Externalities and Market Failures

Externalities and Market Failures

• An externality refers to the side effect of an activity that impacts bystanders whose interests aren't considered.
• Externalities don't directly affect those involved in the activity
• For example, driving a car leads to pollution, traffic, and road damage, affecting others.
• Externalities result in market failures, leading to outcomes not in society's best interest.

Private vs. Society's Interest

• Private interest involves individual costs and benefits.
• Society's interest includes all costs and benefits, regardless of who experiences them.
• If your choices do not affect others, your private and society's interests align
• Market failure occurs when choices affect others, creating conflicts between private and societal interests and tension between involved parties and bystanders.

Types of Externalities

• Negative externality harms bystanders by imposing costs on others, such as taking up parking spaces or causing health issues through secondhand smoke.
• Positive externality benefits bystanders, like health insurers benefiting from someone's exercise or neighbors enjoying a garden.
• Overproduction occurs with pollution because more pollution is generated than what is socially optimal.
• Underproduction happens with vaccination, where vaccination rates fall below society's best interest.

Costs and Benefits of Externalities

• Marginal private cost is the seller's cost to produce one more unit, illustrated by the firm's supply curve, like the labor and electricity needed for another gallon of gas.
• Marginal external cost is the additional cost imposed on bystanders from producing one more unit, such as pollution from producing an extra gallon of gas.
• Marginal social cost encompasses all marginal costs, regardless of who bears them, and can be calculated by Marginal private costs + Marginal external costs.
• Marginal private benefit is the considered benefits to buyers.
• Marginal external benefit is the extra benefits bystanders experience, added on top of MPB (Marginal private benefit).
• Marginal social benefit is calculated by MPB+MEB.

The Externality Problem and Socially Optimal Quantity

• The best outcome for society is not always where the market settles.
• Market outcomes fail to include the interests of bystanders
• This results in the market's failure to find the most efficient outcome in the presence of externalities
• Socially optimal quantity refers to the quantity most efficient for society, considering the interests of buyers, sellers, and bystanders, involving all costs and benefits.
• Producing more of an item is logical for society as long as its marginal social benefit is at least equal to its marginal social cost.

Analyzing Externalities

• To Analyze externalities:
  • Find where supply equals demand to identify the equilibrium quantity
  • Determine if the externality is positive or negative
  • Determine where the marginal social benefit (MSB) equals marginal social cost (MSC)
  • Compare the equilibrium quantity with the socially optimal quantity to see if there is over or underproduction
• Step one: finding the equilibrium quantity; buyers equal the marginal private benefit (demand) and sellers equal the marginal private cost (sellers).
• Step two: assess externalities by determining if the externality is positive or negative
• Marginal external cost is $2.10 per gallon, thus the marginal social cost of each gallon of gas is also $2.10 per gallon HIGHER than the marginal private cost.
• Marginal external benefit is $10 per flu shot
• The marginal social benefit of each flu shot is $10 higher than it's marginal private benefit
• Step Three: find the socially optimal quantity
• Step Four: compare the equilibrium and socially optimal quantity

Market Failure

• Overproduction of gas (DWL) occurs because the market produces more gas than is socially optimal, shifting the DWL triangle back to 0 to reduce production.
• Underproduction of flu shots (DWL) occurs because the market has fewer flu shots than is socially optimal, shifting the DWL triangle forward to encourage production.
• Socially optimal quantity brings balance, where unregulated market is found with private and demand/supply, as where socially optimal quantity is reached with Social and Demand/Supply

Solving Externality Problems

• The goal is to internalize the externality by ensuring people consider the effects of their actions on bystanders. Solutions include:
  • Private bargaining (the Coase theorem)
  • Corrective taxes and subsidies
  • Cap and trade
  • Laws, rules, and regulations
  • Government support for public goods Assigning ownership rights for common resource problems

The Coase Theorem

• If bargaining is costless and property rights are clearly defined and enforced, private bargains can solve externality problems

Corrective Taxes and Subsidies

• People tend to ignore external costs or benefits in their choices
• Solutions include introducing a tax or subsidy.
• For negative externalities, a corrective tax equal to the external cost incentivizes reducing harmful activity.
• For positive externalities, a corrective subsidy equal to the external benefit encourages more beneficial activity.

Cap and Trade

• A quota is a government restriction on the quantity of goods or services bought and sold in the market
• A negative externality solution is setting a quota like water use quotas at the socially optimal quantity.

Laws, Rules, and Regulations

• They primarily address problems caused by negative externalities.
• Examples:
  • Noise restrictions that deter noisy neighbors
  • Speeding laws to reduce danger to fellow citizens
  • Automaker fuel efficiency regulations to lower pollution
  • Safety laws minimizing endangerment of workers
  • Required workplace antivirus software to reduces the risk of network hacks

Characteristics of Goods

• Nonexcludable products are those that someone cannot easily be excluded from using.
• Nonrival goods are those for which one person's use does not subtract from another's.
• Excludable goods are those that someone can be easily excluded from using.
• Rival goods are those for which one's use of something comes at someone else's expense.

Types of Issues with Nonexcludable Goods

• Nonrival and Nonexcludable goods are considered public goods
  • Public goods have free riders because you can't exclude nonpayers, resulting in too little being produced by the market.
• Rival and Nonexcludable goods are considered a common resource
  • Common resources lead to the tragedy of the commons because people overuse them.
• A free rider problem occurs when someone benefits from a good without bearing the costs
• The government can provide or purchase public goods to address underproduction.
• Common resources tend to be overused and exploited
• Assigning property rights gives the “common” property to someone so that they incentive to prevent depletion.

The Labor Market

• Businesses buy labor, and their demand target is to lower wages for cheaper labor.
• Workers sell labor, and their supply increases with higher wages and more hours worked.

Reasons for Wage Variation

• Employer demand depends on productivity.
• Signaling involves workers using human capital acquisition to increase productivity through knowledge and skills gained through education.
• Skilled individuals expand their knowledge and hone time management, critical thinking, and multitasking abilities
• Workers with more education tend to earn more
• Signaling education signals the worker’s abilities
• Credible signals intelligence and productivity to potential employers
• It can credibly convey private information that is hard for someone to verify

Incentivizing Productivity

• Employers aim to keep employees focused and hard-working.
• Employers closely monitor their employees
• Employers pay workers an efficiency wage, which encourages greater worker productivity
• Superstars are those who are liked the best and leverage technology to their advantage

Wages

• Compensating differential refers to the differences in wages required to offset the desirable or undesirable aspects of a job
• Wages can differ due to job attributes, not just worker attributes

Undesirable vs. Desirable Attributes

• Jobs with undesirable attributes show a labor supply shift left, leading to less quantity supply and higher wages.
• Jobs with desirable attributes show a labor supply shift right, leading to more quantity supply and lower wages.
• Institutional factors like government regulations, unions, and market structures also affect wages.

Government Regulations

• Licensing laws for occupations requiring a license decrease labor supply and result in higher wages and fewer jobs.
• Minimum wage acts an example of a price floor, pushing wages above equilibrium and causes unemployment as supply wants more jobs than demand is willing to hire
• Labor demand inelasticity means they won't reduce employment that much
• Elasticity in labor demand reduces employment a lot and causes much unemployment

Unions

• Unions are organizations of workers that join factors to negotiate with employers for better pay and conditions with collective bargaining.
• Collective bargaining gives workers more help and leads to higher wages and job protection
• Unions improve productivity and have standards

Market Structure

• Businesses set low wages because workers have no other options in the area, giving businesses all the power.
• Monopsony means the market has one buyer of labor resulting in minimum wage increases
• Minimum wage increases may not leaf to reduced employment

Sources of Discrimination

• Prejudice involves negative attitudes toward someone because they belong to a group, which can be costly for businesses and individuals.
• Implicit bias involves unconscious judgments, so solutions are structured assessments, like blind auditions.
• Statistical discrimination uses observations about the average characteristics of a group to make inferences because gathering specific worker information is a lengthy process
• Institutional discrimination involves bias against disadvantaged groups.