Chapter 10 Externalities.docx
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Chapter 10 Externalities
Externality: The uncompensated impact of one persons actions on the well being of a
If an externality has a negative effect on a bystander it is called a Negative-Externality.
If there is a positive effect on a bystander it is called a Positive-Externality.
The market equilibrium is not efficient because buyers and sellers do not think about
bystanders. This is because the equilibrium fails to maximize the total benefit of society
as the bystander is a member of society.
Carbon emissions from vehicles. Drivers pollute too much, government tries to
counter by taxing gas and setting emissions standards.
Historic buildings are positive externalities as bystanders get pleasure from them.
Builders want to tear them down. Government combats by regulating the destruction of
Barking dogs create externalities to the neighbors. Dog owners tend to not care
and don’t do anything. Government makes it illegal to disturb the peace.
New research creates a positive externality of knowledge people can use.
Inventors don’t invent in fear of stolen ideas, government combats with patent laws and
Externalities and Market Efficiency
In the case of negative externalities the social cost is higher then the producers cost.
Social Cost: Includes the cost to the producers plus the cost to the bystanders.
The new curve of the social cost will be above the previous supply curve and the
difference will represent the external cost of the externality.
The new equilibrium quantity and price would be where the demand curve crosses the
social cost curve.
With a negative externality there is a deadweight loss of the area between the previous
equilibrium quantity and the new equilibrium.
One way to get the socially optimal level of production is to impose a tax. This would
bring the supply curve in line with the social cost curve, creating a new equilibrium at the
socially optimal levels of supply and demand. The use of such ta is called internalizing
Internalizing the Externality: Alter incentives so that people take account of the
external effects of their actions.
The social value is greater then and private value in the case of a positive externality, this
means that the social value curve lies above the demand curve. The social value is
represented by the difference between the demand curves. The optimal value is found at
the equilibrium of the social value curve and the supply curve. To move the market
closer to the socially optimum equilibrium a subsidy can be imposed.
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