topic 7-8 externalities.pptVIP

7 Externalities Recall: Adam Smith’s “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 person’s 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 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 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