Chapter 5 Externalities: Problems and Solutions

Externalities: Problems and Solutions
Chapter 5
5.1 Externality Theory
5.2 Private-Sector Solutions to Negative Externalities
5.3 Public-Sector Remedies for
Externalities
5.4 Distinctions Between Price and Quantity Approaches to
Addressing Externalities

5.5 Conclusion
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

Externalities: Problems and Solutions

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

In December 1997, representatives from over 170 nations met in Kyoto, Japan, to attempt one of the most ambitious international negotiations ever: an international pact to limit the emissions of carbon dioxide worldwide because of global warming. The nations faced a daunting task.
The cost of reducing the use of fossil fuels, particularly in the major industrialized nations, is enormous.
Replacing these fossil fuels with alternatives would significantly raise the costs of living in developed countries.

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

Externalities: Problems and Solutions externality 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.

market failure A problem that causes the market economy to deliver an outcome that does not maximize efficiency.

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

5.1

Externality Theory
Economics of Negative Production Externalities negative production externality
When a firm’s production reduces the well-being of others who are not compensated by the firm.

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

Examples of Externalities
Negative Externalities
Pollution
Cell phones in a movie theater
Congestion on the internet
Drinking and driving
Student cheating that changes the grade curve The “Club” anti-theft device for automobiles Positive Externalities
Research & development
Vaccinations
A neighbor’s nice landscape
Students asking good questions in class
The “LoJack” anti-theft device for automobiles Not Considered Externalities
Land prices rising in urban area
Known as “pecuniary” externalities

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

Figure 5.1 (with increasing cost MD function)

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

5.1

Externality Theory
Economics of Negative Production Externalities

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

5.1

Externality Theory
Economics of Negative Production Externalities private marginal cost (PMC)
The direct cost to producers of producing an additional unit of a good. social marginal cost (SMC)
The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others. © 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and Solutions

5.1

Externality Theory
Economics of Negative Production Externalities private marginal benefit (PMB)
The direct benefit to consumers of consuming an additional unit of a good by the consumer.

social marginal benefit (SMB)
The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others. © 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Chapter 5 Externalities: Problems and