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4THEECONOMICSOFTHEPUBLICSECTORCopyright©2004South-Western10ExternalitiesCopyright©2004South-Western•Recall:AdamSmith’s“invisiblehand”ofthemarketplaceleadsself-interestedbuyersandsellersinamarkettomaximizethetotalbenefitthatsocietycanderivefromamarket.Butmarketfailurescanstillhappen.Copyright©2004South-WesternEXTERNALITIESANDMARKETINEFFICIENCY•Anexternalityreferstotheuncompensatedimpactofoneperson’sactionsonthewell-beingofabystander.•Externalitiescausemarketstobeinefficient,andthusfailtomaximizetotalsurplus.Copyright©2004South-WesternEXTERNALITIESANDMARKETINEFFICIENCY•Anexternalityarises......whenapersonengagesinanactivitythatinfluencesthewell-beingofabystanderandyetneitherpaysnorreceivesanycompensationforthateffect.Copyright©2004South-WesternEXTERNALITIESANDMARKETINEFFICIENCY•Whentheimpactonthebystanderisadverse,theexternalityiscalledanegativeexternality.•Whentheimpactonthebystanderisbeneficial,theexternalityiscalledapositiveexternality.Copyright©2004South-WesternEXTERNALITIESANDMARKETINEFFICIENCY•NegativeExternalities•Automobileexhaust•Cigarettesmoking•Barkingdogs(loudpets)•LoudstereosinanapartmentbuildingCopyright©2004South-WesternEXTERNALITIESANDMARKETINEFFICIENCY•PositiveExternalities•Immunizations•Restoredhistoricbuildings•ResearchintonewtechnologiesFigure1TheMarketforAluminumCopyright©2004South-WesternQuantityofAluminum0PriceofAluminumEquilibriumDemand(privatevalue)Supply(privatecost)QMARKETCopyright©2004South-WesternEXTERNALITIESANDMARKETINEFFICIENCY•Negativeexternalitiesleadmarketstoproducealargerquantitythanissociallydesirable.•Positiveexternalitiesleadmarketstoproducealargerquantitythanissociallydesirable.Copyright©2004South-WesternWelfareEconomics:ARecap•TheMarketforAluminum•Thequantityproducedandconsumedinthemarketequilibriumisefficientinthesensethatitmaximizesthesumofproducerandconsumersurplus.•Ifthealuminumfactoriesemitpollution(anegativeexternality),thenthecosttosocietyofproducingaluminumislargerthanthecosttoaluminumproducers.Copyright©2004South-WesternWelfareEconomics:ARecap•TheMarketforAluminum•Foreachunitofaluminumproduced,thesocialcostincludestheprivatecostsoftheproducersplusthecosttothosebystandersadverselyaffectedbythepollution.Figure2PollutionandtheSocialOptimumCopyright©2004South-WesternEquilibriumQuantityofAluminum0PriceofAluminumDemand(privatevalue)Supply(privatecost)SocialcostQOPTIMUMOptimumCostofpollutionQMARKETCopyright©2004South-WesternNegativeExternalities•Theintersectionofthedemandcurveandthesocial-costcurvedeterminestheoptimaloutputlevel.•Thesociallyoptimaloutputlevelislessthanthemarketequilibriumquantity.Copyright©2004South-WesternNegativeExternalities•Internalizinganexternalityinvolvesalteringincentivessothatpeopletakeaccountoftheexternaleffectsoftheiractions.Copyright©2004South-WesternNegativeExternalities•AchievingtheSociallyOptimalOutput•Thegovernmentcaninternalizeanexternalitybyimposingataxontheproducertoreducetheequilibriumquantitytothesociallydesirablequantity.Copyright©2004South-WesternPositiveExternalities•Whenanexternalitybenefitsthebystanders,apositiveexternalityexists.•Thesocialvalueofthegoodexceedstheprivatevalue.Copyright©2004South-WesternPositiveExternalities•Atechnologyspilloverisatypeofpositiveexternalitythatexistswhenafirm’sinnovationordesignnotonlybenefitsthefirm,butenterssociety’spooloftechnologicalknowledgeandbenefitssocietyasawhole.Figure3EducationandtheSocialOptimumCopyright©2004South-WesternQuantityofEducation0PriceofEducationDemand(privatevalue)SocialvalueSupply(privatecost)QMARKETQOPTIMUMCopyright©2004South-WesternPositiveExternalities•Theintersectionofthesupplycurveandthesocial-valuecurvedeterminestheoptimaloutputlevel.•Theoptimaloutputlevelismorethantheequilibriumquantity.•Themarketproducesasmallerquantitythanissociallydesirable.•Thesocialvalueofthegoodexceedstheprivatevalueofthegood.Copyright©2004South-WesternPositiveExternalities•InternalizingExternalities:Subsidies•Usedastheprimarymethodforattemptingtointernalizepositiveexternalities.•IndustrialPolicy•Governmentinterventionintheeconomythataimstopromotetechnology-enhancingindustries•Patentlawsareaformoftechnologypolicythatgivetheindividual(orfirm)withpatentprotectionapropertyrightoveritsinvention.•Thepatentisthensaidtointernalizetheexternality.Copyright©2004South-WesternPRIVATESOLUTIONSTOEXTERNALITIES•Governmentactionisnotalwaysneededtosolvetheproblemofexternalities.Copyright©2004South-WesternPRIVATESOLUTIONSTOEXTERNALITIES•Moralcodesandsocialsanctions•Charitableorganizations•Integratingdifferenttypesofbusinesses•ContractingbetweenpartiesCopyright©2004South-WesternTheCoaseTheorem•TheCoaseTheoremisapropositionthatifprivatepartiescanbargainwithoutcostovertheallocationofresources,theycansolvetheproblemofexternalitiesontheirown.•TransactionsCosts•Transactioncostsarethecoststhatpartiesincurintheprocessofagreeingtoandfollowingthroughonabargain.Copyright©2004South-WesternWhyPrivateSolutionsDoNotAlwaysWork•Sometimestheprivatesolutionapproachfailsbecausetransactioncostscanbesohighthatprivateagreementisno