EC120 Chapter 10-Externalties Week 6
-We examine why markets sometimes fail to allocate resources efficiently, how government policies can
potentially improve the market’s allocation, and what kinds of policies are likely to work best.
-Externality-the uncompensated impact of one person’s actions on the well-being of a bystander
-An externality arises when a person engages in an activity that influences the well-being of a bystander
and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is
adverse, it is called a negative externality; if it is beneficial it is called a positive externality.
-The market externality is not efficient when there are externalities
-Externalities come in many varieties and these are some examples:
The exhaust from cars is a negative externality because it creates smog that other people have to
breathe. As a result of this externality, drivers tend to pollute too much. The federal government
attempts to solve this problem by setting emission standards for cars. It also taxes gasoline to reduce
the amount that people drive.
Research into new technologies provides a positive externality because it creates knowledge that
other people can use. Because inventors cannot capture the full benefits of their inventions, they tend
to devote too few resources to research. The federal government addresses this problem partially
through the patent system which gives inventors exclusive rights to their inventions for a period of time.
-In each of these cases, some decision maker fails to take account of the external effects of his or her
behaviour. The government responds by trying to influence this behaviour to protect the interests of
Externalities and Market Inefficiency
Welfare Economics: A Recap
-At any given quantity, the height of the demand curve shows the willingness to pay of the marginal
buyer. In other words, it shows the value to the consumer of the last unit of aluminum bought.
-Vice versa for the supply curve
-In the absence of government intervention, the price adjusts to balance the supply and demand for
-Now, let’s suppose that aluminum factories emit pollution. For each unit of aluminum produced, a
certain amount of smoke enters the atmosphere.
-Because the smoke creates a health risk for those who breathe the air, it is a negative externality.
-Because of the externality, the cost to society of producing aluminum is larger than the cost to the EC120 Chapter 10-Externalties Week 6
-For each unit of aluminum produced the social cost includes the private costs of the aluminum
producers plus the costs to those bystanders affected adversely by the pollution.
-The planner would choose the level of aluminum production at which the demand curve crosses the
social-cost curve. The planner does not produce more than this level because the social cost of
producing additional aluminum exceeds the value to consumers
-Note that the equilibrium quantity of aluminum is larger than the socially optimal quantity.
-This is measured through the concept of deadweight loss
-Internalizing the Externality-alter incentives so that people take account of the external effects of their
-Putting a tax on the aluminum producers would be referred to as such
-Aluminum producers would then take into account the external effects of their actions. EC120 Chapter 10-Externalties Week 6
-To a large extent, the benefit of education is private. The consumer of education becomes a more
productive worker and thus reaps much of the benefit in the form of higher wages. Beyond these
private benefits, however, education also yields positive externalities
-One externality is that a more educated population leads to more informed voters, which means better
government for everyone.
-Another externality is that a more educated population tends to mean lower crime rates
-Once again, the government can correct the market failure by inducing market participants to
internalize the externality. The appropriate response is the case of positive externalities is exactly the
opposite to the case of negative externalities. To move the market equilibrium closer to the social
optimum, a positive externality requires a subsidy. In fact, that is exactly the policy the government
follows: Education is heavily subsidized through public schools and government scholarships.
-To summarize: Negative externalities lead markets to produce a larger quantity than is socially
desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. To
remedy the problem, the government can internalize the externality by taxing goods that have negative
externalities and sub