Chapter 10: Externalities

Chapter 10 is about externalities and the efforts at regulating them.

An externality is an effect of a person’s actions on a bystander. These can be both good and bad, or beneficial and negative. The idea of a social cost accompanies externalities, which is the private cost of producing a good and the cost of a bystander. A negative externality would cause the supply curve to shift up, making the optimal quantity less than the equilibrium quantity. However, for positive externalities, the demand curve is shifted up because the optimal quantity is greater than the equilibrium quantity. The externalities can be taken into account when the externality is internalized, making it so that people take into account the external effects of their actions. Governments would internalize positive externalities by imposing subsidies, but taxes on negative externalities.

Technology spillover is a positive externality that refers to the impacts of a firm's research on the access of another firm’s access to technology. The government would attempt to internalize the externality by subsidizing the production of robots, leading to the supply curve shifting down and the equilibrium quantity going up. The government’s use of subsidies to promote technology enhancing industries is called industrial policy, but is in debate between economists about the precision of industrial policy. But, firms themselves would deal with rt technology spillovers through patent protection, giving them exclusive use of their inventions, and gives them property right. So, if other firms would want to use the new product, they would have to go to the original firm for permission, which gives an= incentive to engage in research to advance technology.

The government could also control an externality by prohibiting the behavior that leads to it altogether. The government would need to set a good ground basis for the rules, and so they need specific details of each industry. However, the details are hard to obtain.

The government’s use of taxes to deal with negative externalities are called corrective, or Pigouvian taxes. An ideal tax would equal to the cost from an activity with negative externalities and ideal subsidies would equal the benefit with positive externalities. Corrective taxes places a price on an externality (such as pollution), and it moves pollution to only the firms that spend the most to reduce it. The supply curve would be perfectly elastic because firms could produce as much as they want, as long as they pay the tax.

Governments could also issue pollution permits, which imposes a cost and a set amount of pollution that firm could produce. In this case, the supply curve would remain perfectly inelastic because the quantity of pollution is fixed based off the permits. Pollution permits are seen as a more cost effective and efficient way of keeping the environment clean. With the use of government intervention to reduce the negative externality of pollution, it would reduce the cost of environment protection and increase the public's demand for a clean environment.

An idea proposed by Coase, the Coase Theorem suggests that if private parties can bargain without cost over allocation of resources, they can solve the problem of externalities on their own. The initial distribution of rights does not matter for the ability to reach the efficient outcome. No matter how the rights are initially distributed, it only determines the distribution of economic well being, and both parties could reach max efficiency.