Externalities and Market Inefficiency
How externalities cause markets to allocate resources inefficiently and how to remedy those
externalities
Welfare Economics : A Recap
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To make our analyse concrete we will consider the market for steel
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This graph shows information about cost and benefits
It shows the marginal change for the supply and the demand
In a market without government intervention we see the market will be efficient
shown as Q market
Negative Externalities
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The steel production emit pollutants
For each unit of steel produced, a certain amount of smoke enter the atmosphere
For each steel produced the social cost equals the private cost of the steel
production plus the cost of those bystanders harmed by pollution
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The social cost is above the supply curve because it takes into account the external
cost imposed on society by steel production
The social planner wants to maximize the total surplus derived from the market—the
value to consumers of steel minus the cost of producing steel.
The planner would choose the level of steel production at which the demand curve
crosses the social-cost curve
Below this level of production, the value of the steel to consumers exceeds the social
cost of producing it
Above this level of production, the social cost of producing additional steel exceeds
the value to consumers.
The graph shows the market inefficiency that occurs if we compare between Q
optimum and Q market
To move the graph towards achieving the optimal outcome is to tax every production
of steel
The use of such tax is call internalizing the externality, altering incentives so that
people take into account the external effects of their actions
This would make an incentive to buy less steel and produce less
Positive Externalities
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Consider education as part of positive externalities
With education it creates more informed people and more productive workers in a
private sense
But in an external sense, it has created more informed voters, lowered the crime rate
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and encouraged technological advancement within a nation.
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The demand curve does not reflect the value to society of the good
The social value is above the private value
This can be corrected by the government by inducing market participants to
internalize the externality
Therefore we need subsidization
To summarize
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is socially desirable.To
remedy the problem, the government can internalize the externality by taxing goods with
negative externalities and subsidizing goods with positive externalities.
Public Policies toward Externalities
Externalities cause inefficiency market allocation therefore we need government intervention
to remedy the efficient allocation.
There are two ways which are the Command and control policies and Market based policies
Command-and-Control Policies: Regulation
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The government can remedy an externality by either requiring or forbidding certain
behaviors
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Market-Based Policy 1: Corrective Taxes and Subsidies
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Instead of regulating behavior in response to an externality, the government can use
market-based policies to align private incentives with social efficiency
For example are taxing externality which are called corrective taxes or Pigovian taxes
The corrective taxes would equal the external benefit to turn the negative externality
to a positive one
Taxing externalities make the goals more effective as the tax works more flexible and
are made to make incentives
Corrective taxes alter incentives to make the society far better off
Market-Based Policy 2: Tradable Pollution Permits
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For example the EPA tells two factories that factory A and B must only pollute 300
tons of emissions. But at the end of the year Factory A wants to pollute 400 tons and
factory B only needs to pollute 200 tons. Thus Factory B agrees to lower their
emission if Factory A pays. The total pollution stays the same but the social welfare
change
This creates a new kind of scare resources which is a tradable pollution permit
This resource will be governed by the market mechanism of supply and demand
Objections to the Economic Analysis of Pollution
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There is an argument to be made that no one should have the right to pollute
But this argument isn't realistic because we face trade off every day and we must act
upon it
Private Solutions to Externalities
The Types of Private Solutions
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Sometimes the problem of externalities is solved with moral codes and social
sanctions
The private market can often solve the problem of externalities by relying on the selfinterest of the relevant parties. Sometimes the solution takes the form of integrating
different types of businesses
Another way for the private market to deal with external effects is for the interested
parties to enter into a contract.
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The Coase Theorem
Coase theorem the proposition that if private parties can bargain without cost over the
allocation of resources, they can solve the problem of externalities on their own
The Coase theorem says that private economic actors can potentially solve
the problem of externalities among themselves. Whatever the initial distribution of rights,
the interested parties can reach a bargain in which everyone is better off and the outcome
is efficient.
Why Private Solutions Do Not Always Work
Not everyone is willing to bargain and fail to solve a problem because of a transaction cost
transaction costs, the costs that parties incur during the process of agreeing to and following
through on a bargain
Reaching an efficient bargain is especially difficult when the number of interested
parties is large, because coordinating everyone is costly
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