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ECON 1B03 (523)
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Department
Economics
Course
ECON 1B03
Professor
Bridget O' Shaughnessy
Semester
Winter

Description
Unit 5: The Economics of the Public Sector - Objective 1: Externalities and Market Inefficiency 5.1.1 Negative Externality Caused by Pollution Let us examine negative externalities by highlighting important details from Figure 10.2 on page 208 of the textbook (reproduced here as Figure 5.1): Figure 5.1: Pollution and the social optimum From Mankiw/Kneebone/McKenzie/Rowe. Principles of Microeconomics © 2008 Nelson Education Ltd. Reproduced by permission. www.cengage.com/permissions. As previously mentioned, the market economy fails to provide the correct amount of some products. The negative externality form of market failure causes an improper allocation of resources because too much of a product may be produced. As seen in the figure above, the correct amount Q OPTIMUM is determined by the equilibrium of the social cost curve and the demand curve. The current supply curve is greater than the social cost or social supply curve. The reason for current supply to be higher than socially desired supply is that producers, if not held responsible for pollution costs, would tend to over-supply. This leads to pollution levels that are above safe environmental limits, thereby causing harmful effects on bystanders. The current quantity of the product QMARKET is determined by the equilibrium of the current supply curve and the demand curve. The current amount produced (Q MARKET exceeds the correct amount (Q OPTIMUM due to the divergence between the two supply curves. The divergence between the two supply curves has caused this negative externality. This excessive production leads to over pollution and also causes inefficiency in resource allocation. Given the reality that society’s resources are scarce and must therefore be used for the best possible use, negative externality (excessive production) implies that the scarce resources used up for the extra production could have been put to more optimal use for producing other needed goods. In the next objective, we will examine the range of potential solutions to correct this negative externality by achieving the correct amount of this product. For now, let us turn our attention to positive externality. 5.1.2 Positive Externality Caused by Education As stated earlier, an externality (external effect) is the uncompensated impact of one person’s action on the well-being of a bystander. If the impact is beneficial, the externality is called a positive externality. Education leads to positive externalities because a more educated population leads to many benefits that spill over onto bystanders or others who are not involved in either acquiring or providing the education. This spillover benefit could be in the form of a more educated workforce that elects more efficient public servants, which would lead to better government, which would help all members of society, not just those who acquired the education. Moreover, higher education leads to higher earnings, and so there could be more net contributions to the treasury from educated workers in the form of more taxes paid as compared to services consumed. These higher taxes will be used by governments to provide additional services that would benefit all members of society, not just those who acquired the education. Recall that negative externalities cause overproduction. The problem with positive externalities is that underproduction occurs, leading to an improper allocation of society’s scarce resources. Since more of this good or service should be produced, too few resources are being allocated to the production of this good or service, thus causing market failure. Let us examine positive externalities by highlighting important details from Figure 10.4 on page 212 in the textbook. This figure is reproduced below as Figure 5.2: Figure 5.2: Education and the social optimum From Mankiw/Kneebone/McKenzie/Rowe. Principles of Microeconomics © 2008 Nelson Education Ltd. Reproduced by permission. www.cengage.com/permissions. In this figure, the current demand curve is less than the social demand or social value curve. The reason why current demand for education by students is less than the socially desired demand (or social value curve) is that students are not able to capture all the benefits fromtheir education since some of the benefits spill over onto bystanders, and so students would not demand as much education as society would desire. The current quantity of the product (Q MARKET ) is determined by the equilibrium of the current demand curve and the supply curve. The correct amount (Q OPTIMUM ) is determined by the equilibrium of the social value or social demand curve and the supply curve. As seen in the figure, the current amount produced (Q MARKET) is less than the correct amount (QOPTIMUM ). The divergence between the two demand curves has caused this positive externality. The problem of positive externalities in education thus leads to a less than optimal number of students at colleges and universities. The next section examines the range of potential solutions to correct this positive externality by achieving the correct amount of this product. 5.2.1 Private Solutions to Externalities Private solutions are based on the premise that government action is not always needed to solve the problem of externalities because people themselves can develop private solutions. There is a variety of private solutions.  Moral codes and social sanctions often offer private solutions to externalities. Many people have a sense of morality that leads them to reduce their harmful effects on bystanders. Also, people’s sense of social courtesy leads them, in public places, to talk softly on cell phones or lower the volume level on headsets while listening to music.  Charities are also designed to offer private solutions to externalities. For example, negative externalities such as pollution could be reduced by environmental organizations such as Greenpeace or the Sierra Club, which are typically non-profit, private-donor-funded organizations. Similarly, the problem of positive externalities in education leading to a less than optimal number of students at colleges and universities can be solved by gifts from private entities such as alumni, corporations, and charitable educational foundations. People and corporations can donate to such charitable organizations and obtain an official receipt for income tax purposes by the Canada Revenue Agency. The added incentive of letting charitable donations become tax deductible encourages private solutions for correcting externalities.  Self-interest of concerned parties and private contracts between interested parties also offer private solution to an externality. These solutions have the potential to be very effective, according to a theorum formalized by economist Ronald Coase. TheCoase theorem, as stated in the textbook on page 215, proposes that if private parties can bargain over the allocation of resources without incurring any cost, then they can solve the problem of externalities on their own. The theorem postulates that regardless of the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient. It should be noted that the Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement. Sometimes the costs of bringing the parties together, the costs of reaching an agreement that could involve lawyer’s fees, and the costs of enforcing the agreement might prohibit a private contract from being finalized. These costs are collectively called transaction costs and prevent a private solution to the externality. This leads us to consider the need for public policy solutions to externalities, which we will examine in the next section. 5.2.2 Public Policy Solutions to Externalities Government or public policy solutions for the problem of externalities are generally classified as either command-and-control policies or market-based policies. The extent or degree of governmental involvement differs in each of these two policy classes. There is complete governmental control when the government sets regulations under command-and- control policies, whereas in market-based policies, the government’s role is limited because this class of policies aims to provide incentives so that private decisions makers may solve the externality problem on their own. Let
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