Externalities

Externalities

Incomplete or unenforceable property rights result in externalities and then market failure

Production

Consumption

Positive

Negative

Positive

Negative

Shifts supply up

Shifts supply down

Shifts demand down

Shifts demand up

e.g. Production of electricity by burning coal

Private cost: ATC to firm

Social cost: private cost plus external cost of polluted environment

e.g. New vaccine discovered

Private cost: research costs and ATC to firm

Social cost: private cost less external cost of reduced health care costs and fewer days of lost production due to sickness

Too much produced

Not enough produced

e.g. Smoking in a public place

Private benefit: satisfaction and enjoyment

Social benefit: private benefit less external benefit lost because of second-hand smoke causing health problems

e.g. University education

Private benefit: increased future earnings

Social benefit: private benefit plus external benefit of increased contribution to society

Too much consumed

Not enough consumed

Deadweight loss

Market failure

UNLESS

Private solutions

Government policies

Coase therom

Note: pigovian taxes eliminate deadweight loss

Command and control approach

Limits or regulations on the amount or type of activity that firms or individuals are allowed to engage in, e.g. installation of catalytic converters

Negative externality of production

Positive externality of consumption

Positive externality of production

Negative externality of consumption

Private bargaining will result in an efficient solution if transactions costs are low, e.g. apple growers and bee-keepers making a private arrangement

Pigovian taxes and subsidies

Tax on electricity where the tax = the externality

Subsidy on research where the subsidy = the externality

Tax on cigarettes where the tax = the externality

Subsidy on university education where the subsidy = the externality

Externalities of production cause shifts of the supply curve and externalities of consumption cause shifts of demand

Externalities of production deal in private/social costs and externalities of consumption deal in private/social benefits

Negative externalities result in too much produced/consumed and positive externalities result in too little

Negative externalities can be reduced by a tax and positive externalities can be recognised by a subsidy

Market-based approach

System of tradable emissions allowances – government releases allowances equal to allowable emissions which firms are free to buy and sell ('cap and trade' system), e.g. allowances for sulphur dioxide emissions can be bought and sold on the Chicago Mercantile Exchange