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Thursday, April 05, 2007

Externalities in a Nutshell (Are Shells a Negative Externality?)

A recent exchange, which proves that economists answer questions with at least twice as many words as necessary.

A question from a friend:

Positive externalities, such as education or advances in technology - do they precipitate government intervention in order for the market to reach equilibrium? It seems a bit counter-intuitive that advances in technology would produce a surplus rather than a shift in the supply curve. (pardon me if I manage to mince my terms - I'm in only my first econ course)

My response:

Yes, it does seem counterintuitive. Let me explain negative externalities first, without a graph, if it's possible!

Let's say pollution is a negative externality. It is an externality because its total cost to society is not realized by the producers (i.e. they don't have to pay to pollute). In fact, the people that often pay for pollution are the people that breathe the polluted air or those that have to treat the polluted water. This makes the plant's profits artificially high, so they produce too much (at least more than they would if they had to pay for pollution).

Now think about positive externalities. Both education and advances in technology produce positive side effects. Because people often can't say how much better off they are because you are smarter, they don't realize the benefits. That is to say, if you are smarter or have a good technology, most people won't even realize that you are improving their life, much less quantify how much they'd be willing to pay for you to use that tech/knowledge (this is how we determine how much the benefit is worth). Since people don't realize how much they benefit, and remembering that a negative externality causes overproduction, it should be easy to see that in the case of education, people will not allocate enough money/resources to achieve optimal education for the society.

So yes, governments can intervene to help the market reach what we call "social equilibrium." In the case of pollution, they can tax the plant for CO2 emissions or create a tradeable permit scheme (which has benefits we'll discuss another time). In the case of education, the government can subsidize public education to make it more widely available. In one case, the government taxes, in the other, it pays out. If we were all smart enough (i.e. omniscient) we could effectively allocate all resources, and government taxing and spending would be a wash.

To you last point, yes, technology and education do shift the supply curve to the right--everyone gets to consume more at a lower price! But because they are positive externalities, we don't all benefit as much as we could if we had more tech or knowledge. Very fascinating stuff. If you still wanna chat about it, let me know!

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