: If a party engages in an activity that harms/benefits themselves, that is not part of the externality. ex: You smoke cigarettes. (benefit to you) - You pay for cigarettes. (cost to you, not an externality) - You spend money on gum and mouthwash. (cost to you, not an externality) - You will probably face some health issues in the future. (cost to you, not an externality) -You smoke around a non-smoker and it bothers them. (negative externality) -You eventually end up with Medicare paying your health costs. (negative externality) -You die younger than a non-smoker and stop drawing Social Security. (positive externality)

A. Negative Externalities Ex: pollution from the production of coal-fired electricity - you pay for electricity and get its benefits - the power plant incurs production costs and receives payment for the electricity it sells - pollution from the power plant harms the environment and bothers people The social cost of coal-fired electricity is greater than the private cost of coal-fired electricity. social cost = production costs + externality costs

The _________________ outcome will be where supply and demand are equal. The market ____________________ externalities. The private cost plus the externality cost is the ______________________________ of the action. The socially optimal outcome is a ____________ quantity and __________________ price.

B. Positive Externalities Ex: K-12 education (in many nations it is not free) - student pays for education and gets its benefits - school incurs production costs and receives payment for services - society as a whole benefits by having more educated residents The social benefits of education are greater than the private benefits of education. social benefit = private benefit + externality benefit

Microeconomics Dr. Katie Sauer

The market outcome will be where supply and demand are equal. The market ignores externalities. The private benefit plus the externality benefit is the true benefit to society of the action. The socially optimal outcome is a __________ quantity and ______________price.

II. Public Policy: Government responses to externalities If the market ignores externalities, then perhaps there is reason for the government to step in. Two common types of government responses to externalities: 1. command and control 2. market based 1. Command and Control = regulate the behavior directly Ex: laws against dumping untreated water into rivers Ex: must attend school until you are 16 2. market based = provide incentives so people/firms choose to change behavior Ex: gasoline tax Ex: flu shot subsidies Market based solutions allow the externality to be internalized. - alter the incentives so that people/firms take the external effects of an action into account a. Internalizing a negative externality A negative externality can be internalized by imposing a _____________________ on the good. Recall, a tax shifts the supply curve to the left by the amount of the tax. If the tax was set at the _______________________ _____________________, the supply curve would then coincide with the social cost curve. Now the market outcome is socially optimal.

Microeconomics Dr. Katie Sauer

b. Internalizing a positive externality A positive externality can be internalized by ____________________________ the good. A subsidy can be used to shift the demand curve to the right. If the subsidy was set at the same amount as the externality benefit, the demand curve would then coincide with the social benefit curve. Now the market outcome is socially optimal.

III. Private Solutions (non-government solutions) We do not necessarily need government involvement to correct externalities. Types of private solutions: 1. moral codes ex: the Golden Rule 2. nonprofits and charities ex: Sierra Club, University Alumni Foundation 3. self-interest / contracts

How well does the private sector do when dealing with externalities? - depends on how well property rights are defined - depends on ease of bargaining (how many parties?) - depends on transaction costs The Coase Theorem: If property rights are well-defined and if private parties can bargain costlessly, then the private market will solve the externality problem. ____________________________________________________________________ Chapter Summary: -When a transaction between a buyer and seller affects a third party, that effect is called an externality. -If an activity yields negative externalities, the socially optimal quantity in a market is less than the equilibrium quantity. -If an activity yields positive externalities, the socially optimal quantity is greater than the equilibrium quantity. -Governments use various policies to remedy the inefficiencies caused by externalities. - regulation - corrective taxes - subsidies -In certain situations, people can solve externality issues without government intervention.