1. Externalities – Definition and examples An externality arises when a firm or person engages in an activity that affects the well-being of a third party, yet neither pays nor receives any compensation for that effect. If the impact on the third party is beneficial, it is called a externality. The following graph shows the demand and supply curves for a good with this type of externality. The dashed drop lines on the graph reflect the market equilibrium price and quantity for this good. Shift one or both of the curves to reflect the presence of the externality. If the social cost of producing the good is not equal to the private cost, then you should shift the supply curve to reflect the social costs of producing the good; similarly, if the social value of producing the good is not equal to the private value, then you should shift the demand curve to reflect the social value of consuming the good. With this type of externality, in the absence of government intervention, the market equilibrium quantity produced will be than the socially optimal quantity. Which of the following generate the type of externality previously described? Check all that apply. A leading software company has decided to increase its research budget for inventing new open-source technologies. The city where you live has turned the publicly owned land next to your house into a park, causing trash dropped by park visitors to pile up in your backyard. Alex has planted several trees in his backyard that increase the beauty of the neighborhood, especially during the fall foliage season. Your roommate, Kate, has bought a cat to which you are allergic. 2. Efficiency in the presence of externalities Roses confer many external benefits on society: the beauty they add to a room or garden, the wonderful aroma they give off, and so on. Therefore, the market equilibrium quantity of roses is not equal to the socially optimal quantity. The following graph shows the demand for roses (their private value), the supply of roses (the private cost of producing them), and the social value of roses, including both the private value and external benefits. Use the black point (plus symbol) to indicate the market equilibrium quantity. Next, use the purple point (diamond symbol) to indicate the socially optimal quantity. 3. The effect of negative externalities on the optimal quantityof consumption Consider the market for bolts. Suppose that a hardware factory dumps toxic waste into a nearby river, creating a negative externality for those living downstream from the factory. Producing an additional ton of bolts imposes a constant external cost of $75 per ton. The following graph shows the demand (private value) curve and the supply (private cost) curve for bolts. Use the purple points (diamond symbol) to plot the social cost curve when the external cost is $75 per ton. The market equilibrium quantity is tons of bolts, but the socially optimal quantity of bolt production is tons. To create an incentive for the firm to produce the socially optimal quantity of bolts, the government could impose a ofper ton of bolts. 4. Understanding different policy options to correct for negativeexternalities Carbon dioxide emissions have been linked to worsening climate conditions. The following table lists some possible public policies aimed at reducing the amount of carbon dioxide in the air. For each policy listed, identify whether it is a command-and-control policy (regulation), tradable permit system, corrective subsidy, or corrective tax. 5. Correcting for negative externalities – Regulation versus tradablepermits Suppose the government wants to reduce the total pollution emitted by three local firms. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. If the government wants to reduce total pollution in the area to 6 units, it can choose between the following two methods: Available Methods to Reduce Pollution 1. The government sets pollution standards using regulation. 2. The government allocates tradable pollution permits. Each firm faces different costs, so reducing pollution is more difficult for some firms than others. The following table shows the cost each firm faces to eliminate each unit of pollution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) is prohibitively expensive. Firm Cost of Eliminating the… First Unit of Pollution Second Unit of Pollution Third Unit of Pollution (Dollars) (Dollars) (Dollars) Firm X 130 165 220 Firm Y 90 115 140 Firm Z 600 750 1,200 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units. Method 1: Regulation The first government employee suggests to limit pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units. Complete the following table with the total cost to each firm of reducing its pollution by 2 units. Firm Total Cost of Eliminating Two Units of Pollution (Dollars) Firm X Firm Y Firm Z Method 2: Tradable Permits Meanwhile, the other employee proposes using a different strategy to achieve the government’s goal of reducing pollution in the area from 12 units to 6 units. He suggests that the government issues two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution. Firms are free to trade pollution permits with one another (that is, buy and sell them) as long as both firms can agree on a price. For example, if firm X agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit while firm X would end up with only one permit and would have to reduce its pollution by 3 units. Assume the negotiation and exchange of permits are costless. Because firm Z has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Y and a permit from firm X so that it doesn’t have to reduce its own pollution emissions. At which of the following prices is firm Y willing to sell one of its permits to firm Z, but firm X is not? Check all that apply. $123 $212 $219 $569 $595 Suppose the owners of the three firms get together and agree on a trading price of $218 per permit.