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Externalities

Externality exists when the actions or decisions of one person or group impose a cost or bestow a benefit on second or third parties.

Externalities are sometimes called spillovers effects or neighborhood effects. Inefficient decisions result when decision makers fail to consider social costs and benefits.

DEFINITION

externality A cost imposed or benefit bestowed on an individual or a group that is outside, or external to, the transaction.

Examples : Air, water, land, sight, and sound pollution; traffic congestion; automobile accidents; abandoned housing; nuclear accidents; and secondhand cigarette smoke.

Characteristics of Externalities

1 Externalities can be produced by consumers as well as by companies.

2 Externalities are reciprocal in nature.

3 Externalities can be positive or negative.

4 Public goods can be viewed as a special kind of externality.

5 True externalities are not reflected in market prices.

Why does externalities pose problems for resource allocation in a market system?

The conditions for Pareto optimal allocation of resources are different in the presence of externalities and public goods than when the competitive market assumptions are satisfied.

This means that competitive markets do not allocate true externalities and public goods effectively.

In general, too little of public goods will be supplied by the private market and too many negative externalities will be produced by the private market.

When a negative externality exist , the price of a good or service does not reflect the full marginal social costs (MSC) of resources allocated to its production. There is an extra cost to third parties referred to as the marginal external cost (MEC). This is the extra cost to third parties of the production of another unit of the good producing the negative externality. MEC is a true incremental cost that is not included in the price.

NEGATIVE EXTERNALITY

External Cost or negative externality

D = MSB

S = MPC

$100

5

External Cost or negative externality

D = MSB

S = MPC

$100

5

MEC 10

D = MSB

S = MPC

$100

5

MSC = MPC + MEC

$ 110

$ 105

4.5

10

D = MSB

S = MPC

$100

5

MSC = MPC + MEC

$ 110

$ 105

4.5

10

C

A

B

Social Gain from reducing production

Class Exercise

The manufacturer of trucks produce pollution of various kinds. Producing a truck creates one unit of pollution and a unit of pollution has a cost of $3,000. Imagine that the supply of trucks is competitive. The market supply and demand for trucks is shown in the Table.

P Qs Qd SMC 19 480 660 20 540 630 21 600 600 22 660 570 23 720 540 24 780 510 25 840 480

Plot the supply and demand curve for the truck market and find the private

market equilibrium price and quantity.

Price Quantity Quantity Social Marginal ($000) Supplied Demanded Costs 19 480 660 20 540 630 21 600 600 22 660 570 23 720 540 24 780 510 25 840 480

The equilibrium price and quantity

D

S = MPC

21

600

Class Exercise

Price Quantity Quantity Social Marginal ($000) Supplied Demanded Costs 19 480 660 19+3=22 20 540 630 20+3=23 21 600 600 21+3=24 22 660 570 22+3=25 23 720 540 23+3=26 24 780 510 24+3=27 25 840 480 25+3=28

Since Producing a truck creates one unit of pollution and a unit of pollution has a cost of $3,000. And If the social costs of pollution are taken into account, then the equilibrium price and quantity became as follow:

The New Equilibrium Price and Quantity

D

S = MPC

21

600

MSC

23

540

For a positive externality, prices do not fully reflect the marginal social benefits of a good or service. The marginal external benefit (MEB) is the additional benefit to a third party of an additional unit of output being produced.

external benefit or positive externality

D = MPB

MPB + MEB = MSB

S

45

30

25

10

10 12

Z

V

U

H

Gain from increasing output

Internalization of an externality occurs when the marginal private benefits or costs of goods and services are adjusted so that the users consider the actual marginal social benefit or cost of their decisions. In the case of a negative externality, the MEC is added to MPC for internalization. For a positive externality, the MEB is added to MPB to internalize the externality. Internalizing the externality results in changes in prices to reflect full MSC or benefit of a good.

Internalization of Externalities

When there are public consequences of private decisions, the usual competitive market process has no mechanism for incorporating the cost or benefits of those public consequences.

The producer of a negative externality is imposing external costs on others, while the producer of a positive externality is producing external benefits ( e.g., a public good ).

Basic Issue

Pigouvian Tax is a Method of Internalizing Negative Externalities

Pigouvian Tax

This tax is designed to adjust the MPC of a good to internalize the externality. The tax must equal the MEC per unit of output to achieve this objective. The tax is designed to internalize a negative externality by making sellers of the product pay a fee equal to the MEC per unit of output sold.

D = MSB

S = MPC

$100

5

MSC = MPC + MEC

$ 110

$ 105

4.5

10

$95

G

A

J

B F

H

D = MSB

S = MPC

$100

5

MSC = MPC + MEC

$ 110

$ 105

4.5

10

$95

G

A

J

B F

H

Tax Revenue = Total External Costs

Gain in Well-Being

Internalizing Negative Externality Associated With Goods Sold in Monopolistic Markets

Suppose that a negative externality is associated with output sold by a monopoly. In a monopoly case two distortions exist. One do to monopoly power and another do to the existence of the negative externality.

In the case of monopoly power, to little output is produced in the context of economic efficiency. For the negative externality too much output is being produced. This situation creates a policy dilemma. Short of breaking up the monopoly and then taxing the competitive company, another solution exists.

The monopoly initially is producing an annual output level ( ) lower than the Efficient quantity ( ). This is Equivalent to saying that it is behaving as a perfectly competitive industry for which marginal cost has been increased two account for the negative externality. In fact, the monopolistic distortion can offset part or all of the distortion resulting from the negative externality.

*QmonompolyQ

Pm

Qm Q*

MPC

MPC + MEC = MSC

MR D = MSB

A

B

F

C

+ externality gains

monopolistic losses

Summary

A negative externality (also called "external cost" or "external diseconomy") is an economic activity that imposes a negative effect on an unrelated third party. It can arise either during the production or the consumption of a good or service

Many negative externalities are related to the environmental consequences of production and use.

Summary

Examples for negative production externalities include: Air pollution from burning fossil fuels. This activity causes damages to crops, (historic) buildings and public health. Anthropogenic climate change as a consequence of greenhouse gas emissions from burning oil, gas, and coal. Water pollution by industries that adds effluent, which harms plants, animals, and humans. Noise pollution during the production process, which may be mentally and psychologically disruptive. Negative effects of Industrial farm animal production. The depletion of the stock of fish in the ocean due to overfishing.

Summary

Examples for negative consumption externalities include: Sleep deprivation due to a neighbor listening to loud music late at night. Antibiotic resistance, caused by increased usage of antibiotics. Shared costs of declining health and vitality caused by smoking and/or alcohol abuse. Higher congestion costs and increased accident risks when people use public roads. Consumption by one consumer causes prices to rise and therefore makes other consumers worse off, perhaps by reducing their consumption.

General Theory of Second Best

Examples of positive production externalities include: • A beekeeper who keeps the bees for their honey. A side effect or

externality associated with such activity is the pollination of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey.

• The construction and operation of an airport. This will benefit local businesses, because of the increased accessibility.

• An industrial company providing first aid classes for employees to increase on the job safety. This may also save lives outside the factory.

• A foreign firm that demonstrates up-to-date technologies to local firms and improves their productivity.

Positive Externality


Examples of positive consumption externalities include: • An individual who maintains an attractive house may confer

benefits to neighbors in the form of increased market valuesfor their properties.

• An individual receiving a vaccination for a communicable disease not only decreases the likelihood of the individual's own infection, but also decreases the likelihood of others becoming infected through contact with the individual.

• Driving an electric vehicle charged by electricity from a renewable source, reducing greenhouse gas emissions and improving local air quality and public health.


Examples of positive consumption externalities include: • Increased education of individuals, as this can lead to broader society

benefits in the form of greater economic productivity, a lower unemployment rate, greater household mobility and higher rates of political participation.

• An individual buying a product that is interconnected in a network (e.g., a smartphone). This will increase the usefulness of such phones to other people who have a video cellphone.

• In an area that does not have a public fire department, homeowners who purchase private fire protection services provide a positive externality to neighboring properties, which are less at risk of the protected neighbor's fire spreading to their (unprotected) house.


Pigouvian Subsidy is a means of internalizing positive externality

Pigouvian Subsidy or positive externality

This subsidy is considered a payment made by government to either the buyers or sellers of a good. so that the price paid by consumers is reduced. This payment must equal the MEB of the good.


S = MSC

Z

V

U

X

R

Y D’ = MPBi + $20 = MSB

D = MPB

10 12

10

25

30

45

Subsidy Payment

فيديو

Welfare analysis

With and without externalities: we can use a form of economic theory called welfare analysis to show why it is socially preferable to internalize externalities.

The main idea is that the area on a supply and demand curve can be used to measures total benefits and costs. The area under the demand curve shows total benefits; the area under the supply curve shows total costs.

Welfare analysis of the automobile market without externalities

The total value of (Q0) unites purchased is shown by areas (A+B+C). The total cost of purchasing these unites is area (c). Then the net social benefit from the production and consumption of (Q0) unites is (A+B).

Consumer surplus

Producer surplus

Total cost

A

B

Q0

P0

C

D

S

Qs,d

P


Economists call market equilibrium efficient because it maximizes net social benefit. If we were to produce less than (Q0) units, or more, net benefit would be less than at (Q0). At (Q1) the net benefit is only part of the area (A+B).

Consumer surplus

Producer surplus

Total cost

A

B

Q0

P0

C

D

S

Qs,d

P

Q1


At (Q2) we realize the full net benefit (A+B) but we also experience some net social loss, shown here by area (D).The overall social benefit, then is (A+B-D), a lower amount than at (Q0).

Consumer surplus

Producer surplus

Total cost

A

B

Q0

P0

C D

S

Qs,d

P

Q2

D Net losses

Welfare analysis with externalities

The combination of private and external costs gives a social cost curve ( ), which lies above the ordinary supply curve. The market private equilibrium ( ) no longer maximizes net social benefits.

S

0Q

Total private cost

Q1

P0

C D

S + Externality

Qs,d

P

Q0

Net Social losses

S

C

A

B

D

consumer surplus with External Cost

Producer surplus with External Cost


Total private cost

Q1

P0

C D

S + Externality

Qs,d

P

Q0

Net Social losses

S

C

A

B

D



With the new higher total social cost curve, social benefit is only

The area ( ) is social loss, so that the overall net social benefit is

A B

A B D

D


Total private cost

Q1

P0

C D

S + Externality

Qs,d

P

Q0

Net Social losses

S

C

A

B

D



We would do better to lower equilibrium to ( ), avoiding the net social loss ( ), and of course this is exactly what we seek to accomplish with a pollution tax.

Notes that, the area indicates the total cost of pollution at point is

But of this total cost, only ( ) is considered net social loss.

D

1Q

C D0Q

D

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E-Mail [email protected] scholar.cu.edu.eg ... Externalities Externality exists when the actions or decisions of one person or group impose a cost or bestow a benefit on