2010 Wuhan UniversityC H A P T E RExternalitiesExternalitiesEconomicsP R I N C I P L E S O FP R I N C I P L E S O FN. Gregory MankiwN. Gregory Mankiw10In this chapter, In this chapter, look for the answers to these questions:look for the answers to these questions:What is an externality?Why do externalities make market outcomes inefficient? How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? What public policies aim to solve the problem of externalities?2EXTERNALITIES3A Review One basic principle of economics: Markets are usually a good way to organize economy activity. In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. Individuals choose their courses of action by weighing the expected marginal benefits of any decision against its expected marginal costs.EXTERNALITIES4Introduction One type of market failure: externality An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. Externalities can be negative or positive, depending on whether impact on bystander is adverse or beneficial. EXTERNALITIES5Introduction Self-interested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient. Another principle of economics : Governments can sometimes improve market outcomes. In presence of externalities, public policy can improve efficiency. EXTERNALITIES6A story Scenario Motorcycle rider leaves home early in the morning. Imposes on neighbors still asleep. Question What kind of externality exists here? How can the externality be solved? In the real world, the story happens every day. Why dont people use the way above to solve the problem?EXTERNALITIES7Examples of Negative ExternalitiesAir pollution from a factoryThe neighbors barking dogLate-night stereo blasting from the dorm room next to yoursNoise pollution from construction projectsHealth risk to others from second-hand smokeTalking on cell phone while driving makes the roads less safe for othersEXTERNALITIES80123450102030Q (gallons)P $The market for gasolineRecap of Welfare EconomicsDemand curve shows private value, the value to buyers (the prices they are willing to pay).Supply curve shows private cost, the costs directly incurred by sellers.The market eqm maximizes consumer + producer surplus.$2.5025EXTERNALITIES90123450102030Q (gallons)P $The market for gasolineAnalysis of a Negative ExternalitySupply (private cost)External cost = value of the negative impact on bystanders = $1 per gallon (value of harm from smog, greenhouse gases)Social cost = private + external cost external cost EXTERNALITIES100123450102030Q (gallons)P $The market for gasolineAnalysis of a Negative ExternalityDSSocial costThe socially optimal quantity is 20 gallons.At any Q 20, social cost of the last gallon is greater than its value to society.25EXTERNALITIES110123450102030Q (gallons)P $The market for gasolineAnalysis of a Negative ExternalityDSSocial costMarket eqm (Q = 25) is greater than social optimum (Q = 20).25One solution: tax sellers $1/gallon, would shift S curve up $1.EXTERNALITIES12Examples of Positive ExternalitiesBeing vaccinated against contagious diseases protects not only you, but people who visit the salad bar after you. R market Q would equal optimal Q.)EXTERNALITIES17If negative externality market quantity larger than socially desirableIf positive externality market quantity smaller than socially desirableTo remedy the problem, “internalize the externality” tax goods with negative externalities subsidize goods with positive externalitiesEffects of Externalities: SummaryEffects of Externalities: SummaryEXTERNALITIES18Case Study: Technology Spillover A potentially important type of positive externality is called a technology spillover - the impact of one firms research and production efforts on other firms access to technological advance.In this case, the government can internalize the externality by subsidizing the effort of R&D. Technological progress is the key to why living standards rise over time. But different markets have different technology spillovers, and the size of technology spillovers is difficult to measure.EXTERNALITIES19Discuss: Who should be paid?Silvia lives near a airport. One day, she was awaked by a plane. She thought she should be paid for this. Should she be paid? Should she be paid for neighbors barking dog? If everyone who lives near the airport request payment for the noise, it will be a huge cost for the airport. Who will bear the cost? Is it possible that every externalities be paid?EXTERNALITIES20Adjudication and Property RightsTo solve the problems with externalities, clearly defined property rights is required.Adj