Ch

 10:  Externali0es  

1  
 In this chapter,
look for the answers to these questions

• What  is  an  externality?  

• Why  do  externali0es  make  market  outcomes  
inefficient?    
• What  public  policies  aim  to  solve  the  problem  
of  externali0es?  
• How  can  people  some0mes  solve  the  problem  
of  externali0es  on  their  own?    Why  do  such  
private  solu0ons  not  always  work?      

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2  
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Introduc0on  
• One  of  the  Ten  Principles  from  Chapter  1:      
         Markets  are  usually  a  good  way    
         to  organize  economy  ac5vity.      
In  absence  of  market  failures,  the  compe00ve  
market  outcome  is  efficient,  maximizes  total  
surplus.    
• One  type  of  market  failure:      
externality,  the  uncompensated  impact  of  one  
person’s  ac0ons  on  the  well-­‐being  of  a  bystander.  
• Externali0es  can  be  nega+ve  or  posi+ve,    
depending  on  whether  impact  on  bystander  is  
adverse  or  beneficial.     3  
 Introduc0on  
• Self-­‐interested  buyers  and  sellers  neglect  the  
external  costs  or  benefits  of  their  ac0ons,    
so  the  market  outcome  is  not  efficient.      
• Another  principle  from  Chapter  1:      
         Governments  can  some5mes    
         improve  market  outcomes.    
In  presence  of  externali0es,  public  policy  can  
improve  efficiency.    

4  
 Examples  of  Nega0ve  Externali0es  
• Air  pollu0on  from  a  factory  
• The  neighbor’s  barking  dog  
• Late-­‐night  stereo  blas0ng  from    
the  dorm  room  next  to  yours  
• Noise  pollu0on  from    
construc0on  projects  
• Health  risk  to  others  from     ©  M.  Shcherbyna/ShuXerstock.com  

second-­‐hand  smoke  
• Talking  on  cell  phone  while  driving  makes  the  roads  less  
safe  for  others  

5  
 Recap  of  Welfare  Economics  
P The market for gasoline
$5 The market eq’m
maximizes consumer
+ producer surplus.
4
Supply curve shows
3 private cost, the costs
$2.50 directly incurred by sellers.
2
Demand curve shows
private value, the value
1
to buyers (the prices they
are willing to pay).
0
0 10 20 25 30 Q
(gallons)
6  
 Analysis  of  a  Nega0ve  Externality  
P The market for gasoline
$5 Social cost
= private + external cost
4 external
cost Supply (private cost)
3 External cost
= value of the
2 negative impact
on bystanders
1 = $1 per gallon
(value of harm
0 from smog,
0 10 20 30 Q
greenhouse gases)
(gallons)
7  
 Analysis  of  a  Nega0ve  Externality  
P The market for gasoline
The socially
$5
Social optimal quantity
cost is 20 gallons.
4
S
3 At any Q < 20,
value of additional gas
2 exceeds
At any Qsocial
> 20, cost.
D social cost of the
1 last gallon is
greater than its value
0 to society.
0 10 20 25 30 Q
(gallons)
8  
 Analysis  of  a  Nega0ve  Externality  
P The market for gasoline
$5
Social Market eq’m
cost (Q = 25)
4
S is greater than
social optimum
3
(Q = 20).

2 One solution:
D tax sellers
1 $1/gallon,
would shift
0 S curve up $1.
0 10 20 25 30 Q
(gallons)
9  
 “Internalizing  the  Externality”  

• Internalizing  the  externality:    altering  incen0ves  so  

that  people  take  account  of  the  external  effects  of  
their  ac0ons  
• In  our  example,  the  $1/gallon  tax  on  sellers  makes  
sellers’  costs  =  social  costs.  
• When  market  par0cipants  must  pay  social  costs,  
market  eq’m  =  social  op0mum.      
 (Imposing  the  tax  on  buyers  would  achieve  the  same  
outcome;  market  Q  would  equal  op0mal  Q.)  

10  
 Examples  of  Posi0ve  Externali0es  
• Being  vaccinated  against    
contagious  diseases  protects    
not  only  you,  but  people  who    
visit  the  salad  bar  or  produce    
sec0on  aier  you.    
• R&D  creates  knowledge    
others  can  use.   ©  Peter  Bernik/ShuXerstock.com  

• People  going  to  college  raise  the  

popula0on’s  educa0on  level,   Thank you for
which  reduces  crime  and   not contaminating
improves  government.   the fruit supply!

11  
 Posi0ve  Externali0es  
• In  the  presence  of  a  posi0ve  externality,    
the  social  value  of  a  good  includes  
– private  value  –  the  direct  value  to  buyers  
– external  benefit  –  the  value  of  the    
posi0ve  impact  on  bystanders  

• The  socially  op0mal  Q  maximizes  welfare:  

– At  any  lower  Q,  the  social  value  of    
addi0onal  units  exceeds  their  cost.  
– At  any  higher  Q,  the  cost  of  the  last  unit  exceeds  its  
social  value.  

12  
ACTIVE LEARNING 1
Analysis  of  a  posi0ve  externality  
P The market for flu shots
External benefit
$50 = $10/shot

40 § Draw the social

value curve.
S
30 § Find the socially
optimal Q.
20 § What policy would
internalize this
10 externality?
D

0 Q
0 10 20 30 13  
ACTIVE LEARNING 1
Answers   Socially optimal Q
P The market for flu shots
= 25 shots.
$50
external To internalize the
40 benefit externality, use
subsidy = $10/shot.
S
30

Social value
20 = private value
+ $10 external benefit
10
D

0 Q
0 10 20 25 30 14  
    
 
Effects   o f   E xternali0es:     S ummary  
If  nega0ve  externality  
– market  quan0ty  larger  than  socially  desirable  
If  posi0ve  externality  
– market  quan0ty  smaller  than  socially  desirable  
To  remedy  the  problem,    
   “internalize  the  externality”  
– tax  goods  with  nega0ve  externali0es  
– subsidize  goods  with  posi0ve  externali0es  

15  
Public  Policies  Toward  Externali0es  
Two  approaches:  
• Command-­‐and-­‐control  policies  regulate  behavior  
directly.    Examples:  
– limits  on  quan0ty  of  pollu0on  emiXed  
– requirements  that  firms  adopt  a  par0cular  
technology  to  reduce  emissions  
• Market-­‐based  policies  provide  incen0ves  so  that  
private  decision-­‐makers  will  choose  to  solve  the  
problem  on  their  own.    Examples:  
– correc0ve  taxes  and  subsidies  
– tradable  pollu0on  permits  
16  
 Command-­‐and-­‐control  policies    
• E.g:  it  is  a  crime  to  dump  poisonous  chemicals  into  the  
water  supply.  But  it  is  impossible  to  prohibit  all  
pollu0ng  ac0vity.    
• For  instance,  virtually  all  forms  of  transporta0on  
produce  some  undesirable  pollu0ng  by-­‐products.  But  it  
would  not  be  sensible  for  the  government  to  ban  all  
transporta0on.  
• Society  has  to  weigh  the  costs  and  benefits  to  decide  
the  kinds  and  quan00es  of  pollu0on  it  will  allow.  
• Environmental  regula0ons:  e.g.  dictates  a  maximum  
level  of  pollu0on  that  a  factory  may  emit;  requires  that  
firms  adopt  a  par0cular  technology  to  reduce  
emissions;  etc  
17  
 Correc0ve  Taxes  &  Subsidies  
• Correc+ve  tax:    a  tax  designed  to  induce  
private  decision-­‐makers  to  take  account  of  the  
social  costs  that  arise  from  a  nega0ve  
externality  
• Also  called  Pigouvian  taxes  aier  Arthur  Pigou  
(1877-­‐1959).      
• The  ideal  correc0ve  tax  =  external  cost.  
• For  ac0vi0es  with  posi0ve  externali0es,    
ideal  correc0ve  subsidy  =  external  benefit.  

18  
 Correc0ve  Taxes  &  Subsidies  
• Other  taxes  and  subsidies  distort  incen0ves  
and  move  economy  away  from  the  social  
op0mum.  
• Correc0ve  taxes  &  subsidies    
– align  private  incen0ves  with  society’s  interests  
– make  private  decision-­‐makers  take  into  account  
the  external  costs  and  benefits  of  their  ac0ons  
– move  economy  toward  a  more  efficient  alloca0on  
of  resources      

19  
 Correc0ve  Taxes  vs.  Regula0ons  
• Different  firms  have  different  costs  of  pollu0on  
abatement  (cunng  pollu0on).      
• Efficient  outcome:    Firms  with  the  lowest  abatement  
costs  reduce  pollu0on  the  most.          
• A  pollu0on  tax  is  efficient:  
– Firms  with  low  abatement  costs  will  reduce  
pollu0on  to  reduce  their  tax  burden.  
– Firms  with  high  abatement  costs  have  greater  
willingness  to  pay  tax.  
• In  contrast,  a  regula0on  requiring  all  firms  to  reduce  
pollu0on  by  a  specific  amount  not  efficient.    
20  
 Correc0ve  Taxes  vs.  Regula0ons  

Correc0ve  taxes  are  beXer  for  the  environment:  

• The  correc0ve  tax  gives  firms  incen0ve  to  con0nue  
reducing  pollu0on  as  long  as  the  cost  of  doing  so  is  less  
than  the  tax.    
• If  a  cleaner  technology  becomes  available,    
the  tax  gives  firms  an  incen0ve  to  adopt  it.  
• In  contrast,  firms  have  no  incen0ve  for  further  
reduc0on  beyond  the  level  specified  in  a  regula0on.    

21  
 Example  of  a  Correc0ve  Tax:    The  Gas  Tax  
The  gas  tax  targets  three  nega0ve  externali0es:  
– Conges0on  
The  more  you  drive,  the  more  you  contribute  to  
conges0on.  
– Accidents  
Larger  vehicles  cause  more  damage  in  an  accident.  
– Pollu0on  
Burning  fossil  fuels  produces  greenhouse  gases.  

22  
 ACTIVE LEARNING 2
A.  Regula0ng  lower  SO2  emissions  
• Acme  and  US  Electric  run  coal-­‐burning  power  plants.    Each  
emits  40  tons  of  sulfur  dioxide  per  month,    
total  emissions  =  80  tons/month.          
• Goal:    Reduce  SO2  emissions  25%,  to  60  tons/month  
• Cost  of  reducing  emissions:  
     $100/ton  for  Acme,  $200/ton  for  USE  
Policy  op0on  1:    Regula0on  
Every  firm  must  cut  its  emissions  25%  (10  tons).  
Your  task:    Compute  the  cost  to  each  firm  and    
total  cost  of  achieving  goal  using  this  policy.      

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 ACTIVE LEARNING 2
A.  Answers  
• Each  firm  must  reduce  emissions  by  10  tons.      
• Cost  of  reducing  emissions:  
     $100/ton  for  Acme,  $200/ton  for  USE.  
• Compute  cost  of  achieving  goal  with  this  policy:  
 Cost  to  Acme:    (10  tons)  x  ($100/ton)  =  $1000  
 Cost  to  USE:    (10  tons)  x  ($200/ton)  =  $2000  
   Total  cost  of  achieving  goal  =  $3000  

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 2
B.  Tradable  pollu0on  permits  
• Ini0ally,  Acme  and  USE  each  emit  40  tons  SO2/month.  
• Goal:    reduce  SO2  emissions  to  60  tons/month  total.  
Policy  op0on  2:    Tradable  pollu0on  permits  
• Issue  60  permits,  each  allows  one  ton  SO2  emissions.    Give  
30  permits  to  each  firm.      
Establish  market  for  trading  permits.    
• Each  firm  may  use  all  its  permits  to  emit  30  tons,    
may  emit  <  30  tons  and  sell  leiover  permits,    
or  may  purchase  extra  permits  to  emit  >  30  tons.    
Your  task:    Compute  cost  of  achieving  goal  if  Acme    
uses  20  permits  and  sells  10  to  USE  for  $150  each.    
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 ACTIVE LEARNING 2
B.  Answers  
• Goal:    reduce  emissions  from  80  to  60  tons  
• Cost  of  reducing  emissions:  
     $100/ton  for  Acme,  $200/ton  for  USE.  
Compute  cost  of  achieving  goal:  
 Acme  
– sells  10  permits  to  USE  for  $150  each,  gets  $1500  
– uses  20  permits,  emits  20  tons  SO2  
– spends  $2000  to  reduce  emissions  by  20  tons  
– net  cost  to  Acme:    $2000  −  $1500  =  $500  
con$nued…  

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 2
B.  Answers,  con$nued  
• Goal:    reduce  emissions  from  80  to  60  tons  
• Cost  of  reducing  emissions:  
     $100/ton  for  Acme,  $200/ton  for  USE.  
 USE  
– buys  10  permits  from  Acme,  spends  $1500  
– uses  these  10  plus  original  30  permits,  emits  40  tons  
– spends  nothing  on  abatement  
– net  cost  to  USE  =  $1500  
 Total  cost  of  achieving  goal  =  $500  +  $1500  =  $2000  
 Using  tradable  permits,  goal  is  achieved  at  lower  total  cost  
and  lower  cost  to  each  firm  than  using  regula$on.  
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 Tradable  Pollu0on  Permits  
• A  tradable  pollu0on  permits  system  reduces  
pollu0on  at  lower  cost  than  regula0on.        
– Firms  with  low  cost  of  reducing  pollu0on    
do  so  and  sell  their  unused  permits.  
– Firms  with  high  cost  of  reducing  pollu0on    
buy  permits.      
• Result:    Pollu0on  reduc0on  is  concentrated  
among  those  firms  with  lowest  costs.      

28  
 Tradable  Pollu0on  Permits    
in  the  Real  World  
• SO2  permits  traded  in  the  U.S.  since  1995.  
• Nitrogen  oxide  permits  traded  in  the  northeastern  U.S.  
since  1999.  
• Carbon  emissions  permits  traded  in  Europe  since  
January  1,  2005.  

29  
 Correc0ve  Taxes  vs.    
Tradable  Pollu0on  Permits  
• Like  most  demand  curves,  firms’  demand  for  the  ability  
to  pollute  is  a  downward-­‐sloping  func0on  of  the  
“price”  of  pollu0ng.      
– A  correc0ve  tax  raises  this  price  and  thus  reduces  
the  quan0ty  of  pollu0on  firms  demand.  
– A  tradable  permits  system  restricts  the  supply  of  
pollu0on  rights,  has  the  same  effect  as  the  tax.      
• When  policymakers  do  not  know  the  posi0on  of  this  
demand  curve,  the  permits  system  achieves  pollu0on  
reduc0on  targets  more  precisely.      

30  
 Objec0ons  to  the    
Economic  Analysis  of  Pollu0on  
• Some  poli0cians,  many  environmentalists  argue  that  
no  one  should  be  able  to  “buy”  the  right  to  pollute,  
cannot  put  a  price  on  the  environment.  
• However,  people  face  tradeoffs.    The  value  of  clean  air  
and  water  must  be  compared  to  their  cost.    
• The  market-­‐based  approach  reduces  the  cost  of  
environmental  protec0on,  so  it  should  increase  the  
public’s  demand  for  a  clean  environment.    

31  
 Private  Solu0ons  to  Externali0es  
Types  of  private  solu0ons:  
• Moral  codes  and  social  sanc0ons,    
e.g.,  the  “Golden  Rule”  
• Chari0es,  e.g.,  the  Sierra  Club  
• Contracts  between  market  par0cipants  and  
the  affected  bystanders  

32  
 Private  Solu0ons  to  Externali0es  
• The  Coase  theorem:    
If  private  par0es  can  costlessly  bargain  over  
the  alloca0on  of  resources,  they  can  solve  the  
externali0es  problem  on  their  own.  

33  
 The  Coase  Theorem:    An  Example  
Dick  owns  a  dog  named  Spot.      
Nega0ve  externality:      
Spot’s  barking  disturbs  Jane,    
Dick’s  neighbor.      

©Viorel  Sima/ShuXerstock.com  
The  socially  efficient  outcome    
maximizes  Dick’s  +  Jane’s  well-­‐being.      
– If  Dick  values  having  Spot  more     See Spot bark.
than  Jane  values  peace  and  quiet,    
the  dog  should  stay.      
Coase  theorem:    The  private  market  will  reach  the  
efficient  outcome  on  its  own…      

34  
 The  Coase  Theorem:    An  Example  
• CASE  1:        
Dick  has  the  right  to  keep  Spot.      
Benefit  to  Dick  of  having  Spot  =  $500  
Cost  to  Jane  of  Spot’s  barking  =  $800  
• Socially  efficient  outcome:      
Spot  goes  bye-­‐bye.  
• Private  outcome:      
Jane  pays  Dick  $600  to  get  rid  of  Spot,    
both  Jane  and  Dick  are  beXer  off.    
• Private  outcome  =  efficient  outcome.  

35  
 The  Coase  Theorem:    An  Example  
• CASE  2:      
Dick  has  the  right  to  keep  Spot.      
Benefit  to  Dick  of  having  Spot  =  $1000  
Cost  to  Jane  of  Spot’s  barking  =  $800  
• Socially  efficient  outcome:      
See  Spot  stay.  
• Private  outcome:      
Jane  not  willing  to  pay  more  than  $800,    
Dick  not  willing  to  accept  less  than  $1000,    
so  Spot  stays.      
• Private  outcome  =  efficient  outcome.  
36  
 The  Coase  Theorem:    An  Example  
• CASE  3:      
Jane  has  the  legal  right  to  peace  and  quiet.    
Benefit  to  Dick  of  having  Spot  =  $800  
Cost  to  Jane  of  Spot’s  barking  =  $500  
• Socially  efficient  outcome:    Dick  keeps  Spot.  
• Private  outcome:    Dick  pays  Jane  $600  to  put  up  with  
Spot’s  barking.  
• Private  outcome  =  efficient  outcome.  

The private market achieves the efficient outcome

regardless of the initial distribution of rights.
37  
 ACTIVE LEARNING 3
Applying  Coase  
Collec0vely,  the  1000  residents  of  Green  Valley  
value  swimming  in  Blue  Lake  at  $100,000.    
A  nearby  factory  pollutes  the  lake  water,  and  
would  have  to  pay  $50,000  for  non-­‐pollu0ng  
equipment.    
A.  Describe  a  Coase-­‐like  private  solu0on.      

B.  Can  you  think  of  any  reasons  why  this  solu0on  

might  not  work  in  the  real  world?  

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why  Private  Solu0ons  Do  Not  Always  Work  
1.  Transac+on  costs:      
The  costs  par0es  incur  in  the  process  of    
agreeing  to  and  following  through  on  a  bargain.  
 These  costs  may  make  it  impossible  to  reach  a  
mutually  beneficial  agreement.    
2.  Stubbornness:      
Even  if  a  beneficial  agreement  is  possible,    
each  party  may  hold  out  for  a  beXer  deal.  
3.  Coordina0on  problems:  
If  #  of  par0es  is  very  large,  coordina0ng  them  
may  be  costly,  difficult,  or  impossible.  
39  
 Summary

• An  externality  occurs  when  a  market  

transac0on  affects  a  third  party.    If  the  
transac0on  yields  nega0ve  externali0es  (e.g.,  
pollu0on),  the  market  quan0ty  exceeds  the  
socially  op0mal  quan0ty.      
If  the  externality  is  posi0ve  (e.g.,  technology  
spillovers),  the  market  quan0ty  falls  short  of  
the  social  op0mum.  

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Summary

• Some0mes,  people  can  solve  externali0es  on  

their  own.    The  Coase  theorem  states  that  the  
private  market  can  reach  the  socially  op0mal  
alloca0on  of  resources  as  long  as  people  can  
bargain  without  cost.    In  prac0ce,  bargaining  is  
oien  costly  or  difficult,  and  the  Coase  
theorem  does  not  apply.  

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Summary

• The  government  can  aXempt  to  remedy  the  

problem.    It  can  internalize  the  externality  
using  correc0ve  taxes.    It  can  issue  permits  to  
polluters  and  establish  a  market  where  
permits  can  be  traded.    Such  policies  oien  
protect  the  environment  at  a  lower  cost  to  
society  than  direct  regula0on.  

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.