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ECN 104 Lecture Notes - Overconsumption, Private Good, Salad Bar

Course Code
ECN 104
Tsogbadral Galaabaatar

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Chapter 10: Externalities
oWhat is an externality?
oWhy do externalities make market outcomes inefficient?
oWhat public policies aim to solve the problem of externalities?
oHow can people solve the problem of externalities on their own? Why
do such private solutions not always work
oOne of the principles from Chapter 1:
Markets are usually a good way to organize economy
In absence of market failures, the competitive market outcome
is efficient, maximizes total surplus
oOne type of market failure
Externality: the uncompensated impact of one person’s actions
on the well-being of a bystander
Can be negative or positive, depending on whether
impact on bystander is adverse or beneficial
oSelf-interested buyers and sellers neglect the external costs or benefits
of their actions, so the market outcome is not efficient
oAnother principle from Chapter 1:
Governments can sometimes improve market outcomes
In presence of externalities, public policy can improve efficiency
Examples of Negative Externalities
oAir pollution from a factory
oThe neighbour’s barking dog
oNoise pollution from construction projects
oHealth risk to others from second-hand smoke

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“Internalizing the Externality”
oAltering incentives so that people take account of the external effects
of their actions
oWhen market participants must pay social costs, market equilibrium =
social optimum
Example: $1/gallon tax on sellers makes sellers’ costs = social
oImposing tax on buyers would achieve the same outcome; market
quantity = social optimum quantity)
Examples of Positive Externalities
oBeing vaccinated against contagious diseases protects not only you,
but people who visit the salad bar or produce section after you
oResearch and Development creates knowledge others can use
oPeople going to college raise the population’s education level, which
reduces crime and improves government
Positive Externalities
oIf the presence of a positive externality, the social value of a good
Private value – the direct value to buyers
External benefit – the value of the positive impact on
oThe socially optimal Q maximizes welfare:
At any lower Quantity, the social value of additional units
exceeds their cost
At any higher Quantity, the cost of the last unit exceeds its
social value
Effects of Externalities: SUMMARY
oIf negative externality
Market quantity larger than socially desirable
oIf positive externality

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Market quantity smaller than socially desirable
oTo remedy the problem, “internalize the externality”
Tax goods with negative externalities
Subsidize goods with positive externalities
Public Policies Toward Externalities
oTwo approaches:
Command-and-control policies regulate behaviour directly.
Limits on quantity of pollution emitted
Requirements that firms adopt a particular technology to
reduce emissions
Market-based policies provide incentives so that private
decision-makers will choose to solve the problem on their own
Corrective taxes and subsidies
Tradable pollution permits
Corrective Taxes and Subsidies
oCorrective Tax: a tax designed to induce private decision-makers to
take account of the social costs that arise from a negative externality
oAlso called Pigovian taxes after Arthur Pigou (1877-1959)
oThe ideal corrective tax = external cost
oFor activities with positive externalities, ideal corrective subsidy =
external benefit
oOther taxes and subsidies distort incentives and move economy away
from the social optimum
oCorrective taxes and subsidies
Align private incentives with society’s interests
Make private decision-makers take into account the external
costs and benefits of their actions
Move economy toward a more efficient allocation of resources
Corrective Taxes vs. Regulations
oDifferent firms have different costs of pollution abatement
oEfficient outcome: Firms with the lowest abatement costs reduce
pollution the most
oA pollution tax is efficient:
Firms with low abatement costs will reduce pollution to reduce
their tax burden
Firms with high abatement costs have greater willingness to pay
oIn contrast, a regulation requiring all firms to reduce pollution by a
specific amount not efficient
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