Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Chapter 5.
Instructor: J INKOOK L EE
Department of Economics / Texas A&M University
ECON 202 504
Principles of Microeconomics

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Externalities
Four Categories of Goods
Externality : A benefit or cost that affects someone who is not directly involved in the production or consumption of a good.
both positive and negative externality are possible.
When there is an externality, competitive market does not work well.
with negative (positive) externalities, market may produce more (less) quantity than the efficient amount.
Government intervention can resolve problems from externalities, and may increase economic efficiency .

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Positive Externality or Negative Externality

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Effect of Externalities
Four Categories of Goods
An externality causes a difference between the private cost of production and the social cost.
Private cost : The cost borne by the producer of a good or service.
Social cost : The total cost of producing a good or service (private cost + external cost).
An externality also causes a difference between the private benefit of consumption and the social benefit.
Private benefit : The benefit received by the consumer of a good or service.
Social benefit : The total benefit from consuming a good or service
(private benefit + external benefit).

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
When a firm produce electricity, it only consider private costs.
private costs: cost of generating electricity.
social cost: private cost + external costs of pollution.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Summary of effects with market equilibrium, supply curve is above the demand curve.
marginal social cost is greater than the marginal benefit to consumers
( Q
Market
, P
Market
) is not efficient economic surplus is reduced by deadweight loss.
too much of the good will be produced.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
When students receive a college education, they can not capture all its benefits.
private benefit: benefit from learning knowledge.
social benefit: private benefit + external benefit from less crime.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Summary of effects with market equilibrium, demand curve is above the supply curve.
marginal social benefit is greater than the marginal cost.
( Q
Market
, P
Market
) is not efficient economic surplus is reduced by deadweight loss.
too little of the good will be produced.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Market Failure and Property Rights
Four Categories of Goods
Market failure : A situation in which the market fails to produce the efficient level of output due to externalities.
Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations.
Property rights : The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.
example: paper company

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Economically Efficient Level of Pollution Reduction
Sulfur dioxide emissions contribute to smog and acid rain. Then what is the economically efficient level of the pollutant? Zero?
At the economically efficient level, MB from pollutant reduction should equal MC.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Private Solutions to Externalities
Four Categories of Goods
When the reduction in the pollutant increase from 7.0(mt) to 8.5(mt),
Benefit and Cost
Total Benefit = $375 (A+B)
Total Cost = $255 (B)
Net Benefit = $120 (A)
Private Solution 1
People offer to pay the electric company
$255 (B)
Private Solution 2
Electric company pay people $255 (B) for the right to pollute.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Coase theorem : Private bargaining will result in an efficient solution to the problem of externalities, if transactions costs are low , if all parties to the agreement have full information about the costs and benefits associated with the externality, if all parties must be willing to accept a reasonable agreement.
Transactions costs : The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Government Policies on Negative Externalities
Pigouvian tax
When there is a negative externality, government impose a tax.
the tax should be equal to the cost of externality.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Four Categories of Goods
Government Policies on Positive Externalities
Subsidy
When there is a positive externality in consumption, government give consumers a subsidy, or payment.
the subsidy should be equal to the value of the externality.

Externalities/Economic Efficiency
Four Categories of Goods
Private Solutions to Externalities
Government Policies on Externalities
Rivalry / Excludability
Rival : one person’s consuming a unit of a good means no one else can consume it.
Non-rival : one person’s consumption does not interfere with another person’s consumption.
Excludable : anyone who does not pay for a good cannot consume it.
Non-excludable : it is im possible to exclude others from consuming the good, whether they have paid for it or not.

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Category of This Good?
Four Categories of Goods

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
Free Riding
Four Categories of Goods
A public good (e.g. national defence) is..
nonrival: your consuming national defense does not interfere with your neighbor’s consuming it.
nonexcludable: you cannot be excluded from consuming it, whether you pay for it or not.
Free riding : Benefiting from a (public) good without paying for it.
Q. How can an economy prevent free riding?

Externalities/Economic Efficiency
Private Solutions to Externalities
Government Policies on Externalities
The Tragedy of the Commons
Four Categories of Goods
Common resources (e.g. pasture) is..
rival: the grass one family’s cow ate is not available for another family’s cow.
nonexcludable: every family in the village has the right to use the pasture.
The Tragedy of the Commons : The tendency for a common resource to be overused.
Q. How can an economy prevent the tragedy of the commons?