Externalities
ECO 230
J.F. O’Connor
Topics
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Nature of externalities
Why do externalities cause market failure
Private solutions to an externality problem
Failure of private solutions
Government policies to solve externality
problems
Externality
• An externality arises when the actions of a
person have an effect on a third party or
bystander. An externality is positive if the
effect on the bystander is beneficial and is
negative if the effect is harmful
• Examples: Acid rain, auto exhaust, barking
dogs, basic research, education, loud and
nasty music next door, cigarette smoke, wet
lands, forests, plant emissions into air or
water supplies.
Essence of the Problem
• Person or firm making the decision does not
take account of the effects of its actions on
third parties.
• Waste water from a paper plant contains a
chemical that reduces the volume of fish in
the local river (Paper plants use large
amounts of water)
• A person investing in education does not
take account of the benefits that education
to other members of society
Private vs. Social Cost
• We need to distinguish between the firm’s
marginal cost, which we call the private
marginal cost (PMC) and society’s marginal
cost (SMC) which is the sum of the PMC
and the value of the fish lost by the
additional unit of output from the plant. For
a competitive industry, the supply curve is
the sum of the private marginal costs of the
firms.
Market Failure
• Market solution: P = PMC
• Socially efficient solution, P = SMC
• Negative externality, PMC<SMC, so market
solution gives more output and a lower
price than is efficient. Hence, market
failure.
• See graph. Market solution: P=$.5, Q=70
Efficient solution: P=$.7, Q=60
Figure1. TheMarket for Paper
NegativeExternality
1.2
P
r
i
c
e
$
p
e
SMC
1.0
0.8
S
0.6
0.4
,
D
0.2
0.0
20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Quantity(bil. lb. per year)
Positive Externality
• Apple trees provide bees with pollen from
which they make honey. Apple trees
generate a positive externality for bee
keepers.
• Now, SMC < PMC. Market solution gives
lees output and a higher price than is
efficient
• See graph.
Resolving Externality Problems
• Key is to internalize the cost or benefit of
the externality.
• Alternatives: private action and government
action.
• Private solutions likely to work when
bargaining or transactions cost are low. That
is the essence of the Coase Theorem
Solving the Paper Plant Problem
• The paper firms:
1. buy the fishing rights on the rivers that they use.
2. pay the fishermen $0.3 per unit of paper
• Government:
1. sets emission limits (pollution permits ) for the
firms
2. sets standard for the concentration of the chemical
in the river
3. imposes a tax of $0.3 per unit on paper producers
Private Solutions
• If the ownership of the fishing rights are
clear and they can be purchased without
major bargaining cost, then #1 will work.
• If fishermen are organized and negotiations
between the parties are not too costly, #2
will work.
Government Solutions
• Widely used by EPA. Leads to
inefficiencies. If trading of quotas is
allowed, some of the inefficiencies are
eliminated