Module
Micro: 39
Econ: 75
Externalities and Public Policy
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• How external benefits and costs cause
inefficiency in markets.
• Why some government policies to deal
with externalities, such as emissions
taxes, tradable emissions permits, and
Pigouvian subsidies, are efficient,
although others, including environmental
standards, are not.
Arthur Cecil Pigou
Policies Toward Pollution
• Environmental
Standards
(emissions testing;
sewage treatment)
• Emissions Taxes
• Tradable Emissions
Permits
Production, Consumption, and
Externalities
• Private versus social benefits
• Private versus social costs
Externalities
A Pigouvian tax is a tax levied on a market activity
that generates negative externalities (or a subsidy
for a positive externality. The tax or subsidy is
intended to correct the market outcome. In the
presence of negative externalities, the social
cost of a market activity is not covered by the
private cost of the activity. In the presence of
positive externalities, the social benefit of a
market activity is not covered by the private
benefit of the activity.
Positive Externalities
When the
production and
consumption of a
good provides
benefits to third
parties, that good
is said to provide
positive
externalities to
society.
Price, MSB
S
Popt
Pmkt
Pcons
Subsidy
MPB
Qmkt Qopt
MSB
Qty home
improvements
Positive Externalities
• We can see that the market
under-produces goods that
generate positive externalities.
In other words, we don’t get
enough of a good thing.
• This is inefficient and produces
deadweight loss just like price
controls and monopoly. This
represents benefits that would
be enjoyed by society if the
socially optimal, not the market,
output was produced.
• The area of the deadweight
triangle is above the supply
curve, with base of (Qopt - Qmkt),
and height of (Pmsb – Pmkt),
Price, MSB
S
Popt
Pmkt
Pcons
Subsidy
MPB
Qmkt Qopt
MSB
Qty home
improvements
Positive Externalities
Price, MSB
• How could policy
eliminate the
deadweight loss?
• We could provide a
subsidy (called a
Pigouvian subsidy)
on each unit of home
improvement goods
demanded
S
Popt
Pmkt
Pcons
Subsidy
MPB
Qmkt Qopt
MSB
Qty home
improvements
Negative Externalities
Price, MSC
When the production
and consumption of a
good creates costs to
third parties, that
Popt
good is said to create Pmkt
negative externalities Pfirm
to society.
MSC
MPC
Tax
D
Qopt Qmkt
Qty electricity
Negative Externalities
• We can see that the market
over-produces goods that
Price, MSC
generate negative
externalities. In other words,
we get too much of a bad
thing.
• This is inefficient and
produces deadweight loss
just like price controls and
monopoly. This represents
additional costs that would
not be incurred by society if
the socially optimal, not the
market, output was
produced.
MSC
MPC
Popt
Pmkt
Tax
Pfirm
D
Qopt Qmkt
Qty electricity
Negative Externalities - Examples
• Smokers ignore the unintended but harmful impact
of toxic ‘passive smoking’ on non-smokers
• Acid rain from power stations in the UK can damage the
forests of Norway
• Air pollution from road use and traffic congestion
• The social costs of drug and alcohol abuse
• External costs of scraping the seabed for supplies of
gravel
Negative Externalities - Examples
• External costs of traveling by taxi
• The environment damage caused by the intensive
use of fertilizers in agriculture
• The external costs of cleaning up from litter and
the dropping of chewing gum
• The external costs of the miles that food travels
from producer to the final consumer
Network Externalities
A network externality exists when
the value to an individual of a good
or service depends on how many
other people use the same good or
service.
• When more people use Facebook
or Twitter, it becomes more
valuable to you.
Figure 75.1 In Pursuit of the Efficient Quantity of Pollution
Ray and Anderson: Krugman’s Economics for AP, First Edition
Copyright © 2011 by Worth Publishers
Figure 75.2 Environmental Standards versus Emissions Taxes
Ray and Anderson: Krugman’s Economics for AP, First Edition
Copyright © 2011 by Worth Publishers
Figure 75.3 Positive Externalities and Consumption
Ray and Anderson: Krugman’s Economics for AP, First Edition
Copyright © 2011 by Worth Publishers
Figure 75.4 Negative Externalities and Production
Ray and Anderson: Krugman’s Economics for AP, First Edition
Copyright © 2011 by Worth Publishers