Externalities

00:01 Hello and welcome back to your onlinepresentation of microeconomics.

00:05 My name is James DeNicco, this presentation is going to be about externalities.

00:10 We're gonna learn what externalities are and why we care about them.

00:13 They introduce inefficiencies into the market.

00:16 We're gonna look at what policies we can take to address externalities and what are some private solutions to externalities and when do those solutions break down? So first, what is an externality? An externality is the uncompensated impact of one person's actions on the wellbeing of a bystander.

00:34 So what are some examples of these externalities? One is pollution.

00:38 So you have these smoke stacks, they create a negative externality because people have to breathe in the air.

00:45 Now it's costly for firms to retrofit for production, retrofit their smoke stacks to reduce pollution, so they don't.

00:52 So that leaves a role for government to come in and regulate that pollution because the they have the uncompensated impact on bystanders.

01:01 That's a negative externality.

01:03 An example of a positive externality might be a restored historic building, right? It conveys a positive externality cause people enjoy the beauty and the history.

01:12 However, the owner doesn't get the full benefit and is too quick to tear the building down, it's gonna cost them a lot to retrofit and to fix that building so that other people can appreciate the beauty.

01:24 He incurs all the cost but he has to share the benefit so sometimes it's not worth it to him to restore that building.

01:31 So there is a role for government you can come in and you can subsidize.

01:35 You can say, "hey, here's the money to help restore that building because it conveys this positive externality to everybody.".

01:41 Another externality is a dog barking, that's a negative externality.

01:46 It's your dog, you bought the dog but there's an uncompensated third party.

01:49 That's the person that has to listen to the dog bark.

01:52 Alright, that pollutes his air waves and not like a smoke stack but it pollutes his air waves in that he has to hear that that conveys a negative externality on him.

02:01 That's uncompensated, so now there's a role for government to come in and say, "hey, you have to stop that dog from barking, you have to bring it inside.

02:09 If you can't control it, you'll have to get rid of the dog.

02:12 Another example of an externality is research, alright? Research conveys a positive externality because it creates these new technologies that everybody can use that increases our knowledge.

02:24 However, sometimes there's not a lot of incentive to do research if people can just go ahead and take what you've done.

02:31 You don't get to capture the full benefit.

02:33 You incur the full cost but you don't get to incur the full benefit so sometimes there's not enough incentive to go out there and do research and development.

02:41 So you can have government policies that encourage it, you can give patents that allow people to get the full benefit of the research development and therefore they'll go out and be willing to do it.

02:53 So we have all these different examples of these externalities and they leave a role for policy, so let's take a look at some of the policies we can implement to address these externalities.

03:04 You basically have two types.

03:06 You have command and control policies, those right to use of regulation, you say you do this or else or you can have market-based policies, those are encouragements, right it's the carrot and the the stick.

03:18 It's alright if you do this, we'll give you this, otherwise we're gonna wack you.

03:22 Alright, taxes and subsidies.

03:26 So first the command and control, alright - regulation.

03:29 You can think of the Environmental Protection Agency, alright they tell you, hey you can't go ahead and dumped that stuff in a river, that's just a command and control policy.

03:38 That's regulating that externality that's saying, hey you can't impact these people this way or you have to go ahead and you have to retrofit your smoke stacks to reduce your carbon footprint because you're costing society too much.

03:52 You have all these uncompensated people being impacted by your actions so you can have that direct heavy-hand, that command and control or a market-based policy would be a corrective tax.

04:06 It's a tax to induce private decision-makers, it's to encourage them to take account of the social cost okay, that arise from these negative externalities.

04:17 So what's an example of when we can use this corrective tax? Well when there's a negative externality, so let's take for example the aluminum market.

04:25 So you have a firm that's producing aluminum, so the producer doesn't consider the total cost.

04:31 They just consider their internal, their private cost.

04:35 So we have prices in quantity here where these green lines come together, our supply and demand.

04:41 This is the demand for aluminum and the green line is the supply just looking at the private cost.

04:47 Well there's the uncompensated third parties here from the pollution of producing the aluminum.

04:52 There's too much aluminum being produced.

04:55 The actual cost is the social cost plus the private cost so you have to find a way to force the firms to internalize that cost.

05:04 One way you can do it is by instituting the tax.

05:08 Now if you do it just right, you'll institute a tax which is the size of the social cost, the external cost plus the social cost then you'll be at the social optimum.

05:18 You'll shift that supply curve to the left because it's more costly for the firm to produce.

05:23 They'll produce the lower quantity which is in line with the social optimum.

05:28 You can also have subsidies, this is another market-based policy so if there's some sort of positive externality from some sort of action, you want to encourage that.

05:38 And you can encourage that by subsidizing production, so let's take a look at what that looks like.

05:44 So here now, we have our demand, right? This is the private value, this is the private value, say it's robot production here in our example.

05:54 So the firm doesn't consider the external benefits of robot production which is discovery of new and better technologies.

06:02 Right, they do too little of it compared to the social optimum.

06:07 The social plan of the government, they can come in and they could try to fix that problem with the subsidy.

06:12 So you're gonna see here again, we have our price and our quantity, we have our private value and we have the supply.

06:19 However the total value is greater than the private values, the private value plus the external benefit.

06:26 So how do you encourage more robot production? Well you can go ahead and you can subsidize the production, you can make it cheaper for them to produce the robots.

06:36 That'll shift the supply curve to the right and that'll increase the amount produced up to the social optimum.

06:43 So when it's a negative externality, you want to put a tax in place to try to discourage production, want to decrease production to get to the social optimum.

06:54 When it's a positive externality, you want more of it, you would encourage it by subsidizing production so that they produce more and they'll increase to the social optimum.

07:04 Sometimes you don't need the government involved, sometimes private solutions work.

07:09 So what are some examples of private solutions? Well sometimes we have these moral codes and these social sanctions like parents teaching their kids not to litter, right cause littering, that has an effect on an uncompensated third party.

07:23 So we teach our children, we teach them not to do these things.

07:26 That's one way to address these externalities.

07:29 You also have charities like the Sierra club, they raise money to try to protect the environment, or you can rely on self-interested parties, right, so the self-interest of relevant parties.

07:41 So let's take an example of somebody who has an apple orchard and another person who is a beekeeper.

07:47 They're side-by-side, one grows the apple tree, sells the apples, the other has the bees so he can make honey.

07:54 Alright, now the bees and the apples, they provide a positive externality for each other.

08:00 So the trees, they provide nectar for the bees so the bees can eat and they can flourish.

08:06 The bees, they pollinate the trees so they help the trees.

08:10 So the beekeeper and the person who owns the apple orchard right, they incur the total cost but they share the benefit so sometimes they'll underproduce.

08:23 So now what can happen is, you can have an integration of the businesses.

08:27 You could have, say the beekeeper the apple orchard owner, they can look and say, "Well, I'm not producing enough, he's not producing enough because we benefit each other, so maybe if I buy both businesses, I can produce more apples and I can have more bees because we're helping each other out, we're producing enough to convey that positive externality to each other".

08:47 or if not, I can have one guy buy the business, you can have a social contract or you can have a private contract.

08:52 You can contractually agree to produce more so that both of you doing it and you help each other out.

08:58 So these contractual agreements or just the integration of businesses, can sometimes address these externalities.

09:07 However, private solutions don't always work out, so we have what's called the Coase Theorem.

09:12 That's the proposition that private parties can bargain without cause over the allocation of resources.

09:18 They can solve the problem, the externalities on their own.

09:21 The trouble is, sometimes, there's cost involved, there's transaction cost involved.

09:26 So let's take an example here of the barking dog, we have neighbor Bob.

09:30 He's sick of neighbor Chip's dog barking, says "I will give you $50 to get rid of that barking dog of yours".

09:37 Right, this is a private solution.

09:39 Chip's a little offended, "How dare you put a dollar value on my dog, I won't get rid of him for a penny under a hundred" So he has neighbor Bob say, "Deal, I would have given you $150 to get rid of that dog" Right so there's some consumer surplus there, so that will work out.

09:57 Right, you can take care of that externality by getting rid of the dog But if there's transaction cost, sometimes that can get a little messy.

10:08 Say we have neighbor Chip now, he says, "well, turns out only my mom will take the dog and it will cost me $100 to ship them, so now I need $200 to get rid of the dog".

10:20 Neighbor Bob was only willing to pay $150, the transaction cost got in the way of that private solution, so it didn't work out.

10:28 So you know sometimes, bargaining just breaks down as well.

10:31 So a deal would you be possible but finding the right price for both parties can be difficult.

10:36 It's difficult to come to that solution and the more parties involved in the deal, the more that it can go wrong, so these private solutions are sometimes difficult but they do exist.

10:47 So what have we learned here? We know what externalities are, and they know how they introduce inefficiencies into the market.

10:54 We understand the difference between command and control policies, command and control, it's like the EPA Regulation, you do this.

11:01 We have the market-based policies with our taxes and our subsidies, and we also understand how private solutions can sometimes address these externalities but sometimes they break down because of transaction cost.

11:13 So that's your presentation on externalities, thank you.