Externality
The uncompensated impact of one person’s actions on the well being of a bystander; cause markets to be inefficient and thus, fail to maximize total surplus
“Invisible Hand”
Theory by Adam Smith; the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market
An externality arises when…
a person engages in activity that influence the well being of a bystander and yet neither pays nor receives any compensation for the effect
Negative externality
When the impact on the bystander is adverse. They lead markers to produce a larger quantity than socially desirable ex:
-Pollution
-Automobile exhaust
-Cigarette smoking
-Barking dogs (loud pets)
-Loud stereos in an apartment building
-Sriracha Sauce
-Pollution
-Automobile exhaust
-Cigarette smoking
-Barking dogs (loud pets)
-Loud stereos in an apartment building
-Sriracha Sauce
Positive externality
When the impact on the bystander is beneficial; the social value of the good exceeds the private value. Lead markets to produce a smaller quantity than is socially desirable ex:
-Immunizations
-Restored historic buildings
-Research into new technologies
-Education
-Immunizations
-Restored historic buildings
-Research into new technologies
-Education
EX: The Market for Aluminum
Assumption is that firms only care about revenue
Assumption is that firms only care about revenue
-The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
-If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.
-For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.
-If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.
-For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.
Negative Externalities on graphs
The intersection of the demand curve and the social-cost curve determines the optimal output level.
-The socially optimal output level is less than the market equilibrium quantity.
-The socially optimal output level is less than the market equilibrium quantity.
Optimal Quantity Price
External Cost = Supply Quantity
External Cost = Supply Quantity
Set Social Cost = Demand (private value)
where social cost = private cost (supply curve) + External cost
where social cost = private cost (supply curve) + External cost
Internalizing an externality
Involves altering incentives so that people take account of the external effects of their actions.
-achieving the social optimal output
-The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.
-achieving the social optimal output
-The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.
Examples of Positive Externalities
-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.
-Impact of the internet, computing technology
-Created knowledge spillovers to other firms
-Impact of the internet, computing technology
-Created knowledge spillovers to other firms
Positive Externalities on graphs
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 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 Cont
By subsidies–Used as the primary method for attempting to internalize positive externalities.
Ex: Mexico and Opportunidades
Industrial Policy, government intervention in the economy that aims to promote technology-enhancing industries
Ex: 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.
Ex: Mexico and Opportunidades
Industrial Policy, government intervention in the economy that aims to promote technology-enhancing industries
Ex: 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.
Public Policy Towards Externalities
When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .
-command-and-control policies, these usually take the form of regulations ex: requirement that all students be immunized
-Market based policies, government uses taxes and subsidies to align private incentives with social efficiency; Cap and Trade-Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another.
-A market for these permits will eventually develop.
-A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost
-command-and-control policies, these usually take the form of regulations ex: requirement that all students be immunized
-Market based policies, government uses taxes and subsidies to align private incentives with social efficiency; Cap and Trade-Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another.
-A market for these permits will eventually develop.
-A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost
Pigovian taxes
Taxes enacted to correct the effects of a negative externality. Ex: If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could
-tell the firm to reduce its pollution by a specific amount (i.e. regulation). NAAQS or…
-levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). Gas tax, cigarette tax
-tell the firm to reduce its pollution by a specific amount (i.e. regulation). NAAQS or…
-levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). Gas tax, cigarette tax
Private Solutions to Externalities
Government action is not always needed to solve the problem of externalities.
Moral codes and social sanctions
Charitable organizations (Bill and Melinda Gates)
Contracting between parties (Coase Theorem)
Moral codes and social sanctions
Charitable organizations (Bill and Melinda Gates)
Contracting between parties (Coase Theorem)
Coase Theorem
A proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
They can arrive at an efficient (least cost) solution
That solution may have undesirable distributional outcomes
They can arrive at an efficient (least cost) solution
That solution may have undesirable distributional outcomes
Transaction Costs
the costs that parties incur in the process of agreeing to and following through on a bargain.
Problems with Private Solutions to Externalities
Sometimes the approach fails because transaction costs can be so high that private agreement is not possible/difficult to negotiate/hard to assign property rights
Which of the following is an example of a positive externality?
a) Bob mows Hillary’s lawn and is paid $100 for preforming the service
b) While mowing the lawn, Bob’s lawnmower spews out smoke that Hillary’s neighbor Kris has to breathe
c) Hillary’s newly cut lawn makes her neighborhood more attractive
d) Hillary’s neighbors pay her if she promises to get her lawn cut on a regular basis
a) Bob mows Hillary’s lawn and is paid $100 for preforming the service
b) While mowing the lawn, Bob’s lawnmower spews out smoke that Hillary’s neighbor Kris has to breathe
c) Hillary’s newly cut lawn makes her neighborhood more attractive
d) Hillary’s neighbors pay her if she promises to get her lawn cut on a regular basis
c) Hillary’s newly cut lawn makes her neighborhood more attractive
If the production of a good yields a negative externality, then the social cost curve lie_____the supply curve, and the socially optimal quantity is ______then the equilibrium quantity
a) above, greater
b) above, less
c) below, greater
d) below, less
a) above, greater
b) above, less
c) below, greater
d) below, less
b) above, less
When the government levies a tax on a good equal to the external cost associated with the good’s production, it _____the price paid by consumers and makes the market outcome ________ efficient
a) increases, more
b) increases, less
c) decreases, more
d) decreases, less
a) increases, more
b) increases, less
c) decreases, more
d) decreases, less
b) increases, less
Which of the following statements about corrective taxes is NOT true?
a) Economists prefers them to command-and-control regulation
b) They raise government revenue
c) They cause deadweight losses
d) They reduce the quantity sold in a market
a) Economists prefers them to command-and-control regulation
b) They raise government revenue
c) They cause deadweight losses
d) They reduce the quantity sold in a market
c) They causes deadweight losses
The government auctions off 500 units of pollution rights. They sell for $50 per unit, raising total revenue of $25,000. This policy is equivalent to a corrective tax of _____per unit of pollution
a) $10
b) $50
c) $450
d) $500
a) $10
b) $50
c) $450
d) $500
b) $50
The Coase Theorem does NOT apply if
a) there is a significant externality between two parties
b) the court system vigorously enforces all contracts
c) transaction cost make negotiating difficult
d) both parties understand the externality fully
a) there is a significant externality between two parties
b) the court system vigorously enforces all contracts
c) transaction cost make negotiating difficult
d) both parties understand the externality fully
c)
Property law
a. helps to ensure that only voluntary exchanges occur in the economy
b. tends to decrease the level of economic efficiency
c. helps define ownership rights to resources
d. establishes property taxes
e. helps to distribute government property in the economy
a. helps to ensure that only voluntary exchanges occur in the economy
b. tends to decrease the level of economic efficiency
c. helps define ownership rights to resources
d. establishes property taxes
e. helps to distribute government property in the economy
C
When a widow is harmed by mail fraud,
a. she may be compensated under property law
b. her legal action will be in the category of antitrust law
c. she may be compensated under tort law
d. this is a potential Pareto improvement
e. an economic efficiency has risen
a. she may be compensated under property law
b. her legal action will be in the category of antitrust law
c. she may be compensated under tort law
d. this is a potential Pareto improvement
e. an economic efficiency has risen
C
Excise taxes can create inefficiency by
a. increasing output
b. reducing output
c. lowering prices
d. forcing each consumer to pay more than he was willing to pay before the tax
e. decreasing tax revenues
a. increasing output
b. reducing output
c. lowering prices
d. forcing each consumer to pay more than he was willing to pay before the tax
e. decreasing tax revenues
B
Pollution resulting from the production of a good creates a market failure called a negative externality.
a. True
b. False
a. True
b. False
A
Positive externalities are market failures arising from some beneficial consequences of the production or consumption of a
product that spill over to third parties. Ultimately, too little of the production that create positive externalities takes place.
a. True
b. False
product that spill over to third parties. Ultimately, too little of the production that create positive externalities takes place.
a. True
b. False
A
Which of the following is an example of a positive externality?
a. air pollution
b. a person who litters in a public park
c. a consumer whose dream comes true when she buys a new convertible
d. a nice garden in front of your neighbor’s house
e. the pollution of a stream
a. air pollution
b. a person who litters in a public park
c. a consumer whose dream comes true when she buys a new convertible
d. a nice garden in front of your neighbor’s house
e. the pollution of a stream
D
When the consumption of a good by one person imposes costs on a party other than the producer,
a. the consumption creates a positive externality
b. the good is a public good
c. the consumption creates a negative externality
d. too little of the good is produced from society’s point of view
e. the market will correct the problem if left alone
a. the consumption creates a positive externality
b. the good is a public good
c. the consumption creates a negative externality
d. too little of the good is produced from society’s point of view
e. the market will correct the problem if left alone
C
When production creates negative externalities, social welfare can be increased through
a. antitrust law
b. subsidization
c. taxation
d. free market policies
e. allocative efficiency
a. antitrust law
b. subsidization
c. taxation
d. free market policies
e. allocative efficiency
C
A production process, such as the making of honey, creates a positive externality. (Nearby orchards are pollinated by the
bees, increasing output per tree.) Given perfect competition, which of the following holds?
a. all of the following statements are correct
b. at the current output level, the marginal social cost exceeds the marginal private cost
c. the actual output level falls short of the ideal or efficient output level
d. the implied inefficiency could be remedied by an appropriately-sized excise tax
e. the marginal benefit to the honey consumer, in the absence of any corrective action, exceeds the
marginal benefit to the apple consumer
bees, increasing output per tree.) Given perfect competition, which of the following holds?
a. all of the following statements are correct
b. at the current output level, the marginal social cost exceeds the marginal private cost
c. the actual output level falls short of the ideal or efficient output level
d. the implied inefficiency could be remedied by an appropriately-sized excise tax
e. the marginal benefit to the honey consumer, in the absence of any corrective action, exceeds the
marginal benefit to the apple consumer
C
The sulfur dioxide emitted by power plants (that subsequently kills potato crops via acid rain) is an example of
a. marginal social benefit exceeding marginal private benefit
b. marginal private cost exceeding marginal social cost
c. a negative externality that could be removed by a tax
d. a negative externality that could be removed by a subsidy
e. a public good that is, by its very nature, nonexcludable
a. marginal social benefit exceeding marginal private benefit
b. marginal private cost exceeding marginal social cost
c. a negative externality that could be removed by a tax
d. a negative externality that could be removed by a subsidy
e. a public good that is, by its very nature, nonexcludable
C
In the presence of a negative externality,
a. marginal private costs exceed marginal social costs
b. marginal social benefits exceed marginal social costs
c. marginal social benefits exceed marginal private costs
d. marginal social costs exceed marginal private costs
e. the price is equal to both marginal social cost and marginal private cost
a. marginal private costs exceed marginal social costs
b. marginal social benefits exceed marginal social costs
c. marginal social benefits exceed marginal private costs
d. marginal social costs exceed marginal private costs
e. the price is equal to both marginal social cost and marginal private cost
D
When the consumption of a good involves positive externalities,
a. some individuals are harmed when other individuals consume the good
b. a free market produces too little of the good
c. the individuals consuming the good do not benefit from it
d. taxes are needed to bring about efficiency
e. economic efficiency has been achieved
a. some individuals are harmed when other individuals consume the good
b. a free market produces too little of the good
c. the individuals consuming the good do not benefit from it
d. taxes are needed to bring about efficiency
e. economic efficiency has been achieved
B
If consumption of a good creates positive externalities, then
a. private demand is greater than marginal social benefit
b. marginal private benefit is less than marginal social benefit
c. private cost is less than marginal social cost
d. marginal social cost is greater than marginal social benefit
e. marginal private cost is zero
a. private demand is greater than marginal social benefit
b. marginal private benefit is less than marginal social benefit
c. private cost is less than marginal social cost
d. marginal social cost is greater than marginal social benefit
e. marginal private cost is zero
B
A good is said to be excludable if
a. those who do not pay for it can be prevented from consuming it
b. those who do not produce the good can be prevented from consuming it
c. it is not traded in the public market
d. there is no rivalry in consumption
e. its use can be continued indefinitely
a. those who do not pay for it can be prevented from consuming it
b. those who do not produce the good can be prevented from consuming it
c. it is not traded in the public market
d. there is no rivalry in consumption
e. its use can be continued indefinitely
A
Free-rider problems typically arise from
a. all public and private goods
b. nonexcludable goods
c. excludable goods
d. rival goods
e. nonrival goods
a. all public and private goods
b. nonexcludable goods
c. excludable goods
d. rival goods
e. nonrival goods
B
If a good is nonexcludable and nonrival,
a. the market will provide too much of the good
b. the market will provide the good
c. the market will not provide the good
d. neither the market nor government will provide the good
a. the market will provide too much of the good
b. the market will provide the good
c. the market will not provide the good
d. neither the market nor government will provide the good
C
Which of the following is a public good?
a. cable TV service
b. software
c. a fireworks display
d. corn flakes
e. higher education
a. cable TV service
b. software
c. a fireworks display
d. corn flakes
e. higher education
C
A private good is
a. nonrival and nonexcludable
b. rival but nonexcludable
c. rival and excludable
d. nonrival but excludable
e. one whose production imposes a cost on third parties
a. nonrival and nonexcludable
b. rival but nonexcludable
c. rival and excludable
d. nonrival but excludable
e. one whose production imposes a cost on third parties
C
The private market will produce goods that are
a. neither rival nor excludable
b. rival, but not excludable
c. socially desirable, regardless of their excludability and their rivalrous characteristics
d. both rival and excludable
e. rival, but not profitable
a. neither rival nor excludable
b. rival, but not excludable
c. socially desirable, regardless of their excludability and their rivalrous characteristics
d. both rival and excludable
e. rival, but not profitable
D
The property of a public good that allows additional persons to consume the good without reducing its availability to others is
called
a. free riding
b. an externality
c. allocative efficiency
d. nonexcludability
e. nonrivalry
called
a. free riding
b. an externality
c. allocative efficiency
d. nonexcludability
e. nonrivalry
E
Was this helpful?
Let us know if this was helpful. That’s the only way we can improve.
