1. Externalities Chapter 10

2. EXTERNALITIES • An externalityis the uncompensated impact of one person’s actions on another person • Both positive & negative externalities exist • Externalities cause markets to be inefficient • That is, markets do not maximize total surplus

3. Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs (loud pets) • Loud stereos in an apartment building • Noisy Students • Neighbor’s poorly maintained property

4. Positive Externalties • Immunizations • Restored historic buildings • Research into new technologies • Neighbor’s well maintained property

5. MC = MB MARKET INEFFICIENCY • Negative externalities lead markets to overproduce • Positive externalities lead markets to under-produce

6. Supply = MCP External social Cost (private cost) Optimum Spillover Cost Equilibrium MC = MB Demand = MBP (private value) QOPTIMUM QMARKET Negative Externality: Pollution MCT= MCP + MCS Price of Aluminum Quantity of 0 Aluminum

7. External social benefit Supply = MCP (private cost) Optimum Equilibrium Spillover Benefits Demand = MBP (private value) QOPTIMUM QMARKET Positive Externality: Neighbor paints House Price MBT = MBP + MBS Quantity 0

8. Solutions to Externalities • Internalizing an externality involves altering incentives • Government Methods • Taxes (corrective taxes) • Subsidies • Patents • Laws (immunization laws, pollution laws) • Free market solution: • Trading pollution credits

9. Taxing Negative Externalities Impose Tax = spillover cost Shifts Supply Curve left Reach social optimal output Total Cost = Total Benefit Total Cost = MCP + MCS

10. Subsidizing Positive Externalities Impose Subsidy=spillover benefit Shifts demand curve right Reach social optimal output Total Cost = Total Benefit

11. Worksheet • Externalities