CHAPTER 1
Externalities
After studying this chapter you will be able to
Explain how externalities arise
Explain why negative externalities lead to inefficient
overproduction and how property rights, emission
charges, marketable permits, and taxes can be used to
achieve a more efficient outcome
Explain why positive externalities lead to inefficient
underproduction and how public provision, subsidies,
vouchers, and patents can increase economic efficiency
Greener and Smarter
Environmental issues are at the same time everybody’s
problem and nobody’s problem.
Human beings are learning more and more every day.
But are we learning more at a fast enough pace?
How can we ensure that we use resources efficiently in the
face of externalities?
Externalities in Our Lives
An externality is a cost or benefit that arises from
production and falls on someone other than the producer,
or a cost or benefit that arises from consumption and falls
on someone other than the consumer.
A negative externality imposes a cost and a positive
externality creates a benefit.
Externalities in Our Lives
The four types of externality are
Negative production externalities
Positive production externalities
Negative consumption externalities
Positive consumption externalities
Externalities in Our Lives
Negative Production Externalities
Negative production externalities are common.
Some examples are noise from aircraft and trucks,
polluted rivers and lakes, the destruction of animal habitat,
and air pollution in major cities from auto exhaust.
Externalities in Our Lives
Positive Production Externalities
Positive production externalities are less common that
negative externalities.
Two examples arise in honey and fruit production. By
locating honeybees next to a fruit orchard, fruit production
gets an external benefit from the bees, which pollinate the
fruit orchards and boost fruit output; and honey production
gets an external benefit from the orchards.
Externalities in Our Lives
Negative Consumption Externalities
Negative consumption externalities are a common part of
everyday life.
Smoking in a confined space poses a health risk to others;
noisy parties or loud car stereos disturb others.
Externalities in Our Lives
Positive Consumption Externalities
Positive consumption externalities are also common.
When you get a flue vaccination, everyone you come into
contact with benefits.
When the owner of an historic building restores it,
everyone who sees the building gets pleasure.
Negative Externalities: Pollution
Pollution is an old problem and is faced by both rich
industrial countries and poor developing countries.
It is an economic problem that is coped with by balancing
benefits and costs.
Negative Externalities: Pollution
The Demand for a Pollution-Free Environment
The demand for a pollution-free environment is expressed
through the political process and this demand has
increased for two reasons:
Higher incomes: A high-quality environment is a “normal
good,” the demand for which increases with income.
Greater awareness: Greater knowledge about the causes
of environmental problems raises understanding of
environmental issues.
Negative Externalities: Pollution
The Sources of Pollution
Three sources of environmental pollution problems are
Air pollution
Water pollution
Land pollution
Negative Externalities: Pollution
Figure 15.1 shows some
20-year trends in air
pollution in the United
States.
Negative Externalities: Pollution
Private Costs and Social Costs
A private cost of production is a cost that is borne by the
producer, and marginal private cost (MC) is the private
cost of producing one more unit of a good or service.
An external cost of production is a cost that is not borne by
the producer but is borne by others.
Marginal external cost is the cost of producing one more
unit of a good or service that falls on people other than the
producer.
Negative Externalities: Pollution
Marginal social cost is the marginal cost incurred by the
entire society—by the producer and by everyone else on
whom the cost falls—and is the sum of marginal private
cost and marginal external cost.
That is,
MSC = MC + Marginal external cost.
We express costs in dollars but must remember that the
dollars represent the value of a forgone opportunity.
Marginal private cost, marginal external cost, and marginal
social cost increase with output.
Negative Externalities: Pollution
Figure 15.2 illustrates the
MC curve,
the MSC curve,
and marginal external cost
as the vertical distance
between the MC and MSC
curves.
Negative Externalities: Pollution
Production and Pollution: How Much?
In the market for a good with an externality that is
unregulated, the amount of pollution created depends on
the equilibrium quantity of the good produced.
Negative Externalities: Pollution
Figure 15.3 shows the
equilibrium in an
unregulated market with
an external cost.
The quantity produced is
where marginal private
cost equals marginal
social benefit.
Negative Externalities: Pollution
MSB is less than MSC in
the market equilibrium, so
the market equilibrium is
inefficient.
The efficient quantity is
where marginal social cost
equals marginal benefit.
The competitive market
overproduces and creates
a deadweight loss.
Negative Externalities: Pollution
Property Rights
Externalities arise because of the absence of property
rights.
Property rights are legally established titles to the
ownership, use, and disposal of factors of production and
goods and services that are enforceable in the courts.
Negative Externalities: Pollution
Figure 15.4 uses the
example in Figure 15.3 to
illustrate how the
establishment of property
rights achieves an efficient
outcome.
The polluter bears all the
costs.
The market equilibrium is
efficient because
MSC = MSB.
Negative Externalities: Pollution
The Coase Theorem
The Coase theorem is a proposition that if property rights
exist, if only a small number of parties are involved, and if
transactions costs (defined below) are low, then private
transactions are efficient.
There are no externalities because all parties take into
account the externalities involved. The outcome is
independent of who has the property rights.
Negative Externalities: Pollution
The Coase solution works only if transaction costs are low.
Transactions costs are the cost of conducting a
transaction.
An example is the transactions costs of buying a home
include fees for a realtor, a mortgage loan advisor, and
legal assistance.
When a large number of people are involved in an
externality and transactions costs are high, the Coase
solution of establishing property rights doesn’t work and
governments try to deal with the externality.
Negative Externalities: Pollution
Government Actions in the Face of External Costs
There are three main methods that the government uses
to cope with external costs:
Taxes
Emission charges
Marketable permits
Negative Externalities: Pollution
Taxes
The government can set a tax equal marginal external
cost.
The effect of such a tax is to make marginal private cost
plus the tax equal to marginal social cost,
MC + tax = MSC.
This tax is called Pigovian tax, in honor of the British
economist Arthur Cecil Pigou, who first proposed dealing
with externalities in this fashion.
Negative Externalities: Pollution
Figure 15.5 shows how a
pollution tax equal to the
marginal external cost
can achieve an efficient
outcome because
MSC = MSB.
The government collect a
tax revenue.
Negative Externalities: Pollution
Emissions Charges
The government sets a price per unit of pollution, so that
the more a firm pollutes, the higher are its emissions
charges.
For the emissions charge to induce the firm to generate
the efficient level of pollution, the government would need
a lot of information that is usually unavailable.
Negative Externalities: Pollution
Marketable Permits
Each firm is assigned a permitted amount of pollution per
period and firms trade permits.
The market price of a permit confronts polluters with the
social marginal cost of their actions and leads to an
efficient outcome.
This method was used successfully to decrease lead
pollution in the United States.
Positive Externalities: Knowledge
Knowledge comes from education and research and
creates external benefits.
Private Benefits and Social Benefits
A private benefit is a benefit that the consumer of a good
or service receives, and marginal private benefit (MB) is
the private benefit from consuming one more unit of a
good or service.
An external benefit is a benefit that someone other than
the consumer receives. Marginal external benefit is the
benefit from consuming one more unit of a good or service
that people other than the consumer enjoy.
Positive Externalities: Knowledge
Marginal social benefit is the marginal benefit enjoyed by
the entire society—by the consumer and by everyone else
on whom the benefit falls.
Marginal social benefit is the sum of marginal private
benefit and marginal external benefit. That is:
MSB = MB + Marginal external benefit.
Positive Externalities: Knowledge
Figure 15.6 illustrates the
marginal private benefit,
marginal external benefit,
and marginal social
benefit.
It identifies marginal
external benefit as the
vertical distance between
the MB and MSB curves.
Positive Externalities: Knowledge
Figure 15.7 shows how
a private market
underproduces an item
that generates an
external benefit
and creates a
deadweight loss.
Positive Externalities: Knowledge
Government Action in the Face of External Benefits
Four devices that the government can use to achieve a
more efficient allocation of resources in the presence of
external benefits are
Public provision
Private subsidies
Vouchers
Patents and copyrights
Positive Externalities: Knowledge
Public Provision
Under public provision,
a public authority that
receives payment from
the government produces
the good or service.
Figure 15.8(a) shows how
public provision can
achieve an efficient
outcome.
Positive Externalities: Knowledge
Private Subsidies
A subsidy is a payment by the government to private
producers.
If the government pays the producer an amount equal to
the marginal external benefit for each unit produced, the
quantity produced is efficient.
Positive Externalities: Knowledge
Figure 15.8(b) shows
how a subsidy can
achieve an efficient
outcome.
Positive Externalities: Knowledge
Vouchers
A voucher is a token that
the government provides
to households, which they
can use to buy specified
goods or services.
Figure 15.9 shows how
vouchers can achieve a
more efficient outcome.
Positive Externalities: Knowledge
Patents and Copyrights
Intellectual property rights give the creator of knowledge
the property right to the use of that knowledge.
The legal device for establishing an intellectual property
right is the patent or a copyright.
A patent or copyright is a government-sanctioned
exclusive right given to an inventor of a good, service or
productive process to use to produce, use and sell the
invention for a given number of years.
THE END
