Outline
What is an externality?
An externality from an activity refers to the cost or benefit that is imposed on parties not involved in the activity. We will refer to these as third-parties or bystanders.
An externality is said to be negative when it imposes a cost on third-parties.
An externality is said to be positive when it results in a benefit third-parties.
Examples of Externalities
Example of a Negative externality:
When someone smokes a cigarette in close proximity to other people,
the smoker imposes a negative externality on others.
Example of a positive externality:
When someone get a vaccine that prevents them from contracting a disease,
in addition to benefitting themselves, they
provide benefit to others by preventing the spread of the disease.
Identify the externality type (from Acemoglu et al.)
Suppose that you install an invisible tracking device on your laptop that will instantly lead the police to the laptop, it is ever stolen. Does the purchase of the tracking device result in an externality to other laptop users? If yes, what kind of externality.
Do you answers above change, if you instead use a visible computer lock?
Externalities and Market Failure
In the presence of externalities, the equilibrium output does not maximize the welfare (social surplus) in the market.
What is the social surplus?
Equilibrium output = 20.
Equilibrium price = 60.
CS= Areas 1 + 2 + 3 + 4.
PS= Areas 5 + 6 + 7.
Externality cost = Areas 3 + 4 + 6 + 7 + 8
Social Surplus = 1 + 2 + 5 - 8.
Externalities and Market Failure (Continued)
What is the social surplus if a tax of $20 is imposed on the sellers?
Equilibrium output = 15.
Equilibrium price = 70.
CS= Areas 1.
PS= Areas 2 + 5.
Externality cost = Areas 3 + 6.
Government Revenue = Areas 3 + 6.
Social Surplus = 1 + 2 + 5.
Externalities and Market Failure (Continued)
By imposing a tax per unit that equals externality cost per unit, we have increased the social surplus from area (1 + 2 + 5 - 8) to (1 + 2 + 5).
A corrective tax of this kind is called Pigouvian Tax.