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Markets sometimes fail to
allocate resources
efficiently – some of these
market failures are called
externalities
An externality is when a
person engages in an
activity that influences the
well-being of a bystander
who neither pays nor
receives any
compensation for that
effect
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If impact on bystander is adverse – negative
If impact on bystander is beneficial – positive
In both cases, equilibrium is not efficient
when there are externalities
◦ Externality causes cost to society to be
larger than the cost to producers
◦ Social cost includes private costs to
producers plus the cost to bystanders
affected by externality
◦ Show this by putting social cost curve
above the supply curve by the amount of
the external cost
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Optimum quantity of production is where
social cost curve intersects demand curve
Equilibrium quantity is larger than the
socially optimal quantity, so… how do we fix
this?
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We can tax the producer in order to shift the
supply curve upward by the size of the
negative externality
This gives buyers & sellers an incentive to
take into account the external effects of their
actions; a smaller quantity will be consumed
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When there is a positive externality, like
education, the demand curve does not reflect
the value to society of the good
Social value curve is above the demand curve
and optimum quantity level is where social
value curve intersects supply curve
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Positive externality requires a subsidy to
move the demand curve to the right by the
size of the externality (called social value
curve)
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How could technology be a positive
externality?
Tough to measure amount of technology
spillover – debate on if government should
encourage production of technology
Result is patent protection to encourage
development of new ideas
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Can be positive or negative for either…
examples?
Production externalities move social cost
curve up or down from supply curve (private
cost curve)
Consumption externalities move social value
curve up or down from demand curve (private
value curve)
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Don’t always need gov’t to intervene
Can be solved by moral codes/social
sanctions
Charities can deal with externalities
Parties involved might enter into agreement
that corrects the externality
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Proposition that if private parties can bargain
without cost over the allocation of resources,
they can solve the problem of externalities on
their own
If the Benefits > Costs = efficient solution
Problem with private solutions: Transaction
costs (either financially or logistically) >
Benefits
2 major government options when there is an
inefficient allocation of resources:
1. Command-and-Control Policies (Regulation)
What is the Problem? Inefficient?
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2. Market Based Solutions
a. Tradable Pollution Permits
b. Taxes (Pigovian) + Subsidies
- Pigovian Tax – does not cause DWL , but
tries to fix DWL
*Market Based Solutions – generally favored
because: more efficient and lower cost to
implement