04 Lecture 4-externality.pdf

Lecture 4 Externalities Binzhen Wu Tsinghua University Outline Externality theory Definition Underprovision problem in the competitive market. How to address externality problem? Private-sector solutions Public-sector solutions Which one is better? Externality-definition Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so. Negative externality: These activities impose damages on others. Positive externality: These activities benefits on others. Externality-examples Negative Externalities: Acid rain; global warming; pollution; A neighbor’s loud music; Smoking in a restaurant. Student cheats in the exam; Driving after drinking; Traffic congestion Lock your bicycle Positive Externalities: Public goods: positive externality felt by everyone in the economy Research and development; Taking Vaccinations, good driving habit; You neighbor’s nice landscaping A restaurant attracting police officers Lock your bicycle Externality arises because there is no market price attached to the behavior. Market is missing. The behavior of some people affecting others’ welfare does not necessarily cause externality. Eg. Capitalization in housing price The Nature of Externalities Economics of Negative Externalities Goods with negative externalities are produced more than social optimal level because social marginal costprivate marginal cost. The basic concepts and analysis in positive externalities mirror those in negative externalities. Economics of Negative Externalities Consider the following example: A steel firm dumps pollution into a river that harms a fishery downstream. negative externality ? Fishermen downstream are adversely affected. ? And steel firm does not compensate fishermen for this harm. Economics of Negative Externalities Competitive markets, firms maximize their own profits MB = marginal benefit for steel firm Social MB