• When production or consumption of a product places external costs on society (overproduction/over allocation) the society is receiving more of this spillover effect than is optimal.
  • The producer's supply curve is S= MPC or to the right of (below) the fullcost curve (S= MSC).
  • Polluting producer's supply curve understates the total cost of production (S=MSC) .
  • Because the total cost of production is lower (absorbed by society), producers will produce more at a lower cost.
  • Therefore, the supply curve of society (S=MSC) lies to the left of the firm's supply curve (S=MPC) since the cost is greater to the society, due to the spillover costs.

• e.g. Cigarettes create secondhand smoke (negative externalities) for people around the smoker
• e.g. Pollution in the world around us the biggest negative externality today.
  • Causing the biggest market failure: global warming

• When production or consumption of a product creates external benefits for society (underproduction), resources are underallocated.(Positive externality is a market failure becuase the resources are underallocated.)

• The market demand curve D (D= MPB) is to the left of (below) the full-benefit demand curve (D= MSB) due to the spillover benefits that all of society receives.

• e.g. If one person gets vaccinated, it prevents others from contracting the disease from that person, thus benefiting a third party that is not involved in the transaction.
• e.g. If one person gets educated, it benefits the entire society. The person can work as a trained worker, or he/she can be a trained professional worker at any job.
• e.g. Environment-friendly coffins deteriorate purchased by an individual cause less damage to the soil, as it doesn't contain deadly toxins and chemicals. The third party, everyone else, benefits as the environment is less contaminated.
• Welker's Wikinomics is a positive externality for us all. because we contribute to it, and all benefit from it.

• Government is not needed to remedy external costs or benefits under these conditions:
  1. Property ownership clearly defined, which provides incentive for negotiation.
  2. A small number of people involved.
  3. Negligible bargaining costs.
• Confined role of government - encourage bargaining between affected individuals/groups
• Property rights→ externality creates opportunity costs for all parties
• Bargaining results in mutually acceptable solution to externality problem. Compromise!
• Limitations – when dealing with large number of affected parties, high bargaining costs, and community property (ex. air and water) people must rely on the government to find a solution.
  • e.g. global-warming problem, with regard to international issue of carbon-dioxide emission.

• Government erected a framework of laws that define private property and protect it from damage. Damage recovery system permit parties suffering negative externalities to sue for compensation.
• Clearly defined property rights and government liability laws help remedy some externality problems. They do so directly by forcing the perpetrator of the harmful externality to pay damages to those injured. They do so indirectly by discouraging firms and individuals from generating negative externalities for fear of being used.
• Limitations – many externalities do not involve private property but rather property held in common by society ("public")
• Also lawsuits are time consuming and have uncertainty associated with court outcome.

• Direct controls and taxes to counter NEGATIVE externalities
  • Direct controls - (i.e. passing of legislation) force offending firms to incur actual costs of offending activity
    • Raises the MC of production because the business must either pay their fines or adopt new production lines to fix their negative spillover effects on society
  • Taxation: taxes violators to share a portion of the marginal social cost
    
  • These correct the overallocation. Notice that when an industry produce at S= MPC, the equilibrium amount is Qe, but after regulation, supply will shift to S=MSC, in which total quantity supplied decreased by x amount to Qso.
  • C + P = total tax revenue
  • Shifts the production from point Qe to Qso (socially optimal).
  • Quantity decreases and price increases.
• Subsidies and Government Provision counter POSITIVE externalities
  • Subsidies to buyers (e.g. discount coupons for a series of inoculations).
  • Subsidies to producers (e.g. subsidy for inoculation to physicians and medical clinics); also known as an inverse tax.
  • Government Provision (occurs when extremely large externalities lead the government to produce the product as a public good).
  • Shift the production to a socially optimal point, and this will increase quantity and price.

• Public lands (i.e. parks, streets, rivers, lakes, etc.) are all subject to pollution as the rights to use these resources are held "in common" by society.
• Commonly owned land/resources are not maintained or used as carefully as privately owned goods because no one is responsible for them.
• As rational thinkers, each human seeks to maximize his gain. The positive utility of doing something accrues only to that person, but the negative utility is shared by society, so marginal utility always outweights marginal cost. As rational humans, then, people continue to perform deeds harmful to society as a whole.
• There is a lack of incentive to incur internal costs linked to getting rid of pollution when these costs can be transferred externally to society.
• Each person believes his/her own contribution to pollution is negligible, but together, the collective contribution brings an overwelming effect upon society.
• Ex. A common pasture in which anyone can graze cattle will quickly be overgrazed beause each rancher has an incentive to graze as many cattle as possible.

• If public goods or lands are privatized, then those individuals or firms who own them will take the responsibility upon themselves to take care of and regulate the commons
• This solution is not always viable, e.g. the air we breathe in cannot be privatized; nor the oceans.

• An appropriate pollution-control agency determines the amount of pollutants that firms can discharge into the water or air of a specific region annually while maintaining the water or air quality at some acceptable level.
• Essentially, a market is created for the "commons". A price tag is put on pollution.
• Advantages: reduces society's costs by allowing pollution rights to be bought and sold; provides monetary incentive for potential polluters not to pollute; growing revenue from the sale of a fixed quantity of pollution rights can be used for environmental improvement; rising price of pollution rights should stimulate the search for improved pollution-control techniques. Also can be held by conservatist groups to increase the scarcity of the permits, further encouraging less pollution-based methods.
• The price will rise because more and more people will try to obtain the pollution right as the time passes.
• There are two ways of exchanging pollution rights which are exchanging internally and externally. Internally, the polluters might transfer pollution by changing sources within their plants, and externally, they might change regions where the minimum standards are not being met to meet their pollution rights.

• Global warming policies aiming to reduce greenhouse-gas emissions in order to slow or get rid of global warming creates costs and benefits. (Important to look at the MC and MB when deciding on policies)
• Greenhouse gas limits shouldn't be so strict that the costs for the society would outweigh the benefits, but at the same time, limits shouldn't be too relaxed so that society does not receive potential benefits that it would have attained otherwise.
• Market mechanism with its system of prices and profits/losses will adjust appropriately based on the new climates.
  • e.g. air-con sales may rise, while snow shovel sales may decrease
• If no actions are taken to reduce the greenhouse gases, it is certain that the transition costs, which are costs associated with making economic adjustments, will be extremely high.
  • Reducing or eliminating these transition costs is a part of the benefit of slowing or getting rid of the greenhouse problem.