CHAPTE
R 10
Externalities
Economics
PRINCIPLES OF
N. Gregory
Mankiw
http://www.kuaipan.cn/file/id_24772692758498024.htm
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these
questions:
What is an externality?
Why do externalities make market outcomes
inefficient?
What public policies aim to solve the problem of
externalities?
How can people sometimes solve the problem of
externalities on their own? Why do such private
solutions not always work?
2
Allocative Efficiency
• Allocative Efficiency
happens when the
level of output
maximizing society’s
total benefit.
• Allocative Efficiency
happens at the point
where:
MB = MC.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 5
management system for classroom use.
Introduction
One of the principles from Chapter 1:
Markets are usually a good way
to organize economy activity.
In absence of market failures, the competitive
market outcome is efficient, maximizes total surplus.
One type of market failure:
externality, the uncompensated impact of one
person’s actions on the well-being of a bystander.
Externalities can be negative or positive,
depending on whether impact on bystander is
adverse or beneficial.
EXTERNALITIES 6
Introduction
Self-interested buyers and sellers neglect the
external costs or benefits of their actions,
so the market outcome is not efficient.
Another principle from Chapter 1:
Governments can sometimes
improve market outcomes.
In presence of externalities, public policy can
improve efficiency.
EXTERNALITIES 7
Examples of Negative
Externalities
Air pollution from a factory
The neighbor’s barking dog
Late-night stereo blasting from
the dorm room next to yours
Noise pollution from
construction projects
Health risk to others from
second-hand smoke
Talking on cell phone while driving makes the
roads less safe for others
EXTERNALITIES 8
Recap of Welfare Economics
P The market for gasoline
$5 The market eq’m
maximizes consumer
+ producer surplus.
4 MPC
Supply curve shows
3 private cost, the costs
$2.50 directly incurred by sellers.
2
Demand curve shows
MPB private value, the value
1
to buyers (the prices they
are willing to pay).
0
0 10 20 25 30 Q
(gallons)
EXTERNALITIES 9
Analysis of a Negative Externality
P The market for gasoline MSC = MPC + MEC
$5 Social cost
MSC
= private + external cost
4 external MPC
Supply (private cost)
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)
EXTERNALITIES 10
Analysis of a Negative Externality
P The market for gasoline
The
The socially
socially
$5
MSC Social optimal
optimal quantity
quantity
cost is
is 20
20 gallons.
gallons.
4 MPC
S
3 At
At any
any Q
Q << 20,
20,
value
value of
of additional
additional gas
gas
exceeds
exceeds social cost.
2 At any Q > 20, cost.
At any Q social
> 20,
MPB
D social
social cost
cost ofof the
the
1 last
last gallon
gallon is
is
greater
greater than
than its
its value
value
0 to
to society.
society.
0 10 20 25 30 Q
(gallons)
EXTERNALITIES 11
Analysis of a Negative Externality
P The market for gasoline
$5
MSC Social Market eq’m
cost (Q = 25)
4 MPC
S is greater than
social optimum
3
(Q = 20).
2 One solution:
D tax sellers
MPB
1 $1/gallon,
would shift
0 S curve up $1.
0 10 20 25 30 Q
(gallons)
EXTERNALITIES 12
“Internalizing the Externality”
Internalizing the externality: altering incentives
so that people take account of the external effects
of their actions
In our example, the $1/gallon tax on sellers makes
sellers’ costs = social costs.
When market participants must pay social costs,
market eq’m = social optimum.
(Imposing the tax on buyers would achieve the
same outcome; market Q would equal optimal Q.)
EXTERNALITIES 13
Examples of Positive
Externalities
Being vaccinated against
contagious diseases protects
not only you, but people who
visit the salad bar or produce
section after you.
R&D creates knowledge
others can use.
People going to college raise
Thank you for
the population’s education not contaminating
level, which reduces crime the fruit supply!
and improves government.
EXTERNALITIES 14
Positive Externalities
In the presence of a positive externality,
the social value of a good includes
private value – the direct value to buyers
external benefit – the value of the
positive impact on bystanders
The socially optimal Q maximizes welfare:
At any lower Q, the social value of
additional units exceeds their cost.
At any higher Q, the cost of the last unit
exceeds its social value.
EXTERNALITIES 15
ACTIVE LEARNING 1
Analysis of a positive externality
P The market for flu shots
External benefit
$50 = $10/shot
40
Draw the social
value curve.
S= MPC
30 Find the socially
optimal Q.
20 What policy would
internalize this
10 externality?
D = MPB
0 Q
0 10 20 30 16
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= MPC
30
Social value MSB = MPB + MEB
20 = private value
+ $10 external benefit
10
D = MPB
0 Q
0 10 20 25 30 17
Effects of Externalities:
Summary
IfIf negative
negative externality
externality
market
market quantity
quantity larger
larger than
than socially
socially desirable
desirable
IfIf positive
positive externality
externality
market
market quantity
quantity smaller
smaller than
than socially
socially desirable
desirable
To
To remedy
remedy the
the problem,
problem,
“internalize
“internalize the
the externality”
externality”
tax
tax goods
goods with
with negative
negative externalities
externalities
subsidize
subsidize goods
goods with
with positive
positive externalities
externalities
EXTERNALITIES 18
Public Policies Toward
Externalities
Two approaches:
Command-and-control policies regulate
behavior directly. Examples:
limits on quantity of pollution emitted
requirements that firms adopt a particular
technology to reduce emissions
Market-based policies provide incentives so that
private decision-makers will choose to solve the
problem on their own. Examples:
corrective taxes and subsidies
tradable pollution permits
EXTERNALITIES 19
Corrective Taxes & Subsidies
Corrective tax: a tax designed to induce private
decision-makers to take account of the social
costs that arise from a negative externality
Also called Pigouvian taxes after Arthur Pigou
(1877-1959).
The ideal corrective tax = external cost
For activities with positive externalities,
ideal corrective subsidy = external benefit
EXTERNALITIES 20
Corrective Taxes & Subsidies
Other taxes and subsidies distort incentives and
move economy away from the social optimum.
Corrective taxes & subsidies
align private incentives with society’s interests
make private decision-makers take into account
the external costs and benefits of their actions
move economy toward a more efficient
allocation of resources.
EXTERNALITIES 21
Corrective Taxes vs. Regulations
Different firms have different costs of pollution
abatement.
Efficient outcome: Firms with the lowest
abatement costs reduce pollution the most.
A pollution tax is efficient:
Firms with low abatement costs will reduce
pollution to reduce their tax burden.
Firms with high abatement costs have greater
willingness to pay tax.
In contrast, a regulation requiring all firms to
reduce pollution by a specific amount not efficient.
EXTERNALITIES 22
Corrective Taxes vs. Regulations
Corrective taxes are better for the environment:
The corrective tax gives firms incentive to
continue reducing pollution as long as the cost of
doing so is less than the tax.
If a cleaner technology becomes available,
the tax gives firms an incentive to adopt it.
In contrast, firms have no incentive for further
reduction beyond the level specified in a
regulation.
EXTERNALITIES 23
Example of a Corrective Tax: The
Gas Tax
The gas tax targets three negative externalities:
Congestion
The more you drive, the more you contribute to
congestion.
Accidents
Larger vehicles cause more damage in an
accident.
Pollution
Burning fossil fuels produces greenhouse gases.
EXTERNALITIES 24
Tradable Pollution Permits
A tradable pollution permits system reduces
pollution at lower cost than regulation.
Firms with low cost of reducing pollution
sell whatever permits they can.
Firms with high cost of reducing pollution
buy permits.
Result: Pollution reduction is concentrated
among those firms with lowest costs.
EXTERNALITIES 25
Tradable Pollution Permits
Suppose the government aims to reduction pollution by 20%.
Firm A Firm B Firm C Total
Original
5,000 3,000 2,000 10,000
Pollution
Target
4,000 2,400 1,600 8,000
Pollution
Actual -400 +400
4,000 8,000
Pollution =2,000 =2,000
• Firm C has high abatement cost. It chooses to
buy pollution permit from Firm C to avoid the
high abatement cost.
• Firm B has low abatement cost. It reduces
pollution at low cost and sell the permit to Firm
C for a revenue.
EXTERNALITIES 26
Tradable Pollution 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.
As of June 2008, Barack Obama and John McCain
each propose “cap and trade” systems to reduce
greenhouse gas emissions.
EXTERNALITIES 27
Corrective Taxes vs.
Tradable Pollution Permits
Like most demand curves, firms’ demand for the
ability to pollute is a downward-sloping function of
the “price” of polluting.
A corrective tax raises this price and thus
reduces the quantity of pollution firms demand.
A tradable permits system restricts the supply
of pollution rights, has the same effect as the
tax.
When policymakers do not know the position of
this demand curve, the permits system achieves
pollution reduction targets more precisely.
EXTERNALITIES 28
Objections to the
Economic Analysis of Pollution
Some politicians, 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 & water must be compared to their cost.
The market-based approach reduces the cost of
environmental protection, so it should increase the
public’s demand for a clean environment.
EXTERNALITIES 29
CHAPTER SUMMARY
An externality occurs when a market transaction
affects a third party. If the transaction yields
negative externalities (e.g., pollution), the market
quantity exceeds the socially optimal quantity.
If the externality is positive (e.g., technology
spillovers), the market quantity falls short of the
social optimum.
30
CHAPTER SUMMARY
The government can attempt to remedy the
problem. It can internalize the externality using
corrective taxes. It can issue permits to polluters
and establish a market where permits can be
traded. Such policies often protect the
environment at a lower cost to society than direct
regulation.
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