Online ECON - Chapter 10 Guided Reading – Externalities

Key Concepts:

Externality

Internalizing Externalities

Social Value and Social Cost Curves including Optimum

Command and Control Policies

Market-based Policies

Corrective Tax

Tradable Pollution Permits (Cap and Trade)

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Note: Remember we spoke earlier in the term about the lemon tree in my back yard. In August, it
provides shade to my neighbor’s back porch, creating a positive externality. In November, it drops its
leaves into my neighbor’s yard and he must rake them up, creating a negative externality.

Assignment: In the space below, write your answers to the following questions:

Should we allow companies to pay for the right to pollute the environment? Why/Why not?

No, we shouldn’t allow companies to pay for the right to pollute because in the long run we will all
suffer. It might seem good for the market and the economy, but in the long run if the pollution gets out
of hand, we will all suffer. It would be a societal irresponsibility to do business that would cause harm to
our Planet, everyone’s home. As a society we must take measures to go green. Planet Earth is the only
habitable place that we have in the universe now. Look at Elon Musk for example, he is focusing on
creating green energy. He made Tesla, a motor company that only sells electric cars. He is conducting
business in ways that are beneficial to society.

There is a sixteen year old on my street who is thinking about dropping out of school. You will never
meet this teenager. At the end of the day, do you care if he drops out of school? Why/Why not?

Note: An externality is the uncompensated impact of one person’s actions on the well-being of a
bystander.

Assignment: Read Chapter 10 Introduction and Section 10-1a in your textbook.

Note: When thinking about negative externalities, use pollution as the example.

Assignment: Read Section 10-1b

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Note: Figure 2 shows a Social Cost Curve. This curve shows the sum of a) the private cost in the market
(in this example, the aluminum company’s cost as represented by the height of the supply curve) and b)
the external cost (for instance, pollution that the society experiences from the existence of this market).
Notice the Social Cost Curve is not a Supply Curve – it will always lie above the Supply Curve,
representing the fact that there are negative externalities in this market. That is, there are costs to
society that are above and beyond the costs to the aluminum company.

Note: The point where the Social Cost Curve intersects with the Demand Curve is not a new equilibrium.
Instead, we call this point Optimum, because after we take into account the negative externalities
created by the market, this new point (the intersection of the Social Cost Curve and the Demand Curve)
is the optimum amount of aluminum that the society will desire, after taking the negative externality of
pollution into account.

Assignment: Read Section 10-1c.

Note: Figure 3 shows a Social Value Curve. This curve shows the sum of a) the private value in the
market (in this example, the value of the education you receive as represented by the height of the
demand curve) and b) the external value (for instance, the value that the society receives for you being
more educated). Notice the Social Value Curve is not a Demand Curve – it will always lie above the
Demand Curve, representing the fact that there are positive externalities in this market. That is, there is
value to society that is above and beyond the value to the individual student.

Note: The point where the Social Value Curve intersects with the Supply Curve is not a new equilibrium.
Instead, we call this point Optimum, because after we take into account the positive externalities
created by the market, this new point (the intersection of the Social Value Curve and the Supply Curve)
is the optimum amount of education that the society will desire, after taking the positive externalities
associated with having a more educated society into account.

Note: At this point, be sure you understand Figure 2 and Figure 3.

Assignment: Explain Figure 2 and Figure 3 to a friend or family member.

Assignment: Read 10-2 Introduction and 10-2a.

Note: Command and Control policies refer to the government regulating what citizens can do, regulating
how much they can or cannot do, or regulating what they cannot do.

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Assignment: Read 10-2b

Note: A tax on gasoline is a classic example of a corrective tax for the reasons explained in this section.

Note: The positive externalities associated with education are why we subsidize education in our nation.

Assignment: Read 10-2c and 10-2d

Note: There are times when a society can benefit by allowing firms to pay for the right to pollute. This
will be reinforced in one of your discussion posts questions below and also in lecture, but be sure to
have read 10-2c and 10-2d.

Note: Transaction Costs are the costs incurred when arranging agreements between buyers and sellers.

Assignment: Read 10-4 and Chapter Summary.

Assignment: Answer the following five questions:

1) According to this chapter, was the late Senator Edmund Muskie correct in the quote
attributed to him? Why/Why not?

I think Senator Edmund Muskie was correct to say that “we cannot give anyone the option of polluting
for a fee”. We shouldn’t allow companies to pay for the right to pollute because in the long run we will
all suffer. It might seem good for the market and the economy, but in the long run if the pollution gets
out of hand, we will all suffer. It would be a societal irresponsibility to do business that would cause
harm to our Planet, everyone’s home. As a society we must take measures to go green. Planet Earth is
the only habitable place that we have in the universe now. Look at Elon Musk for example, he is
focusing on creating green energy. He made Tesla, a motor company that only sells electric cars. He is
conducting business in ways that are beneficial to society.

2) What does the term Market Failure refer to? What can cause market Failure?

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 Market failure is a situation in which a market left on its own fails to allocate resources
efficiently. This can be caused by externalities such as pollution and policy imposed by the
government.

3) What are the benefits to a society when placing a tax on gasoline?

The benefits to society are that these corrective taxes are a way to deal with the negative externalities
such as pollution that using gasoline causes. The higher the tax the more it will reduce the overall level
of pollution because less people will be willing to pay for it.

4) Does it make economic sense to provide every U.S. citizen with free education through high
school? Why/Why not?

Yes, because in the long run it is beneficial to the economy to have U.S. citizens pursue higher education
because it will create more domestic experts in Science and Medicine for example. That way we would
not have to rely on outsourcing the experts from other countries.

5) Our town has only two factories: an aluminum factory and a paper factory. Both factories are
producing at equilibrium, meaning we purchase all of the aluminum and paper that they
produce. However both factories create pollution (a substance called “Yuck”) that runs into
our town’s river and winds up in our town’s lake where our children swim. Scientists have told
us that our environment can absorb 1 million gallons of Yuck per year without harming our
environment or our citizens, but any more than that then our children may develop cancer.

Currently, the aluminum factory creates 700,000 gallons of Yuck per year, and the paper
factory creates 500,000 gallons of yuck per year.

There are filters available for aluminum factories, but they are very expensive. A filter to
lower the aluminum factory’s creation of Yuck from 700,000 gallons to 500,000 gallons would
cost the aluminum company $100 million. The only other way for the aluminum company to
lower its’ creation of Yuck to 500,000 gallons per year would be to cut production of
aluminum, reduce all of its employees from 40 hours per week to 30 hours per week (and
reduce their wages and benefits accordingly).

There are also filters available for paper factories and they are relatively inexpensive. In fact,
the paper factory could purchase a filter for $1 million that would lower the paper factory’s
creation of Yuck from 500,000 gallons to 300,000 gallons.

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 If the government uses command-and-control (regulation) and decides to limit each of the
two factories to 500,000 gallons of Yuck per year, does the paper company have any incentive
to invest the $1 million to purchase the filter? From your knowledge gained from Chapter 10,
what might be a more economically efficient way for the government to achieve its goal?

No, the paper company already produces no more than 500,000 gallons of Yuck per year which
is the maximum allowed by the government if the command-and-control regulation is used so
they will have no reason to reduce the Yuck production. A better, more economically efficient
way for the government to achieve its goal in reducing pollution would be to levy a corrective
tax for each gallon of Yuck the factories produce. That way both factories will implement
measures to reduce pollution and that way there will be a more significant decrease in pollution.

Assignment: Post your answers to these five questions in Course Discussion 10A in the course in
Blackboard. This Post is due before Friday, April 10 at 11:59 PM.

Assignment: Go back to the beginning of this document and, using your own words, explain each of
the Key Concepts listed.

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