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					Externalities                     CHAPTER    9

    It isn't pollution that's harming the
     environment. It's the impurities in
   our air and water that are doing it.
                                     Dan Quayle
                           44th US Vice President
                                     (1947 - )
CHAPTER CHECKLIST

When you have completed your study of this
chapter, you will be able to

1 Explain why negative externalities lead to inefficient
  overproduction and how the government internalizes the
  externalities.
2 Explain why positive externalities lead to inefficient
  underproduction and how the government internalizes
  the externalities.
EXTERNALITIES IN OUR DAILY LIVES

 An externality is a cost or a benefit that arises from:
    • Production that falls on someone other than the
      producer
    • Consumption that falls on someone other than the
      consumer
 A negative externality is a production or
 consumption activity that creates an external cost.
 A positive externality is a production or consumption
 activity that creates an external benefit.
 EXTERNALITIES IN OUR DAILY LIVES
EXTERNALITIES IN OUR DAILY LIVES

  Four types of externalities:
     •   Negative production externalities
     •   Positive production externalities
     •   Negative consumption externalities
     •   Positive consumption externalities
 EXTERNALITIES IN OUR DAILY LIVES
EXTERNALITIES IN OUR DAILY LIVES

Negative Production Externalities
  Pollution is the major example of this type of
  externality.
  Others are noise and congestion.
Positive Production Externalities
  Example: Orchards provide positive production
  externalities to honey producers, who in turn provide
  positive production externalities to orchards.
 EXTERNALITIES IN OUR DAILY LIVES
EXTERNALITIES IN OUR DAILY LIVES


Negative Consumption Externalities
  Smoking tobacco in a confined space
  Noisy parties
Positive Consumption Externalities
  A flu vaccination
  Restoration of an historic building
  Education and research
9.1 NEGATIVE EXTERNALITIES: POLLUTION

Private Costs and Social Costs
  Marginal private cost is the cost of producing an
  additional unit of a good or service that is borne by the
  producer of that good or service.
  Marginal external cost is the cost of producing an
  additional unit of a good or service that falls on people
  other than the producer.
9.1 NEGATIVE EXTERNALITIES: POLLUTION
  Marginal social cost is the marginal cost incurred by
  the entire society—by the producer and by everyone
  else on whom the cost falls.
  Marginal social cost (MSC) is the sum of marginal
  private cost (MPC) and marginal external cost.
           MSC = MPC + Marginal external cost
  If MSC = MPC, there is no negative externality (all costs
            are paid by supplier in the market)
   When negative externalities exist, market will allocate
         too many resources (overproduction)
                This is MARKET FAILURE.
 9.1 NEGATIVE EXTERNALITIES: POLLUTION

Figure 9.1 shows the
relationship between
cost and output.

When output is 4,000 tons
of chemicals a month:
1. Marginal private
  cost is $100 a ton.
2. Marginal external
  cost is $125 a ton.
3. Marginal social cost is
  $225 a ton.
9.1 NEGATIVE EXTERNALITIES: POLLUTION

Production and Pollution: How Much?
  When an industry is unregulated, the amount of
  pollution it creates depends on the market equilibrium
  price and the quantity of the good produced.
  If the industry creates an external cost, the market
  equilibrium is inefficient. Too much of the good is
  produced.
 9.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 9.2 shows
inefficiency with an
external cost.
1. The market is in
   equilibrium at a
   price of $100 a ton
   and 4,000 tons of
   chemical a month
   is inefficient.
2. Marginal social
  cost exceeds ...
3. Marginal benefit.
 9.1 NEGATIVE EXTERNALITIES: POLLUTION


4. The efficient
  quantity is 2,000
  tons of chemical,
  where marginal
  social cost equals
  marginal benefit.
5. The gray triangle
   shows the dead-
   weight loss created
   by the pollution
   externality.
9.1 NEGATIVE EXTERNALITIES: POLLUTION

Government Actions in the Face of External
 Costs
  The three main methods that governments can use to
  achieve a more efficient allocation of resources in the
  presence of external costs are:
     • Emission charges
     • Marketable permits
     • Taxes
9.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Private Benefits and Social Benefits
  Marginal private benefit is the benefit of an
  additional unit of a good or service that the consumer of
  that good or service receives.
  Marginal external benefit is the benefit of an
  additional unit of a good or service that people other
  than the consumer of the good or service enjoy.
9.2 POSITIVE EXTERNALITIES: KNOWLEDGE
  Marginal social benefit is the marginal benefit
  enjoyed by society—by the consumers of a good or
  service and by everyone else who benefits from it.
  Marginal social benefit (MSB) is the sum of marginal
  private benefit (MPB) and marginal external benefit.
          MSB = MPB + Marginal external benefit
   If MSB = MPB, no positive externality (all benefits are
              enjoyed by buyers in market)
   When positive externalities exist, market will allocate
         too few resources (underproduction)
               This is MARKET FAILURE.
 9.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Figure 9.5 shows an
external benefit.
When 15 million students
attend college:
1. Marginal private benefit
  is $10,000 per student.

2. Marginal external benefit
  is $15,000 per student.

3. Marginal social benefit is
  $25,000 per student.
9.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Figure 9.6 shows
inefficiency with an
external benefit.
1. Market equilibrium
  is at a tuition of
  $15,000 a year and
  7.5 million students
  and is inefficient
  because …
2. Marginal social
  benefit exceeds …
3. Marginal cost.
9.2 POSITIVE EXTERNALITIES: KNOWLEDGE



4. The efficient
  number of students
  is 15 million.

5. The gray triangle
  shows the
  deadweight loss
  created because
  too few students
  enroll in college.
9.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Government Actions In the Face of External
 Benefits
  Four devices that governments can use to achieve a
  more efficient allocation of resources in the presence of
  external benefits:
     •   Public provision
     •   Private subsidies
     •   Vouchers
     •   Patents and copyrights

				
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