Chapter 5- EXternalities Public economics
1 Chapter 5 - Externalities Public Economics
Externality Defined An externality is present when the activity of one entity(person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism Negative externality: These activities impose damages on others Positive externality: These activities benefits on others
2 Externality Defined • An externality is present when the activity of one entity (person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism. – Negative externality: These activities impose damages on others. – Positive externality: These activities benefits on others
Examples of Externalities Negative Externalities Positive externalities Pollution Research development Cell phones in a movie theater Vaccinations Congestion on the internet A neighbor's nice landscape Drinking and driving Students asking good questions Student cheating that changes in class the grade curve The"LoJack" anti-theft devise The Clubanti-theft devise for for automobiles automobiles Not Considered Externalities Land prices rising in urban area Known as"pecuniary externalities
3 Examples of Externalities • Negative Externalities – Pollution – Cell phones in a movie theater – Congestion on the internet – Drinking and driving – Student cheating that changes the grade curve – The “Club” anti-theft devise for automobiles. • Positive Externalities – Research & development – Vaccinations – A neighbor’s nice landscape – Students asking good questions in class – The “LoJack” anti-theft devise for automobiles • Not Considered Externalities – Land prices rising in urban area. – Known as “pecuniary” externalities
Nature of externalities Arise because there is no market price attached to the activity Can be produced by people or firms Can be positive or negative Public goods are special case Positive externality's full effects are felt by everyone in the economy
4 Nature of Externalities • Arise because there is no market price attached to the activity. • Can be produced by people or firms. • Can be positive or negative. • Public goods are special case. – Positive externality’s full effects are felt by everyone in the economy
Graphical Analysis: Negative Externalities For simplicity, assume that a steel firm dumps pollution into a river that harms a fishery downstream Competitive markets, firms maximize profits Note that steel firm only care's about its own profits not the fishery Fishery only cares about its profits, not the steel firms
5 Graphical Analysis: Negative Externalities • For simplicity, assume that a steel firm dumps pollution into a river that harms a fishery downstream. • Competitive markets, firms maximize profits – Note that steel firm only care’s about its own profits, not the fishery’s – Fishery only cares about its profits, not the steel firm’s
Graphical Analysis, continued MB marginal benefit to steel firm MPC marginal private cost to steel firm MD marginal damage to fishery MSC= MPC+MD marginal social cost
6 Graphical Analysis, continued • MB = marginal benefit to steel firm • MPC = marginal private cost to steel firm • MD = marginal damage to fishery • MSC = MPC+MD = marginal social cost
Figure 5.1 MSC= MPC MI (marginal social cost MPC (marginal private cost) (marginal damage MB(marginal benefit) e per year Socially Actual efficient output
Figure 5.1
Graphical Analysis, continued From figure 5.1, as usual, the steel firm maximizes profits at MB=MPC. This quantity is denoted as Q, in the figure Social welfare is maximized at B=Msc Which is denoted as Q in the figure
8 Graphical Analysis, continued • From figure 5.1, as usual, the steel firm maximizes profits at MB=MPC. This quantity is denoted as Q1 in the figure. • Social welfare is maximized at MB=MSC, which is denoted as Q* in the figure
Graphical Analysis, Implications Result 1: Q1>Q Steel firm privately produces" too much"steel, because it does not account for the damages to the fishery Result 2: Fishery's preferred amount is 0 Fishery's damages are minimized at MD=0 Result 3: Q is not the preferred quantity for either party, but is the best compromise between fishery and steel firm Result 4: Socially efficient level entails some pollution Zero pollution is not socially desirable
9 Graphical Analysis, Implications • Result 1: Q1>Q* – Steel firm privately produces “too much” steel, because it does not account for the damages to the fishery. • Result 2: Fishery’s preferred amount is 0. – Fishery’s damages are minimized at MD=0. • Result 3: Q* is not the preferred quantity for either party, but is the best compromise between fishery and steel firm. • Result 4: Socially efficient level entails some pollution. – Zero pollution is not socially desirable
Figure 5.2 MSC= MPC + MD Lisa MPC Bart loses area cang area dcg MD MB Q per yes
Figure 5.2