In this chapter you will: Learn the nature of an externality, see why externalities can make market outcomes inefficient, examine how people can sometimes solve the problem of externalities on their own, consider why private solutions to externalities sometimes do not work, examine the various government policies aimed at solving the problem of externalities. | 4 THE ECONOMICS OF THE PUBLIC SECTOR 10 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 . | 4 THE ECONOMICS OF THE PUBLIC SECTOR 10 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 Copyright © 2004 South-Western Quantity of Aluminum 0 Price of Aluminum Equilibrium Demand (private value) Supply (private cost) QMARKET EXTERNALITIES AND MARKET INEFFICIENCY Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller 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 .
