,4 THE ECONOMICS OF THE PUBLIC SECTOR,10,Externalities,Recall: Adam Smiths “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. But market failures can still happen.,EXTERNALITIES AND MARKET INEFFICIENCY,An externality refers to the uncompensated impact of one persons actions on the well-being of a bystander. Externalities cause markets to be inefficient, and thus fail to maximize total surplus.,EXTERNALITIES AND MARKET INEFFICIENCY,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 AND MARKET INEFFICIENCY,When the impact on the bystander is adverse, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality.,EXTERNALITIES AND MARKET INEFFICIENCY,Negative Externalities Automobile exhaust Cigarette smoking Barking dogs (loud pets) Loud stereos in an apartment building,EXTERNALITIES AND MARKET INEFFICIENCY,Positive Externalities Immunizations Restored historic buildings Research into new technologies,Figure 1 The Market for Aluminum,Copyright 2004 South-Western,Quantity of,Aluminum,0,Price of,Aluminum,EXTERNALITIES AND MARKET INEFFICIENCY,Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a larger quantity than is socially desirable.,Welfare Economics: A Recap,The Market for Aluminum The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.,Welfare Economics: A Recap,The Market for Aluminum For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.,Figure 2 Pollution and the Social Optimum,Copyright 2004 South-Western,Quantity of,Aluminum,0,Price of,Aluminum,Negative Externalities,The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity.,Negative Externalities,Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.,Negative Externalities,Achieving the Socially Optimal Output The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.,Positive Externalities,When an externality benefits the bystanders, a positive externality exists. The social value of the good exceeds the private value.,Positive Externalities,A technology spillover is a type of positive externality that exists when a firms innovation or design not only benefits the firm, but enters societys pool of technological knowledge and benefits society as a whole.,Figure 3 Education and the Social Optimum,Copyright 2004 South-Western,Quantity of,Education,0,Price of,Education,Positive Externalities,The intersection of the supply curve and the social-value curve determines the optimal output level. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good.,Positive Externalities,Internalizing Externalities: Subsidies Used as the primary method for attempting to internalize positive externalities. Industrial Policy Government intervention in the economy that aims to promote technology-enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality.,PRIVATE SOLUTIONS TO EXTERNALITIES,Government action is not always needed to solve the problem of externalities.,PRIVATE SOLUTIONS TO EXTERNALITIES,Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties,The Coase Theorem,The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Transactions Costs Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.,Why Private Solutions Do Not Always Work,Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.,PUBLIC POLICY TOWARD EXTERNALITIES,When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . command-and-control policies. market-based policies.,