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10
Externalities
Microeonomics
N. Gregory
PRINCIPLES OF
Mankiw
In this chapter,
look for the answers to these
questions:
What is an externality?
Why do externalities make market outcomes
inefficient?
Introduction
One of the principles from Chapter 1:
Markets are usually a good way
to organize economy activity.
In absence of market failures, the competitive
market outcome is efficient, maximizes total surplus.
Introduction
Self-interested buyers and sellers neglect the
external costs or benefits of their actions,
so the market outcome is not efficient.
EXTERNALITIES
Examples of Negative
Externalities
P
$5
4
3
$2.50
2
1
0
10
EXTERNALITIES
20 25 30 Q
(gallons)
P
$5
Social cost
= private + external cost
external
cost
External cost
= value of the
negative impact
on bystanders
2
1
0
10
EXTERNALITIES
20
30 Q
(gallons)
= $1 per gallon
(value of harm
from smog,
greenhouse gases)
7
P
$5
Social
cost
At
At any
any Q
Q << 20,
20,
value
value of
of additional
additional gas
gas
exceeds
social
cost.
exceeds
social
At
any
Q
>
20,
At any Q > 20, cost.
3
2
D
1
0
The
The socially
socially
optimal
optimal quantity
quantity
is
is 20
20 gallons.
gallons.
10
EXTERNALITIES
20 25 30 Q
(gallons)
social
social cost
cost of
of the
the
last
last gallon
gallon is
is
greater
greater than
than its
its value
value
to
to society.
society.
P
$5
Social
cost
3
2
D
1
0
10
EXTERNALITIES
20 25 30 Q
(gallons)
Market eqm
(Q = 25)
is greater than
social optimum
(Q = 20).
One solution:
tax sellers
$1/gallon,
would shift
S curve up $1.
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EXTERNALITIES
10
Examples of Positive
Externalities
Positive Externalities
In the presence of a positive externality,
the social value of a good includes
private value the direct value to buyers
external benefit the value of the
positive impact on bystanders
12
ACTIVE LEARNING
External benefit
= $10/shot
$50
40
value curve.
S
30
20
10
internalize this
externality?
0
0
10
20
30
Q
13
ACTIVE LEARNING
Answers
Socially optimal Q
= 25 shots.
$50
To internalize the
externality, use
subsidy = $10/shot.
external
benefit
40
30
Social value
= private value
+ $10 external benefit
20
10
0
0
10
20 25 30
Q
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Effects of Externalities:
Summary
IfIf negative
negative externality
externality
market
market quantity
quantity larger
larger than
than socially
socially desirable
desirable
IfIf positive
positive externality
externality
market
market quantity
quantity smaller
smaller than
than socially
socially desirable
desirable
To
To remedy
remedy the
the problem,
problem,
internalize
internalize the
the externality
externality
tax
tax goods
goods with
with negative
negative externalities
externalities
subsidize
subsidize goods
goods with
with positive
positive externalities
externalities
EXTERNALITIES
15
Two approaches:
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EXTERNALITIES
17
EXTERNALITIES
18
19
20
Congestion
The more you drive, the more you contribute to
congestion.
Accidents
Larger vehicles cause more damage in an
accident.
Pollution
Burning fossil fuels produces greenhouse gases.
EXTERNALITIES
21
ACTIVE LEARNING 2
emissions
Acme and US Electric run coal-burning power plants.
Each emits 40 tons of sulfur dioxide per month,
total emissions = 80 tons/month.
ACTIVE LEARNING 2
A. Answers
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ACTIVE LEARNING 2
24
ACTIVE LEARNING 2
B. Answers
ACTIVE LEARNING 2
B. Answers, continued
EXTERNALITIES
27
EXTERNALITIES
28
29
Objections to the
Economic Analysis of Pollution
Some politicians, many environmentalists argue
that no one should be able to buy the right to
pollute, cannot put a price on the environment.
EXTERNALITIES
30
Private Solutions to
Externalities
EXTERNALITIES
31
Private Solutions to
Externalities
EXTERNALITIES
32
33
CASE 1:
Private outcome:
Jane pays Dick $600 to get rid of Spot,
both Jane and Dick are better off.
34
CASE 2:
Private outcome:
Jane not willing to pay more than $800,
Dick not willing to accept less than $1000,
so Spot stays.
35
CASE 3:
36
ACTIVE LEARNING 3
Applying Coase
Collectively, the 1000 residents of Green Valley
value swimming in Blue Lake at $100,000.
A nearby factory pollutes the lake water, and would
have to pay $50,000 for non-polluting equipment.
A. Describe a Coase-like private solution.
B. Can you think of any reasons why this
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CHAPTER SUMMARY
An externality occurs when a market transaction
affects a third party. If the transaction yields
negative externalities (e.g., pollution), the market
quantity exceeds the socially optimal quantity.
If the externality is positive (e.g., technology
spillovers), the market quantity falls short of the
social optimum.
39
CHAPTER SUMMARY
Sometimes, people can solve externalities on
their own. The Coase theorem states that the
private market can reach the socially optimal
allocation of resources as long as people can
bargain without cost. In practice, bargaining is
often costly or difficult, and the Coase theorem
does not apply.
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CHAPTER SUMMARY
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