Notes 4-Externalities by SabeerAli1


									                              Econ 321 Lecture Notes 4-Externalities

Externality: A spillover effect associated with production or consumption that extends to a
third party outside the market. In other words, an external effect that generates costs or
benefits to the third party.
     Positive externality. (big brake lights, smoke alarms)
     Negative externality. (pollution)

                                NEGATIVE EXTERNALITY
                                Refined Petroleum Market
              MSC= MPC + MEC

                                                  MPC: Marginal Private Cost
                                                  MPD: Marginal Private Benefit
                                                  MEC: Marginal External cost
                             S=MPC                MSC: Marginal Social Cost
    p                                             Yellow shaded area is the social
    p                                             welfare loss due to         the
                              MEC                 externality.


               e   p
              q    q

                                    POSITIVE EXTERNALITY
                                  MARKET FOR SMOKE ALARMS
                                                                   Since the smoke alarm
                                     S=MPC                         owners don’t care about
                                                                   the external benefits
                                                                   market is going to yield
                                                                   aless     than    efficient
                                                                   amount        of   smoke
                                          MSB=MPB + MEB
                         MEB                                       alarms. Yellow triangle is
                                                                   the social welfare loss
                                  D=MPB                            due        to     positive
                   p      e
                   q     q

                              Econ 321 Lecture Notes 4-Externalities

                          Public Policy toward Negative Externalities


Government imposes a tax on negative externality creating agents. (generally producers)

                                Refined Petroleum Market

                        MSC= MPC + MEC            If we put a tax on petroleum at
                                                  the amount of external costs we
                                                  will be able to make the marginal
                             S=MPC                social cost to be equal to the
    e                                             marginal private cost. Thus the
    p                                             market will yield efficicent
    p                                             amount of petroleum.



                e   p
              q     q

    a) Difficult to estimate the external cost. (what is the external cost of water pollution)
    b) Difficult to determine who is responsible for the cost. (who is responsible for air
    c) What should be taxed is not always clear. (putting scrubbers lowers the externality but
       not the quantity)


Government directly regulates the producers production technology. Government requires
certain steps to be taken by producers.
Example: Catalytic converters on cars, scrubbers on factories.

In the short run both Pigovian taxes and regulation give the same results. However, with
regulation (decreased output level) the firms are going to make profits while with taxes no
profits or even losses. Thus the firms prefer regulation over taxes.

     Regulatory solution – approximates corrective tax solution in short run
          Does not give incentive to further reduce externality
     Corrective tax solution – gives incentive to reduce externality when cost effective
          Difficult to apply in real world
          Negative political pressure

                             Econ 321 Lecture Notes 4-Externalities


They are established by giving firms to right to generate certain amount of pollution. (or any
other negative externality). These rights can be bought or sold like any other commodity.
They have three desirable characteristics:
    1) Can reduce the inefficiencies due to externality
    2) Can reduce the pollution in a cost effective manner
    3) Have less political opposition than taxes or regulation.

                         Public Policy toward Positive Externalities

SUBSIDY: A negative tax that correct for the positive externality. A perfect subsidy should
be equal to the magnitude of the externality. For example vaccines in our country like in most
other countries are subsidized by the government. (I.e. they are generally provided free, even
though the marginal cost is not zero)

Excess Burden and Excess Benefit

When there is a positive externality, should we subsidize this market? Efficiency tells us we
should; however when we do that we also have to keep in mind that, we have to raise the
subsidy money from other markets with taxes. And we know that taxes create inefficiencies.
Thus while we are correcting for an inefficiency, we should not create a bigger one. This is
called excess burden, but it doesn’t say all subsidies should be eliminated but the excess
burden effect should be kept in mind. A similar effect is relevant for negative externalities,
when there is negative externality a Pigovian tax might eliminate inefficiency. However, it
also raises some revenue, government can lower the tax rates on other markets since it had
collected money from this market. Thus with a Pigovian tax, we can lower the inefficiencies
in multiple markets. This is called excess benefit.

Irrelevant Externalitites

When there are externalities, there are inefficiencies and government can improve the welfare
of the society eliminating those inefficiencies. However not all externalities create

    1) Pecuniary Externalities: When a new Migros is opened next to Kiler, it will have a
       negative effect on Kiler. Their sales will go down and probably average price level
       also goes down. This is under the definition of negative externality. However, this
       effect work through market system and doesn’t cause any inefficiency and thus not
       requires government action.

                              Econ 321 Lecture Notes 4-Externalities

    2) Inframarginal Externalities: Sometimes externalities exist but they are not effective
       on the margin. For example people who are wealthy would vaccinate their children for
       tuberculosis even if wasn’t subsidized by the government. (namely not free). It is true
       each vaccinated children will have a positive externality on other children but this
       doesn’t affect the decisions on the margin. So there is no inefficiency and no need for
       government action. However the externality might not be inframarginal for the poor
       segment of the society, in this case there is need for government action.

                         Private Actions to Correct an Externality

a) Coase Theorem: In the absence of transactions costs, the allocation of resources will be
independent of the assignment of property rights. This means that when there is nothing to
stop a potentially profitable trade from taking place, the trade will take place and resources
will be allocated to their highest valued uses.
Example: Confectioner and doctor

       Income effect
       Transactions cost, small number of individuals.

b) Mergers: If a single individual or firm owns the both parties (the one which causes the
externality and the one which is exposed the externality) the problem is automatically solved
since the owner will try to maximize the value of its asset.


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