EXTERNALITIES.pptx

Externalities

1. EXTERNALITIES Externality: a by-product of a transaction that affects someone not immediately involved in the transaction

2. EXTERNALITIES Positive externality: a party not immediately involved in the transaction benefits from the transaction Classic example: orchard owner lives next door to a bee keeper Fruit trees make bees more product Bees pollinate tree blossoms

3. EXTERNALITIES Negative externality: a party not immediately involved in the transaction is harmed by the transaction Classic example: Automobile use generates sulfur dioxide that pollutes the air Asthma sufferers Homeowners (paint, metal) Tree owners

4. Negative Externality Application Hog Production: Water quality Air quality Land Prices

5. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 $105 $5 External cost + private MC Marginal Social Cost = Private Marginal Cost plus External Cost

6. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 External cost + private MC Marginal Social Cost = Private Marginal Cost plus External Cost Demand $102 45000 Overproduction and underpriced relative to social optimum of 45000 hogs

7. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 External cost + private MC = social marginal cost Marginal Social Cost = Private Marginal Cost plus External Cost Demand = marginal value $102 45000 Overproduction: Value of last hog is $100, social cost of production is $105. $105

8. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 External cost + private MC = social marginal cost Marginal Social Cost = Private Marginal Cost plus External Cost Demand = marginal value $102 45000 Overproduction: Value of last hog is $100, social cost of production is $105. $105 Deadweight loss from overproduction

9. How can we attain the social optimum? Tax producers to shift supply curve left Tax consumers to shift demand curve to the left Set quota on output to limit supply to 45000 hogs

10. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 External cost + private MC = private MC + tax Marginal Social Cost = Private Marginal Cost plus External Cost Demand $102 45000 Impose $5 tax on producers, generate efficient solution $105 $5 $97

11. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 Marginal Social Cost = Private Marginal Cost plus External Cost Demand 45000 Impose $5 tax on consumers, generate efficient solution $95 $5 $97

12. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 External cost + private MC Marginal Social Cost = Private Marginal Cost plus External Cost Demand $102 45000 Impose hog quota of 45000

13. Supply = private MC Hogs $ Negative Externality: Hog Production 50000 $100 External cost + private MC Marginal Social Cost = Private Marginal Cost plus External Cost Demand $102 45000 Tradeable pollution permits = pollution consistent with 45000 hogs $97 $5 PERMIT VALUE = P – Private MC

14. Positive Externality Application Live music venue creates foot traffic for nearby establishments Restaurant sales Retail sales

15. Supply = private MC Ticket sales $ Positive Externality: Music Venue 1000 $7 $10 $3 Private MC – social benefit Marginal Social Cost = Private Marginal Cost minus External Benefit

16. Supply = private MC Ticket sales $ Positive Externality: Music Venue 1000 $7 $10 $3 Private MC – social benefit = social marginal cost Marginal Social Cost = Private Marginal Cost minus External Benefit Demand = marginal value $8.50 800 Underproduction and overpriced relative to social optimum of 1000

17. Supply = private MC Ticket sales $ Positive Externality: Music Venue 1000 $7 $10 $3 Private MC – social benefit = social marginal cost Marginal Social Cost = Private Marginal Cost minus External Benefit Demand = marginal value $8.50 800 Last unit sold valued at $8.50 but only costs $5.50 to produce Deadweight loss from under-production $5.50

18. How can we attain the social optimum? Subsidize music producers to shift supply curve rightward Subsidize consumers to shift demand curve to the right

19. Supply = private MC Ticket sales $ Positive Externality: Music Venue 1000 $7 $10 $3 Private MC – social benefit = Private MC - subsidy Marginal Social Cost = Private Marginal Cost minus External Benefit Demand = marginal value $8.50 800 Provide $3 subsidy per ticket to music producer

20. Supply = private MC Ticket sales $ Positive Externality: Music Venue 1000 $7 $10 $3 Marginal Social Cost = Private Marginal Cost minus External Benefit Demand $8.50 800 Provide $3 subsidy per ticket to consumer Demand = marginal value + subsidy

21. Externalities Imply that the competitive equilibrium will not result in the social optimum Imply that the competitive equilibrium will result in a dead weight loss Create a role for government intervention