Up until now we have studied cases where the market outcome is an efficient outcome. In the case studied in this chapter externalities, that is not

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1 Up until now we have studied cases where the market outcome is an efficient outcome. In the case studied in this chapter externalities, that is not true. The market outcome need not be efficient. Externalities are a special case of market failure. It will be shown that government intervention can improve the market outcome and possibly lead to an efficient outcome. An externality exists when an economic agent engages in an activity that affects the well-being of a bystander (or the production of a firm) who neither pays nor receives any compensation for the effect. In other words, the effect on the bystander does not come through the market, so price of a good does not adjust to take into account the beneficial or negative effect. If the effect is beneficial (creates more utility for the bystander or gives a firm an improved production function) it is a positive externality. If the effect is detrimental (creates less utility for the bystander or gives a firm a lower production function) it is a negative externality. When production or consumption of a good causes an externality, society is interested in the well-being not just of the buyers and sellers of that good, but also in the well-being of the bystanders that bear the effects of production or consumption of the good. Buyers and sellers don t take into account the external (not within the market) effects of their actions. Thus the market price and quantity of a good that creates an externality does not reflect its full social cost or full social benefit. So the market equilibrium need not be efficient. The equilibrium does not maximize total benefit minus total cost to society of that good. Pollution is a common example of a negative externality. Many firms create pollution when they produce a good. An example: Paper firms release dioxin, a chemical that is believed to raise population s incidence of cancer and birth defects. Paper firms do not add the additional costs of higher cancer and birth defect rates into their cost functions, which determine their supply curves. Buyers of paper do not consider these additional social costs in their demand curves either. So the market for paper does not account for the costs of paper production due to higher cancer and birth defect rates (these are called external costs). The amount of paper produced, and the amount of pollution emitted, will be too high relative to the efficient amounts, unless the government intervenes in some way. Other examples of externalities: 1

2 Exhaust from cars. A negative externality because it creates smog and because CO 2 causes global warming, leading to many problems. To counteract this problem the government sets emissions standards for cars, taxes gasoline to reduce the amount people drive. Note that it is difficult or impossible to calculate the full cost of global warming, as we don t know what harm it may cause in the future and we don t know how many storms, hurricanes etc. can be attributed to global warming. Restored historic buildings create a positive externality because people walking by can enjoy them. They create benefit for not just those who own or rent them. Thus too little restoration of historic buildings takes place relative to the socially optimal amount. Building owners don t get the full benefit of restoration and may destroy old buildings to build new ones more than they would if they got the full social benefit. Thus local governments regulate the destruction of historic buildings and provide tax breaks to owners who restore them. Barking dogs create a negative externality because people who do not own the dogs hear the noise. Dog owners don t bear the full cost of the noise. Research into new technologies creates a positive externality because it results in knowledge that others, not just the inventors and their companies can use. Thus companies would tend to devote too few resources to research relative to the socially optimal amount. That is why government has a patent system that gives inventors or their companies the exclusive rights over their inventions for a limited period of time. Vaccinations against communicable diseases create a positive externality because if one person is vaccinated it becomes less likely than another person will get the disease. Vaccination programs carried out by government rather than by private firms. Otherwise, too few vaccinations would be bought. Education creates a positive externality by giving others the possibility of generating more knowledge through research. Externalities and Market Inefficiency Consider the market for aluminum. The demand curve reflects the value of aluminum to consumers, measured by the prices they are willing to pay. At a given quantity, the height of the demand curve measures the willingness to pay of the marginal buyer the one who would leave the market if price was any higher. The supply curve reflects the cost of producing aluminum. At any given quantity the height of the supply curve is the cost of the marginal seller. When there is no externality from the production or consumption of aluminum, the buyers and sellers of aluminum are the only ones whose welfare is affected by the equilibrium price and quantity of aluminum. Thus total surplus equals consumer surplus plus producer surplus, and this measures the total benefit to society from the existence of an aluminum market. 2

3 Now suppose aluminum factories emit a certain amount of smoke into the atmosphere for each unit of aluminum produced. This smoke worsens the health of those who breathe the air, so it is a negative externality. Because of the externality the cost to society of producing aluminum is higher than the cost to the firm of producing aluminum. We can draw the marginal cost to society curve above the marginal cost the the firm (supply) curve. If the cost to health due to the smoke is proportional to the amount of smoke in the atmosphere, the marginal social cost curve will be the marginal private (firm s) cost curve shifted vertically up. The marginal social cost at each quantity equals the marginal private cost to the firm plus the external cost to those who breathe the air. 3

4 P Marginal Social Cost Supply (Marginal Private cost) Private demand Q To see what quantity of aluminum should be produced, consider what the benevolent social planner would do. The planner wants to maximize total surplus from the market. In this case, to get total surplus, we must add to consumer surplus and producer surplus the surplus from those who are not in the market but who are affected by the externality. The planner chooses the level of aluminum Q at the intersection of the social cost curve and the (private) demand curve. This level of aluminum is optimal because: At any level of aluminum above Q, the marginal social cost of producing additional aluminum is higher than the marginal social benefit (measured by the demand curve) of producing additional aluminum. If the economy is at a point of aluminum production above Q, total surplus can be increased by decreasing aluminum production to the point where marginal social cost equals marginal social benefit, which is Q. If the economy is at a point of aluminum production below Q, total surplus can be increased by increasing aluminum production to the point where marginal social cost equals marginal social benefit, which is Q. In particular, the equilibrium point Q e at the intersection between the private cost curve and the demand curve does not maximize total surplus. Note that equilibrium quantity of aluminum, Q e is larger than the socially 4

5 optimal quantity Q. This is because the externality is negative, so the marginal social cost curve lies to the left of the marginal private cost curve. Therefore the intersection of the demand curve with the marginal social cost curve lies to the left of the intersection of the demand curve with the marginal private cost curve. How can the government achieve the social optimum level of aluminum production? There are several methods. One is to tax aluminum production by an amount per unit that equals the cost to people s health per unit of aluminum produced. That would shift the supply curve vertically up by the amount of the tax so that marginal the private cost curve with tax equals the marginal social cost curve. Then the equilibrium quantity would be the optimal quantity. Positive Externalities Example: Education. Much of the benefit due to education is private. The buyer of education becomes more productive as a worker as gets higher wages. But there are also positive externalities. More educated population may encourage development of technological advances leading to higher productivity and wages for all society. Consider the market for education. Assume that the true value to society of each unit of education is higher by the same amount at every quantity of education. Then the marginal benefit to society curve equals the private marginal benefit curve (demand) shifted up vertically by the marginal external benefit. The optimal quantity Q is at the intersection of the marginal social benefit curve with the marginal cost (supply) curve. This quantity is higher than the quantity Q e at the intersection of the private social benefit curve with the supply curve because the marginal social benefit curve lies to the right of the marginal private benefit curve. 5

6 P Supply Marginal Social benefit Demand (Private benefit) Q To move the market equilibrium closer to the socially optimal point of production, the government can subsidize education. A subsidy shifts the demand curve vertically up by the amount of the subsidy per unit. If the subsidy causes the demand curve to equal the marginal social benefit curve, then the socially optimal level of education is reached. 6