Externalities Part II

ExternalitiesExternalities

Part IIPart II

ExternalitiesExternalities

Part IIPart II

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

In this Topic you will…In this Topic you will…In this Topic you will…In this Topic you will…

• The Market for Aluminum (cont’d)– What quantity of aluminum should

be produced?• Where the demand curve crosses the

social-cost curve. • Below Qoptimum the value of the

aluminum to consumers exceeds rgw social cost of producing it.

• Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers.

• The Market for Aluminum (cont’d)– What quantity of aluminum should

be produced?• Where the demand curve crosses the

social-cost curve. • Below Qoptimum the value of the

aluminum to consumers exceeds rgw social cost of producing it.

• Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers.

Negative Externalities in Negative Externalities in ProductionProduction


Demand (private value)

Supply (private costs)

0

Equilibrium

QmarketQuantity of Aluminium

Price of Aluminium

Social costs

Qoptimum

Cost of pollution

Optimum

Figure 10-2: Pollution and the Social Figure 10-2: Pollution and the Social OptimumOptimumFigure 10-2: Pollution and the Social Figure 10-2: Pollution and the Social OptimumOptimum

• The Market for Aluminum (cont’d)– Reducing aluminum production and

consumption below the market equilibrium level raises total economic well-being.

• The Market for Aluminum (cont’d)– Reducing aluminum production and

consumption below the market equilibrium level raises total economic well-being.



0 Quantity of Aluminium

Price of Aluminium

Social costs


Poptimum

Qoptimum

Figure 10-3: Deadweight Loss of a Negative Figure 10-3: Deadweight Loss of a Negative Production Externality Production Externality Figure 10-3: Deadweight Loss of a Negative Figure 10-3: Deadweight Loss of a Negative Production Externality Production Externality

Pmarket

Qmarket

a

b

HD + A + ED + A + E - H

A + B + C + HA + EE - (B + C + H)

- (A + B + C)DA + B + C + D

Total surplus

Producer surplus

Consumer surplus

ChangeAt QOptimumAt QMarket

D

A B C

E

F G

H

• The Market for Aluminum (cont’d)– How the can social optimum of aluminum

production be achieved?• Tax the producers of aluminum thus shifting the

private supply curve up by the amount of the tax so that it coincides with the social-cost curve.

– Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

– Pigovian taxes are taxes enacted to correct the effects of negative externalities.

– In Figure 10-3, the Pigovian tax is equal to the distance ab.

• The Market for Aluminum (cont’d)– How the can social optimum of aluminum

production be achieved?• Tax the producers of aluminum thus shifting the

private supply curve up by the amount of the tax so that it coincides with the social-cost curve.

– Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

– Pigovian taxes are taxes enacted to correct the effects of negative externalities.

– In Figure 10-3, the Pigovian tax is equal to the distance ab.



• When an externality benefits the bystanders, a positive externality exists.– The social value of the good exceeds the

private value.• Example:• A technology spillover is a type of positive

externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

• When an externality benefits the bystanders, a positive externality exists.– The social value of the good exceeds the

private value.• Example:• A technology spillover is a type of positive

externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

Positive Externalities in Positive Externalities in ProductionProduction


0

Optimum

Quantity of Robots

Price of Robots


Social costs

a

b

Qoptimum

Poptimum

Qmarket

Pmarket Equilibrium

Supply (private costs)Value of technology spillover

Deadweight loss

Figure 10-4: Technology Spillovers and the Figure 10-4: Technology Spillovers and the Social Optimum Social Optimum Figure 10-4: Technology Spillovers and the Figure 10-4: Technology Spillovers and the Social Optimum Social Optimum

• The intersection of the supply curve and the social-value curve determines the optimal output level.– The optimal output level is more than

the equilibrium quantity.– The market produces a smaller quantity

than is socially desirable. – The social value of the good exceeds

the private value of the good.

• The intersection of the supply curve and the social-value curve determines the optimal output level.– The optimal output level is more than

the equilibrium quantity.– The market produces a smaller quantity

than is socially desirable. – The social value of the good exceeds

the private value of the good.



• Internalizing Externalities: Subsidies– Used as the primary method for

attempting to internalize positive externalities.

• Internalizing Externalities: Subsidies– Used as the primary method for

attempting to internalize positive externalities.



– Government intervention in the economy that aims to promote technology-enhancing industries

• Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention.

• The patent is then said to internalize the externality.

• The patent system gives firms a greater incentive to engage in research and other activities that advance technology.

– Government intervention in the economy that aims to promote technology-enhancing industries

• Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention.

• The patent is then said to internalize the externality.

• The patent system gives firms a greater incentive to engage in research and other activities that advance technology.

CASE STUDY:CASE STUDY: The Debate Over Technology The Debate Over Technology PolicyPolicyCASE STUDY:CASE STUDY: The Debate Over Technology The Debate Over Technology PolicyPolicy

• Some externalities are associated with consumption.

• Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages.

• Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education.

• Some externalities are associated with consumption.

• Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages.

• Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education.

Externalities in ConsumptionExternalities in ConsumptionExternalities in ConsumptionExternalities in Consumption

(a) Negative Consumption Externalities (b) Positive Consumption Externalities

Price of Alcohol

Quantity of Alcohol

0 0

Social value


Supply (private cost)

Quantity of Education

Price of Education

Social value


Supply (private cost)

Qmarket QoptimumQoptimum Qmarket

Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities

Economy & Finance

Externalities Part II