EXTERNALITIES: PROBLEMS AND

SOLUTIONS 5
5.1 Externality Theory
5.2 Private-Sector Solutions to Negative Externalities
5.3 Public-Sector Remedies for Externalities
5.4 Distinctions Between Price and Quantity Approaches
to Addressing Externalities
5.5 Conclusion
5 Introduction to Externalities: Global Warming

• In 1997, representatives from over 170 nations

met in Kyoto, Japan, to negotiate an
international pact to limit the emissions of
carbon dioxide.
• Carbon dioxide emissions contribute to global
warming, which could cause enormous
damage.
• The cost of reducing the use of fossil fuels,
particularly in the major industrialized nations,
is immense—perhaps 10% of GDP for the
United States.
 GLOBAL WARMING
• In most areas around the world, however, the
impacts of global warming would be unwelcome,
and in many cases, disastrous.

• The global sea level could rise by almost three feet,

increasing risks of flooding and submersion of low-
lying coastal areas.

• The burning of fossil fuels such as coal, oil, natural

gas, and gasoline produces carbon dioxide, which in
turn traps the heat from the sun in the Earth’s
atmosphere.
 EXTERNALITY
• Global warming due to emissions of fossil fuels is a classic
example of what economists call an externality.

• An externality occurs whenever the actions of one party

make another party worse or better off, yet the first party
neither bears the costs nor receives the benefits of doing so.

• Externalities occur in many everyday interactions. Can be

localized and small.

• Externalities also exist on a much larger scale, such as

global warming or acid rain.
 EXTERNALITY
• Externalities are a classic example of the
type of market failures discussed in
Chapter 1.

• Market failure: A problem that causes the market

economy to deliver an outcome that does not
maximize efficiency.

• Recall the question of when is appropriate

for the gov’t to intervene?
5
Externalities: Problems and Solutions

• Externalities can arise either from the

production of goods or from their
consumption.

• Externalities can be:

 negative
 or positive.
 NEGATIVE EXTERNALITY
• Eg. Steel plant next to a river  besides steel
produces a by-product dumps into the river
through pipes

• Steel plant not the only producer using river

Fishermen use the river catch fish for sale

• Steel plant dumps  less fish available for

catch.

• Steel plant exerting a negative production

5.1 Negative Externalities
• Negative production externality: When a
firm’s production reduces the well-being of
others who are not compensated by the firm.
o Pollution from steel production, dumped in
a river, hurts fishermen.
• Negative consumption externality: When an
individual’s consumption reduces the well-
being of others who are not compensated by
the individual.
o Smoking at a restaurant affects the health
and enjoyment of others.
PRIVATE/SOCIAL BENEFITS & COSTS

• Private benefits and costs are the

benefits and costs borne directly by the
actors in the steel market (the producers
and consumers of the steel products).

• Social benefits and costs are the private

benefits and costs plus the benefits and
costs to any actors outside this steel
market who are affected by the steel
plant’s production process (the
 5.1
Private and Social Marginal Cost

Negative production externalities drive a wedge

between private and social marginal cost.
• Private marginal cost (PMC): The direct cost to
producers of producing an additional unit of a
good.
• Social marginal cost (SMC): The private marginal
cost to producers plus any costs associated with the
production of the good that are imposed on others.
• The loss from pollution is a cost of production
imposed on others.
 5.1
Private and Social Marginal Benefit

Negative consumption externalities drive a wedge

between private and social marginal benefit.
• Private marginal benefit (PMB): The direct benefit to
consumers of consuming an additional unit of a good.
• Social marginal benefit (SMB): The private marginal
benefit to consumers, minus any costs associated
with the consumption of the good that are imposed
on others.
• The loss of health or dining pleasure is a cost of
smoking imposed on others.
5.1
APPLICATION: The Externality of SUVs

The consumption of large cars such as SUVs

produces three types of negative externalities:
1. Environmental externalities: Compact cars
get 25 miles/gallon, but SUVs get only 20.
2. Wear and tear on roads: Larger cars wear
down the roads more.
3. Safety externalities: The odds of having a
fatal accident quadruple if the accident is
with a typical SUV and not with a car of
the same size.
5.1
Positive Externalities

• Positive production externality: When a

firm’s production increases the well-
being of others but the firm is not
compensated by those others.
• Eg. Land with oil  Oil company drills 
Other companies can drill as well first
company exerts positive production
externality on other companies that drill
later.
POSITIVE CONSUMPTION EXTERNALITY

• Positive consumption externality: When an individual’s consumption

increases the well-being of others but the individual is not
compensated by those others.
• Ex. If my neighbor wants to improve the landscaping
around his house. Landscaping will cost him $1,000, but
it is only worth $800 to him. This better view would be
worth $300 to me.
• Total social marginal benefit of landscaping is $1,100,
even though the private marginal benefit to my
neighbor is only $800.
• Social marginal benefit ($1,100) is larger than the social
marginal costs ($1,000), it would be socially efficient for
my neighbor to do the landscaping.
5.2
Private-Sector Solutions to Negative Externalities:
The Solution

• Externalities undermine efficiency because one party

does not pay the costs or get all the (net) benefits of
its actions.
• The solution to this is therefore to internalize the
externality.
• Internalizing the externality: When either private
negotiations or government action lead the price to
the party to fully reflect the external costs or benefits
of that party’s actions.
o The fishermen could pay the steel producer to
reduce production.
5.3
Public-Sector Remedies for Externalities

Public policy makers employ three types of

remedies to resolve the problems associated
with negative externalities:
1. Corrective taxation to discourage use
2. Subsidies to encourage use
3. Regulation to directly change use
5.3
Corrective Taxation and Subsidies

• Taxes and subsidies change the private

marginal cost or marginal benefit
without affecting the social marginal
cost or benefit.

• They can therefore be used to

internalize the externality.
5.3
Regulation

• Regulation has been the traditional choice for

addressing environmental externalities in the
United States and around the world.

• In practice, there are complications that may

make taxes a more effective means of
addressing externalities.

• To see this, switch focus to “market for

pollution reduction.”
5.4
Uncertainty About Costs of Reduction:
Implications for Instrument Choice

• Using taxes leads to lower costs…

• ..but less control over the amount of pollution
reduction.
• The instrument choice depends on whether
the government wants to get the amount of
pollution reduction right or whether it wants
to minimize costs.
7
Public Goods: Trash Collection

Why don’t people pay to have their neighbor’s trash

collected?
• No one wants to pay, but everyone wants someone
else to pay.
• Private trash collection, financed by a voluntary fee
paid by neighborhood residents, faces the classic free
rider problem.
• Goods that suffer from this free rider problem are
known in economics as public goods.
 7.1
Optimal Provision of Public Goods
Goods that are pure public goods are
characterized by two traits.

First, they are non-rival in consumption; that is,

my consuming or making use of the good does not
in any way affect your opportunity to consume the
good.

Second, they are non-excludable; even if you

want to deny someone else the opportunity to
consume or access the public good.

Very few goods meet these conditions in practice.

 PURE PRIVATE GOODS
• Goods that are both excludable and rival are pure private
• goods.

• Private goods such as ice cream are completely rival.

• A private good IS rival and excludable.

• Ex. A private good is my car. Audi has manufactured a

• fixed number of A series sedans; there are not enough built
• for everyone to own one.

• My car is also excludable. No one else is allowed to drive it

 IMPURE PUBLIC GOODS

• Most of the goods as public goods are really impure

• public goods, which satisfy these two conditions to some
• extent but not fully.

• There are two types of impure public goods.

• Some goods are excludable, but not rival.

• Eg. Cable television: the use of cable TV by others in no way

• diminishes your enjoyment of cable, so consumption is non-
• rival. It is possible to exclude you from consuming cable TV.
 PURE PUBLIC GOODS
• Pure public goods are rare because there are few
• goods that are both not excludable and not rival.

• Eg. A pure public good is national defense.

• National defense is not rival because if someone builds a

• house next to yours, that action in no way diminishes your
• national defense protection.

• National defense is not excludable because once an area

• is protected by national defense, everyone in the area is
• protected:
 PUBLIC GOOD AS EXTERNALITY
• It is helpful to think about a public good as one with a large
• positive externality.

• Ex. If you set off fireworks high into the sky, it benefits
• many more people beyond yourself because many people
• will be able to see the display.

• You are not compensated for other people’s enjoyment,

• you can’t exclude others from seeing the fireworks, so you
• can’t charge them for their enjoyment.
 7.1
Defining Pure and Impure Public Goods

Is the good rival in consumption?

Yes No

Is the good Yes Private good Impure public good

excludable? (ice cream) (Cable TV)
No Impure public good Public good
(crowded sidewalk) (defense)
7.1
Optimal Provision of Public Goods

How much of the public good should society provide?

• Markets will not provide the correct amount.

• To answer this question, start by reconsidering the
market for a private good, ice cream cones.

• Ex. Ben and Jerry have different tastes for ice cream
(ice-cream), relative to the other good (cable).
• How does the market aggregate their preferences?
 PRIVATE-SECTOR UNDER-PROVISION

• In general, the private sector in fact underprovides

• public goods because of the free rider problem
• because your enjoyment of public goods is not
• solely dependent on your contribution to them, you
• will contribute less to their provision than is socially
• optimal.

• Since Ben’s consumption of missiles also benefits Jerry, Jerry may

not want to pay (or vice versa).
 PRIVATE SECTOR UNDER-PRODUCTION

• Suppose Ben and Jerry live by themselves far away from

• others. It is July 4th, and they want to have a celebration.
• For this celebration, they care about only two consumption
• goods: ice cream cones and fireworks.

• The price of each of these goods is $1, so for every

• firework they buy, they forgo a serving of ice cream. Ice
• cream is a private good here, but fireworks are a pure
• public good.
 PRIVATE SECTOR UNDERPRODUCTION
• Fireworks are non-rival because both Ben and Jerry can
• enjoy them without impinging on the other’s enjoyment, and
• fireworks are non-excludable because they explode high in
• the sky for both Ben and Jerry to see.

• Neither Ben nor Jerry cares about who sends up the

• firework, as long as it’s up in the sky for them to see. Both
• Ben and Jerry benefit equally from a firework sent up by
• either of them; what matters to them is the total amount of
• fireworks.
7.2
APPLICATION: The Free Rider Problem in Practice

The free rider problem is one of the most powerful

concepts in all of economics.
• Radio and television programming:
o WNYC has an estimated listening audience of
about 1 million people, but only 7.5% of their
listeners support the station.
o The United Kingdom uses a non-market solution:
The BBC charges an annual licensing fee to anyone
who owns and operates a TV!
7.2
APPLICATION: The Free Rider Problem in Practice

• File sharing:
o 85% of users of a file sharing program download
files only from others.
o The file-sharing software Kazaa gives download
priority to users according to their ratings, thus
discouraging free riders.
• Bicycle shares:
o Users were expected to return each bike riding.
o Within four days, not a single bicycle was left.
o Literal example of a “free ride.”
7.2
Can Private Providers Overcome the Free Rider
Problem?

• The free rider problem does not lead to a complete

absence of private provision of public goods.

• Plenty of private-sector TV programming

• The private sector can in some cases combat the free

rider problem to provide public goods by charging user
fees that are proportional to their valuation of the
public good.
7.2
APPLICATION: Business Improvement Districts

Clean, safe sidewalks are public goods.

• Cities attempt to provide them through street repair
and police work, financed with tax revenue.
• But New York City’s Times Square in the 1980s was a
failure:
“Dirty, dangerous, decrepit, and increasingly derelict”
• In 1992, a group of private firms formed a “Business
Improvement District” to improve the area
themselves.
7.2
APPLICATION: Business Improvement Districts
(BID)

How did this BID work?

• A (BID) is a legal entity that privately provides local
services and funds these services with fees charged to
local businesses.
• How do BIDs overcome free rider problem?
• NYC law allows BIDs to levy fees on non-paying
members, as long as 60% of members contribute.
• Resounding success:
• Crime has dropped significantly.
• The area is cleaner and more attractive.
• Business and tourism are booming.
7.2
Altruism

Private markets provide public goods when people

are altruistic.

• Altruistic: When individuals value the benefits

and costs to others in making their consumption
choices, that is, they care about the
outcomes of others as well as
themselves.

• If individuals are altruistic, they may be

willing to contribute to a public good
even if the free rider problem suggests
 ALTRUISM
• In terms of our model, this would be equivalent to Ben
caring not only about the costs of fireworks to himself but
the cost to Jerry as well, so that he is willing to contribute
more to lower Jerry’s burden.

• Many laboratory experiments provide evidence for altruism and show that
people contribute to public goods.

• Evidence for altruism comes from laboratory experiments of

the kind that are typically employed in other fields, such as
psychology, but that are gaining popularity as a means of
resolving difficult economic issues.
7.2
Warm Glow

People might simply feel good about contributing to

public goods or charity.

• Warm glow model: A model of the public goods

provision in which individuals care about both the
total amount of the public good and their particular
contributions as well.

• Different from altruism because people don’t care

about just the amount of the public good.
 7.3
Public Provision of Public Goods
Despite private provision, there is a role for government provision
of public goods:
• Under private provision, not everyone contributes to the good,
even though everyone benefits.
• Government provision potentially solves the problem of non-
contributors.
• Nonetheless, there are several challenges to government
provision.
• Three of those barriers: private responses to public
provision, or “crowd-out”; the difficulty of
measuring the costs and benefits of public goods;
and the difficulty of determining the public’s
preferences for public goods.
7.3
Private Responses to Public Provision: The Problem
of Crowd-Out

• Crowd-out: As the government provides more of a

public good, the private sector will provide less.
• Warm glow: If people care about contributions per se,
they may continue to contribute even when the
government contributes.
• Evidence on crowd-out: Mixed.
o No evidence for full crowd-out
o No consensus on the size of this important
individual response to government intervention
7.3
EVIDENCE: Measuring Crowd-Out

The evidence on crowd-out is mixed.

• Kingman (1989) looked at how contributions varied as
local governments contributed different amounts to
public radio.
• The study found that $1 increase in government
funding for public radio, private contributions fell by
13.5¢.
• Bias: Areas with high government contribution could
be high income, or have a high taste for radio.
7.3
EVIDENCE: Measuring Crowd-Out

Laboratory evidence seems more convincing.

• In another study, individuals tokens to a public good.
o A 2-token tax on every player was then contributed
to the public good.
o Without warm glow effects, players should have
reduced their contributions by 2 tokens.
o However, each player cut his or her contributions
by only 1.43 tokens.
• Unclear how well this result generalizes outside of the
lab, however.
7.3
Measuring the Costs and Benefits of Public Goods

The benefits of highway construction are also

difficult to measure.

• What is the value of the time saved for

commuters due to reduced traffic jams?

• And what is the value to society of the

reduced number of deaths if the highway is
improved?
 COSTS & BENEFITS OF PUBLIC GOODS
• There is a clear free rider problem in relying on the private
sector for this improvement.

• The benefits of highway improvement are fairly small for any

one driver, although they may be quite large for the total set
of drivers using the highway.

• Thus, no one driver will invest the necessary resources to

improve the highway.
7.3
How Can We Measure Preferences for the Public
Good?

Three challenges in measuring preferences for public

goods.
1. Preference revelation: People may not want to reveal
their true valuation because the government might
charge them more for the good if they say that they
value it highly.
2. Preference knowledge: People may not know what
their valuation is.
3. Preference aggregation: How can the government
combine the preferences of millions of citizens?
5.5
Conclusion

• Externalities arise when one party’s

actions affect another party, and the first
party doesn’t fully compensate the other
for this effect.
• Externalities are the classic answer to
the “when” question of public finance: If
externalities are present, then the
market has failed and intervention is
potentially justified.
5.5
Conclusion

• This naturally leads to the “how” question of

public finance. Two solutions:
1. Price-based measures (taxes and subsidies)
2. Quantity-based measures (regulation)
• Which of these methods will lead to the most
efficient regulatory outcome depends on
factors such as the heterogeneity of the firms
being regulated, the flexibility embedded in
quantity regulation, and the uncertainty over
the costs of externality reduction.