ECON 1 Lecture Notes - Lecture 9: Passive Smoking, Market Failure, Externality
28 Apr 2018
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ECON 1: Chapter 10 Notes
Focus Questions:
• What is an externality?
• Why do externalities make market outcomes inefficient?
• What public policies aim to solve the problem of externalities?
• How can people sometimes solve the problem of externalities on their own? Why do such private
solutions not always work?
Introduction
▪ One of the Ten Principles from Chapter 1:
Markets are usually a good way to organize economy activity.
In absence of market failures, the competitive market outcome is efficient, maximizes total surplus.
▪ One type of market failure:
externality, the uncompensated impact of one person’s actions on the well-being of a bystander.
▪ Externalities can be negative or positive,
depending on whether impact on bystander is adverse or beneficial.
▪ Self-interested buyers and sellers neglect the external costs or benefits of their actions,
so the market outcome is not efficient.
▪ Another principle from Chapter 1:
Governments can sometimes improve market outcomes.
In presence of externalities, public policy can improve efficiency.
Examples of Negative Externalities
• Air pollution from a factory
• The neighbor’s barking dog
• Late-night stereo blasting from the dorm room next to yours
• Noise pollution from construction projects
• Health risk to others from second-hand smoke
• Talking on cell phone while driving makes the roads less safe for others
Recap of Welfare Economics
find more resources at oneclass.com
find more resources at oneclass.com
Analysis of a Negative Externality
“Internalizing the Externality”
• Internalizing the externality: altering incentives so that people take account of the external effects of
their actions
• In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs.
• When market participants must pay social costs, market eq’m = social optimum.
(Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)
Examples of Positive Externalities
• Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or
produce section after you.
• R&D creates knowledge others can use.
• People going to college raise the population’s education level, which reduces crime and improves
government.
• In the presence of a positive externality, the social value of a good includes
o private value – the direct value to buyers
o external benefit – the value of the positive impact on bystanders
• The socially optimal Q maximizes welfare:
• At any lower Q, the social value of additional units exceeds their cost.
• At any higher Q, the cost of the last unit exceeds its social value.
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Introduction: one of the ten principles from chapter 1: Markets are usually a good way to organize economy activity. In presence of externalities, public policy can improve efficiency. Internalizing the externality : internalizing the externality: altering incentives so that people take account of the external effects of their actions. The private market achieves the efficient outcome regardless of the initial distribution of rights. Two approaches: command-and-control policies regulate behavior directly. Examples: limits on quantity of pollution emitted: requirements that firms adopt a particular technology to reduce emissions, market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own. Examples: corrective taxes and subsidies tradable pollution permits. If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. True also for permits in effort to reduce permit prices. In contrast, firms have no incentive for further reduction beyond the level specified in a regulation.
