Externalities
By Dr. Shinn-Juh Lin
2021/10/26 Externalities 1
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2021/10/26 Externalities 2
Review
Consumer surplus: buyer’s willingness to pay for a
good minus the amount the buyer actually pays for
it.
Producer surplus: the amount a seller is paid for a
good minus the seller’s cost.
Total surplus: Market Efficiency can be measured
by the sum of consumer surplus and producer
surplus.
Without failure of the market, market equilibrium
maximizes the efficiency (total surplus.)
Market failure typically occurs with: externality and
market power.
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Externalities & Market Inefficiency
Externality arises when a person engages in an
activity that influences the well-being of a
bystander and yet neither pays nor receives any
compensation for that effect.
When the impact on the bystander is adverse, the
externality is called a negative externality.
When the impact on the bystander is beneficial, the
externality is called a positive externality.
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Examples: Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
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Examples: Positive Externalities
Immunizations
Restored historic buildings
Research into new technologies
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Externalities & Market Inefficiency
Externalities cause markets to be inefficient, and
thus fail to maximize total surplus.
Negative externalities lead markets to produce a
larger quantity than is socially desirable.
Positive externalities lead markets to produce a
smaller quantity than is socially desirable.
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The Market for Aluminum
Price of
Aluminum Supply
(private cost)
Equilibrium
Demand
(private value)
0 QMARKET Quantity of
Aluminum
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The Market for Aluminum
The quantity produced and consumed in the
market equilibrium is efficient in the sense that it
maximizes the sum of producer and consumer
surplus.
If the aluminum factories emit pollution (a
negative externality), then the cost to society of
producing aluminum is larger than the cost to
aluminum producers.
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The Market for Aluminum
For each unit of aluminum produced, the social
cost includes the private costs of the producers
plus the cost to those bystanders adversely
affected by the pollution.
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Pollution and the Social Optimum
Price of
Social
Aluminum
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0 QOPTIMUM QMARKET Quantity of
Aluminum
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Price of
Social
Aluminum
cost
Cost of
pollution
Supply
1 (private cost)
8
2 5 6
Equilibrium
7
3
4
Demand
(private value)
0 QOPTIMUM QMARKET Quantity of
Aluminum
CS PS TS
Market 1+2+5+6 3-5-6-8 1+2+3-8
Optimum 1 2+3 1+2+3
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Negative Externalities
The intersection of the demand curve and the
social-cost curve determines the optimal output
level.
The socially optimal output level is less than the
market equilibrium quantity.
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Negative Externalities
To achieve the socially optimal output, the
government can Internalizing an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable
quantity.
internalize an externality involves altering incentives
so that people take account of the external effects of
their actions.
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Positive Externalities
When an externality benefits the bystanders, a
positive externality exists.
The social value of the good exceeds the private value.
A technology spillover is a type of positive externality
that exists when a firm’s innovation or design not only
benefits the firm, but enters society’s pool of
technological knowledge and benefits society as a
whole.
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Education & the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of
Education
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Price of
Education
Supply
1
(private cost)
2 3
4 6 7
Social
value
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of
Education
CS PS TS
Market 1+2+4+6 5 1+2+4+5+6
Optimum
2021/10/26 1+2+3 4+5+6+7
Externalities 1+2+3+4+5+6+7 17
Positive Externalities
The intersection of the supply curve and the
social-value curve determines the optimal output
level.
The optimal output level is more than the equilibrium
quantity.
The market produces a smaller quantity than is
socially desirable.
The social value of the good exceeds the private value
of the good.
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Positive Externalities
Internalizing Externalities: Subsidies 津貼、補助⾦
Used as the primary method for attempting to
internalize positive externalities.
Industrial Policy
Government intervention in the economy that aims to
promote technology-enhancing industries
Patent laws are a form of technology policy that give the
individual (or firm) with patent protection a property right over
its invention.
The patent is then said to internalize the externality.
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Private Solutions to Externalities
Government action is not always needed to
solve the problem of externalities.
Possible private solutions:
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses: bees vs
apple trees.
Contracting between parties.
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The Coase Theorem 寇斯定理
The Coase Theorem is a proposition that if
private parties can bargain without cost over the
allocation of resources, they can solve the
problem of externalities on their own.
Transaction costs are the costs that parties incur in
the process of agreeing to and following through on a
bargain.
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The Coase Theorem
Suppose that Dick owns a dog named Spot. Spot barks
and disturbs Jane, Dick’s neighbor.
Dick gets a benefit from owning the dog, but the dog
confers a negative externality on Jane.
Suppose that Dick gets a $500 benefit from the dog and
Jane bears an $800 cost from the barking.
In this case, Jane can offer Dick $600 to get rid of the
dog, and Dick will gladly accept. Both parties are better
off than they were before, and the efficient outcome is
reached.
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The Coase Theorem
So far, we have assumed that Dick has the legal right to
keep a barking dog.
How different would the outcome be, on the other hand,
if Jane had the legal right to peace and quiet?
In this case, Dick can offer to pay Jane to allow him to keep the
dog. If the benefit of the dog to Dick exceeds the cost of the
barking to Jane, then Dick and Jane will strike a bargain in which
Dick keeps the dog.
Although Dick and Jane can reach the efficient outcome
regardless of how rights are initially distributed, the
distribution of rights is not irrelevant.
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Why Private Solutions Do Not Always Work
Sometimes the private solution approach fails
because transaction costs can be so high that
private agreement is not possible.
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Public Policy Toward Externalities
When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through . . .
command-and-control policies.
market-based policies.
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Command-and-Control Policies
Usually take the form of regulations:
Forbid certain behaviors.
Require certain behaviors.
Examples:
Requirements that all students be immunized.
Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
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Market-Based Policies
Government uses taxes and subsidies to align
private incentives with social efficiency.
Pigovian taxes are taxes enacted to correct the
effects of a negative externality.
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Examples: Regulation versus Pigovian Tax
If the EPA decides it wants to reduce the amount
of pollution coming from a specific plant. The
EPA could…
tell the firm to reduce its pollution by a specific amount
(i.e. regulation).
levy a tax of a given amount for each unit of pollution
the firm emits (i.e. Pigovian tax).
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Equivalence of Pigovian Taxes & Pollution Permits
(b) Pollution Permits
Price of Supply of
Pollution pollution permits
Demand for
pollution rights
0 Q Quantity of
Pollution
2. . . . which, together 1. Pollution
with the demand curve, permits set
determines the price the quantity
of pollution. of pollution . . .
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Market-Based Policies
Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another.
A market for these permits will eventually develop.
A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
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Equivalence of Pigovian Taxes & Pollution Permits
(a) Pigovian Tax
Price of
Pollution
P Pigovian
tax
1. A Pigovian
tax sets the
price of Demand for
pollution . . . pollution rights
0 Q Quantity of
Pollution
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
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