Externality
-side effect of an activity that affects bystanders who’s interests aren’t taken into account
-leads to market failure
Negative externality
-side effect that harms bystanders
-ex. Second hand smoke from smoking cigarettes
-TOO much of these activities occur than is in society’s best interest
Positive Externality
-side effect that benefits bystanders who’s interests
-ex. getting the covid vaccine doesn’t only protect you from getting sick, but also your classmates bc you are less likely to infect them
-LESS than is in society’s best interest
Price change isn’t an Externality
-generates neither additional benefits nor costs
-redistribution between buyers and sellers
Private Interest
-all about the costs and benefits that you personally incur
Society’s Interest
-includes all costs and benefits, whether they accure to you or to others
-a conflict between your private interests and society’s interest can lead to market failure
Marginal Private Costs
-extra cost paid by seller from producing 1 extra unit
-supply curve
External Cost
-cody imposed on BYSTANDERS (imposed on people external to those that generated them
Marginal external costs
-extra cost imposed on bystanders from producing one extra unit
Marginal Social Cost
-all marginal costs regardless of who pays them
= marginal cost + marginal external cost
-ABOVE supply curve
Marginal private benefit
-extra benefit enjoyed by the buyer from purchasing one more extra unit
External benefit
-benefit occurring to bystanders
Marginal external benefit
-extra external benefit accruing to bystanders from one extra unit
-corresponds with demand curve and marginal private benefit
Marginal social benefit
-all marginal benefits, no matter who gets them
= marginal private benefit + marginal external benefit
-lies above the demand curve
Socially Optimal
-outcome that is most efficient for society as a whole
-including interests of buyers, sellers, and bystanders
-determining what quantity of a good will yield the largest economic surplus
Produce until marginal social benefit = marginal social cost
-rational rule for society-> produce more of an item if it’s marginal social benefit is greater than or equal to its marginal social cost
Steps to Analyze Externalities
1)predict the equilibrium outcome
2)assess what externalities are involved
3)find the socially optimal outcome and compare it to the predicted equilibrium
Consequences of Negative Externalities
-lead to over production
-ex. Polluters produce too much greenhouse gas
Consequences of Positive Externalities
-lead to underproduction
-ex.too few people get the flu shot
Solving Externality Problems
- Private Bargaining
Side Payments
-paying someone to do something instead if their actions are harming you
-involves a considerate action in exchange
-if someone has a choice to benefit you, you could pay them to do it
Solving Externality Problems
- Private Bargaining
Coarse Theorem
-if bargaining is costless + property rights are clearly established + enforced, then private bargaining can be used
-private bargaining can restore the socially optimal outcome
-who benefits more from internalizing externality depends on each individuals legal rights
-efficient outcome achieved w/o govt intervention
Solving Externality Problems
- Private Bargaining
-Strategic Investments
-Mergers
-more likely to succeed when benefits from solving externality problems are high and costs of bargaining to find a solution are low
Solving Externality Problems
- Corrective Taxes and Subsidies
Corrective Taxes
-taxes designed to induce people to take account of the negative externalities they cause
-imposing a per unit tax = marginal external cost leading people to make choices as if they are accounting for the marginal external cost of their actions
-efficiently internalizes by making the costs of the negative externality internal to the supplied cost-benefit calculations
-ex.lawsuits,norms,social sanctions
Solving Externality Problems
- Corrective Taxes and Subsidies
Corrective Subsidies
-induce people to take account of the POSITIVE externalities they cause
-can act as an incentive
-total cost = per unit subsidy x socially optimal quantity
-ex.helping others and social recognition
