Externalities
Lecture 10 – academic year 2015/16
Introduction to Economics
Dimitri Paolini
What do we do today?
• The “external” effects of economic
activities
• How do we internalize externalities?
Market efficiency: A brief recap
• In a perfectly competitive market with no
externalities the total welfare of the economic
system is measured as the sum of consumer
surplus and producer surplus.
• “The invisible hand” (of the market) maximize
the total benefit of society
• Markets are usually good instruments to
organize the economic activity
• Sometimes, however: “market failures”
Externalities:
definition and effects
When the transaction between a buyer and a
seller has an effect on a third party, the effect
on the latter is called externality.
Whenever they do not take into account the
“third party”, the equilibrium prices and
quantities are not efficient.
Therefore the externalities cause an inefficient
allocation of resources, i.e. market failure.
The effects of externalities
on society
In the presence of externalities:
•Social welfare is not measured only by the welfare
of consumers and producers, but also by the welfare
of the third party (involuntary participant to the
market).
•The externalities can be negative or positive
•However, ALL externalities are sources of market
inefficiencies in the sense that the quantity
exchanged ≠ optimal quantity.
Negative externalities
Costs on other individuals (consumers or
producers) that are not directly involved in the
market exchange.
Example: smoke of cigarettes, cars’ exhaust
gas
Positive externalities
Direct benefits obtained by individuals
(consumers or producers) not directly involved
in the market exchange.
Example: Vaccines, restoration of a piece of
Art, investment in new technologies.
Externalities and market
inefficiency
• Negative externalities in production
Qmarket > Qoptimum (socially desirable quantity)
social costs > private costs
• Positive externalities in production
Qmarket < Qoptimum
social costs < private costs
Externalities and market
inefficiency
• Negative externalities in consumption
Qmarket > Qoptimum (socially desirable quantity)
Social benefit < private benefit
• Positive externalities in consumption
Qmarket < Qoptimum
Social benefit > private benefit
Negative externalities in
production
Price of
aluminium
Cost of
pollution
Social cost
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
aluminium
Positive externalities in
production
Price of
Robot
Value of
technologica
l diffusion
Supply (private cost)
Social cost
Equilibrium
Optimum
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity
of Robot
Negative externalities in
consumption
Price of
alcoholic
drinks
Supply (private cost)
Equilibrium
Optimum
Demand
(private value)
Social value
0
QOPTIMUM QMARKET
Quantity of
alcoholic drinks
Positive externalities in
consumption
Price of
education
Supply (private cost)
Optimum
Equilibrium
Social value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
education
Positive externalities: the
diffusion of knowledge
A firm that starts a project (e.g., to produce
industrial robot) could develop a new technology
/ generate an innovation in production
techniques so as to improve the initial project.
Such an improvement could benefit the firm but
also the society as a whole, because such
knowledge will accumulate and becomes part of
the social knowledge stock.
Technology diffusion: positive externality
How to internalize externalities?
• Government Intervention: Government can
internalize the externalities by taxing the goods that
causes negative externalities and by subsidizing those
with positive externalities; Ex. Pigovian Tax, Tradable
permits,
• Private solution: Public intervention is not always either
necessary or efficacious to deal with externalities.
------->
Coase’s Theorem
Coase’s Theorem: if the parties in a transaction can
negotiate over the allocation of resources without
costs, then the market can solve the externality
problem.
2. Market policies
To align incentives and social optimum the Public
Authority can decide to rely on “market policies”:
•Regulation: determine a certain level of
environmental pollution that is allowed.
•Pigovian tax: create an incentive to reduce
pollution.
•Tradable permits: voluntary transfer of the rights
to pollute from one firm to the other.
Conclusion
When the transaction between a buyer and a seller
has effects on a third party, there is an externality.
Negative (positive) externalities imply that the quantity
that is exchanged in equilibrium is higher (lower) than
the quantity that is socially desirable.
Solutions to externalities can derive both from private
parties and government intervention.