Externalities (Chpt 10) ? Externality- the uncompensated impact of one persons actions on the well-being of others ? Externalities are a market failure because buyers and sellers ignore the external effects of their actions when deciding how much to demand and supply ? Market failure does not necessarily mean that the market shuts down, it just doenst operate as efficiently. Recall that a tax is another example of a market failure ? Externalities affect economic welfare, so we can analyze this using consumer and producer surplus Some Examples ? There are too many to list or even consider, but here are some major ones: ? Climate Change ? #1 externality of all economic activity ? Caused by emissions from burning oil, gas, and coal ? Water Pollution ? Caused by producers disposing toxins into water systems ? Can be intentional, i.e. using the ocean as a garbage dump, or "unintentional", i.e. an oil drip from any watercraft ? Affects sea life, plants, animals, and ultimately humans ? Overfishing ? Reduces fish stocks below an acceptable level ? Example: tuna stocks have fallen 70% over the last 3o years due to an international fleet of thousands of longliners and increase in the demand for sushi ? Unhealthy Choices ? When some choose to smoke, abuse drugs, or live in an unhealthy manner, they use up more insurance costs than healthy people ? Insurance premiums increase for everyone ? Antibiotic Use ? Antibiotics are found in hand soap, hand-sanitizer, livestock(accounts for 70% of antibiotics used in the U.S.), and OTC and prescribed medicines ? Overuse of antibiotics causes builds resistence to other antibiotics and medical treatments ? Medical procedures at risk: organ transplants, chemotherapy, and treating infection, food-poisoning, meningitis, and pneumonia ? Knowledge Spillover(positive) ? Generally includes any form of education, where one person's knowledge is beneficial to the entire society's well-being ? Example: Wikipedia ? Other examples... ? Noise pollution (motorcycles, pets), financial risk in the banking system, home- ownership(positive) Welfare Implications ? If you enjoy these types of topics: ? Consider taking Environmental Econ. (Econ 471) or Econ of Globalization (Econ 431) ? Read Freakonomics or Superfreakonomics (by Steven Levitt & Stephan Dubner) ? How do externalities affect economic welfare? ? First, it depends if the externality is positive or negative ? Negative- the supplier does not recognize the added cost to the market, so the private cost is less than the social cost ? Positive- the consumer does not recognize the added value to the market, so the private value is less than the social value Graph of a Negative Externality Graph of a Positive Externality Welfare Implications ? Negative externalities reduce economic welfare ? Socially optimum quantity < Actual quantity produced ? How can the market achieve the socially optimal quantity of production? ? Government Intervention ? Internalizing the externality- when incentives are altered so that people take account of the external effects of their actions ? When externality is negative, a tax internalizes the external effects ? When externality is positive, a subsidy internalizes the external effect ? Markets can find their own solution Market Solutions ? Golden Rule ? People internalize externalities for moral reasons ? Not entirely realistic in a capitalist economy ? Charities and Nonprofits ? For just about every externality, there are several nonprofits who work to mitigate the externality ? The government ecourages donations by making them income tax deductible ? Examples: Sierra Club, Greenpeace, Friends of the Earth ? Coase Theorem Coase Theorem ? Coase Theorem- if private parties can bargain without cost over the allocation of resources, they can solve the externailty problem on their own ? Basic idea: When there is an externality, all one has to do is define property rights, and let the parties negotiate an efficient compromise ? Example: A developer wants to build condos in a residential neighborhood, but the residents are agaisnt the condos. The Coase Theorem would put the developer and the residents in one room to let them hash it out ? Nice in theory, but there are two major problems: ? Negotiating does not always work. ? Presence of transaction costs - the costs incurred in the process of agreeing to and following through on a bargain Public Policy ? Regulation ? Requires or forbids certain behavior ? Difficult in practice because it's impossible to prohibit all pollution ? Protection agencies spend a lot of time and money determining which pollutants should be mitigated ? Example: the EPA spends billions of dollars on environmental protection programs ? Corrective Taxes and Subsidies ? Creates an incentive to reduce externalities ? Forces the product to internalize the external costs ? More efficient than regulation (because it targets the producers who pollute the most) ? Emissions Trading ? The government determines an amount of credits each producer holds, creating a "cap" on polluting ? Each credit represents the right to emit a specific amount of pollutant ? Producers who pollute more than the credits they hold, have to buy additional credits on the market ? Producers who pollute less than the credits they hold can sell their extra credits on the market ? How does this reduce pollution? ? Over time, the cap is lowered ? Producers have an incentive to invest in more sustainable production methods
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