Policy Conundrum
There are no SOLUTIONS.
There are just TRADE-OFFS.
Copyright © 2004 South-Western
Market Failure
Recall
• Adam Smith’s “invisible hand” leads self-interested buyers
& sellers in a market to maximize the total benefit for
society.
But market failures can still happen!
• An externality arises when a person engages in an activity
that influences the well-being of a bystander and yet neither
pays nor receives any compensation for that effect.
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EXTERNALITIES AND MARKETS
• When the impact on the bystander is adverse, the
externality is called a negative externality.
• When the impact on the bystander is beneficial, the
externality is called a positive externality.
• Externalities cause markets to be inefficient.
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Negative Externalities
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Automobile exhaust
Factory pollution
Cigarette smoking
Barking dogs (loud pets)
Airplanes (landing/take-off)
Landfills
Chicken litter
Over-fishing/grazing/driving
B.O.
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Coal-Fired Power Plant
• The owner of the plant bears the costs of
the labor, land, concrete, steel, etc. used
in production but does NOT pay for the
clean air used.
• People also agree to buy electricity
(electric bill).
• Social Cost > Private Cost
• Price does not reflect true cost!
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A Voluntary Exchange between a willing
buyer and seller
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But…..
• Although the car owner has paid for the gasoline, he has
NOT paid for the clean air used as he drives.
• Price does not reflect true cost!
. . . COSTS that spill over onto people who
don’t receive the benefits.
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Property Rights
• The incentives are not correct!
• Auto/factory pollution could be solved…..
• tailpipe
• smokestack
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Positive Externalities
• Immunizations
• Landscaping/Home
Maintenance
• Research & Development
• Education
• Green space
• Rainforests
• Species
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Equilibrium = Balance
Price
Supply
Consumer
surplus
Equilibrium
price
• MB = MC = P*
• Qs = Qd
• Allocative efficiency
Producer
surplus
Demand
Equilibrium
quantity
Quantity
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative externalities lead markets to produce and
consume a quantity greater than the socially
optimal quantity.
• Positive externalities lead markets to produce and
consume a quantity less than the socially optimal
quantity.
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The Market for Aluminum
• The quantity produced & consumed at the market
equilibrium is efficient in the sense that it maximizes
the benefits to market participants (buyers & sellers).
• If the aluminum factories emit pollution then the cost to
society of producing aluminum is larger than the cost to
aluminum producers.
• For each unit of aluminum produced, the social cost
includes the private costs of the producers plus the damage
to those bystanders adversely affected by the pollution.
Copyright © 2004 South-Western
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
Aluminum
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Negative Production Externality
• social cost > private cost
• The intersection of the demand curve and the
social-cost curve determines the optimal output
level.
• The private market outcome over-produces and
consumes aluminum at the market equilibrium
quantity.
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The Market for Education
• When an externality benefits the bystanders, a positive
externality exists…..the social value of the good
exceeds the private value.
• Education can be considered a positive externality
• Educated children are more likely to become good citizens
(voters, productive workers, less crime).
• Benefits spill over to general public beyond the benefit to
individual students.
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Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
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Positive Consumption Externality
• social benefit > private benefit
• The intersection of the supply curve and the socialvalue curve determines the optimal output level.
• The private market outcome under produces and
consumes education at the market equilibrium
quantity.
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Solving (addressing) Externalities
• Internalizing an externality involves altering
incentives so that people take account of the external
effects of their actions.
• The government can internalize an externality by
imposing a tax/subsidy to reduce/increase the
equilibrium quantity to the socially optimal level.
• Patents & Copyrights
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Getting an Education
Provides Great Benefits
(even for those not in school)
• Social Value > Private Value
• Private market will under-do it.
• Mandate and subsidize!
• What would society look like if we left all
education up to the private market?
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Immunizations Reduce the Likelihood of
Disease
(even for people who don’t get immunized)
• Social Value > Private Value
• Private market will under-do it.
• Mandate and subsidize!
• What would society look like if we left all
immunizations up to the private market?
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Taxing Activities with Negative Externalities
• Cigarettes
• Alcohol
• Soda/Junk Food
• Gasoline
• Carbon
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Government action is not always needed to
solve the problem of externalities.
• The Coase Theorem proposes that if property rights
are clearly defined and protected private parties can
negotiate without cost, then they can solve the
problem of externalities on their own.
• Transaction costs are the costs that parties incur in the
process of agreeing to and following through on a
negotiated settlement.
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The Citrus Farmer & The Fisherman
The Coase Theorem
citrus farmer
profits per week
fisherman
profits per week
high
output
$2,000
$100
low
output
$300
$600
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The Coase Theorem
citrus farmer
profits per week
fisherman
profits per week
high
output
$2,000
$1,000
low
output
$300
$6,000
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PUBLIC POLICY TOWARD
EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may attempt
to solve the problem through . . .
• command-and-control policies.
• market based policies (taxes, pollution permits)
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More Examples
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Chickens and chicken litter
Burning or hauling leaves/brush and debris
Airport runways
Over-fishing, over-grazing
Microwave ovens
• Green space (woods, parks)
• The Brazilian Rainforest
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PUBLIC POLICY TOWARD
EXTERNALITIES
Policy Conundrum
There are no SOLUTIONS.
There are just TRADE-OFFS.
Copyright © 2004 South-Western