Externalities, Pollution and Global Warming

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Topic 4: Externalities, Pollution and Global Warming
ECON 1210B Economics and Society

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Introduction
Recall: Markets are usually a good way to organize economic activity In the absence of market failures, the market outcome is efficient, maximizes total surplus One major type of market failure: externalities Externality: the uncompensated impact of one person’s actions on the well-being of a bystander 2

Externalities and Efficiency
In the presence of externality, market equilibrium is no longer efficient Individual’s estimates of resources value (or cost) are not correct (from the society’s point of view) Traditional belief: Government to step in to ensure efficient resource allocation And to protect the interest of bystanders as well 3

Negative Externality
Negative Externality: the effect on bystanders is adverse Example: the neighbor’s barking dog talking on cell phone while driving makes the roads less safe for others health risk to others from second-hand smoke noise pollution from construction projects 4

Pollution: A Negative Externality
Firms burn huge quantities of fossil fuels (coal, natural gas, oil) that cause acid rain and global warming Firms dump toxic waste into rivers, lakes, and oceans These environmental issues are simultaneously everybody’s problem and nobody’s problem 5

Pollution: A Negative Externality
Example of negative externality: Air pollution from factory Firm does not bear the full cost of its production, so will produce more than the socially efficient quantity How govt may improve the market outcome: Impose a corrective tax on the firm equal to the external cost of the pollution it generates 6

Recap of Welfare Economics
P $5
4 3 $2.50 2 1 0

The market for gasoline

The market eqm maximizes consumer + producer surplus. Supply curve shows private cost, the costs directly incurred by sellers Demand curve shows private value, the value to buyers (the prices they are willing to pay)

0

10

20 25 30 Q (gallons)

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Analysis of a Negative Externality
Key: distinguish private and social costs Private costs and social costs diverge in the presence of externality Producer concerns private cost, which neglect the external cost (pollution cost) Social cost represents the resource cost to a society social cost = private cost + external cost 8

Analysis of a Negative Externality
P $5
4 3 2 1 0

The market for gasoline Social cost =private+ external cost
external cost

0

External cost = value of the negative impact on bystanders = $1 per gallon (value of harm Supply (private cost) from smog, greenhouse gases) 10 20 30 Q (gallons)

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Analysis of a Negative Externality
P $5
4 3 2 D 1 0

The market for gasoline
Social cost S

The socially The socially optimal quantity optimal quantity is 20 gallons. is 20 gallons.

At any Q < 20, At any Q < 20, value of additional gas value of additional gas exceeds social cost exceeds social cost At any Q > 20, At any Q > 20, social cost of the social cost of the last gallon is last gallon is greater than its value greater than its value 10

0

10

20 25 30 Q (gallons)

Analysis of a Negative Externality
P $5
4 3 2 D 1 0

The market for gasoline Mkt eqm (Q = 25)
Social cost is greater than social optimum S (Q = 20)

overproduction resulted in DWL (red triangle) One solution: impose a corrective tax of $1/gallon on sellers, shift supply curve up $1 11

0

10

20 25 30 Q (gallons)

Internalizing the Externality
Internalizing the externality: altering incentives so that people take account of the external effects of their actions previous example: $1/gallon tax on sellers makes sellers’ costs equal to social costs When market participants must pay social costs, the market eqm matches the social optimum. Imposing the tax on buyers would achieve the same outcome: market Q will equal optimal Q 12

Summary For Pollution: A Negative Externality
With negative externality,...
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