Externalities as
Market Failures
& the “Fixes”
Copyright©2004 South-Western
Mod
74-75
MARKET INEFFICIENCY/FAILURES
• Recall:
Adam Smith’s “invisible hand” of the
marketplace leads self-interested buyers and
sellers in a market to maximize the total benefit
that society can derive from a market.
But market failures can still happen.
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EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality refers to the uncompensated
impact of one person’s actions on the wellbeing of a bystander.
• Externalities cause markets to be inefficient,
and thus fail to maximize total surplus.
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EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality arises...
. . . when a person (or firm) engages in an activity
that influences the well-being of a bystander and yet
neither pays the cost nor receives any compensation
for that effect.
Think of an externality as a spill-over or side effect
of a transaction—affecting others NOT involved in
the actual market transaction.
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EXTERNALITIES AND MARKET
INEFFICIENCY
• When the impact on the bystander is harmful,
we label it an external cost or a negative
externality.
• When the impact on the bystander is beneficial,
we label it an external benefit or a positive
externality.
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative Externalities
•
•
•
•
Pollution
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Positive Externalities
• Immunizations
• Restored historic buildings
• Research into new technologies
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative externalities lead markets to produce
a larger quantity than is socially desirable.
• Why? B/c something “bad” is being produced
but a firm is not having to pay for it!!
• Positive externalities lead markets to produce
a smaller quantity than is socially desirable.
• Why? B/c something “good” is being produced
but a firm is not being paid for it!!
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NEGATIVE EXTERNALITIES
• In analyzing Negative Externalities, we use an S &
D graph of the market
• We call the Demand curve the MSB (Marginal
Social Benefit) curve
• We call the Supply curve the MPC curve,
representing the Private cost
• To “treat” or “remedy” the negative externality, we
show a shift in the Supply curve to show the lesser
amount of Supply of this good that we want, and call
that new Supply curve the MSC (Marginal Social
Cost) curve
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Aluminum as a Polluting good and the
Social Optimum
Price of
Aluminum
Marginal Social
Cost--MSC
Cost of
pollution
Supply
Optimum
Equilibrium
Demand
0
QOPTIMUM QMARKET
Quantity of
Aluminum
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Negative Externalities
Left alone, the market produces a greater
quantity than is socially desirable.
• So…we want to “fix” this market failure
• The intersection of the demand curve and the new
social-cost curve—the MSC curve—determines the
optimal output level.
• For a negative externality, the socially optimal output
level is ALWAYS less than the market equilibrium
quantity.
• The social cost of the good is higher than the private
cost of the good.
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Aluminum as a Polluting good and the
Social Optimum
Price of
Aluminum
Marginal Social
Cost--MSC
Cost of
pollution
Supply
Optimum
Equilibrium
Demand
0
QOPTIMUM QMARKET
Quantity of
Aluminum
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SOLUTIONS TO NEGATIVE EXTERNALITIES
• Internalizing an externality involves altering
incentives so that people take account and bear
the cost of the external effects of their actions.
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PUBLIC POLICY TOWARD
EXTERNALITIES
When negative externalities are significant
there are two ways to “fix” the market failure:
1. Public Policy through Government
action
2. Private solutions through use of the
Coase Theorem
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PUBLIC POLICY Through
GOVERNMENT ACTION
There are 2 types of Government Actions:
1. command-and-control policies.
2. market-based policies.
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GOVERNMENT PUBLIC POLICY
TOWARD EXTERNALITIES
1. Command-and-Control Policies
• Usually takes the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
• Examples:
• Requirements that all students be
immunized.
• Laws on pollution emission levels
• Limits on fish allowed to be caught
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GOVERNMENT PUBLIC POLICY
TOWARD EXTERNALITIES
2. Market-Based Policies
There are 2 types:
A. Pigouvian taxes are taxes enacted to
correct the effects of a negative
externality.
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Pigouvian Taxes
Pigouvian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigouvian
tax sets the
price of
pollution . . .
0
Demand for
pollution rights
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
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© 2004
South-Western
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© 2004
South-Western
GOVERNMENT PUBLIC POLICY
TOWARD EXTERNALITIES
2. Market-Based Policies
B.Cap and Trade permits allow the
voluntary transfer of the right to create the
negative externality from one firm to
another—creating a market for the “right” to
pollute!
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Pollution Permits: An equivalent solution to taxation
Pollution Permits
Price of
Pollution
Supply of
pollution permits
P
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Q
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
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GOVERNMENT PUBLIC POLICY
TOWARD EXTERNALITIES
EXAMPLE of CAP & TRADE PERMITS
• Pollution Permits
• allow the voluntary transfer of the right to pollute
from one firm to another.
• A market for these permits will eventually
develop.
• A firm that can reduce pollution at a low cost
may prefer to sell its permit to a firm that can
reduce pollution only at a high cost.
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Cap and Trade Endorsement
“We now believe that tradable permits are
the most straightforward system of reducing
emissions and creating the incentives necessary
for massive reductions.”
Kert Davies, research director, Greenpeace USA
• Wall Street Journal - August 23, 2005
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COMPARING GOVERNMENT PUBLIC
POLICY TOWARD EXTERNALITIES
Regulation vs Pigouvian Tax vs Tradeable Permits
If the EPA decides it wants to reduce the amount of
pollution coming from a specific plant or industry, the
EPA could…
• tell the firm(s) to reduce pollution by a specific amount
(Command/Control Regulation). This costs $ for admin of
the agency and enforcement
OR
• levy a tax of a given amount for each unit of pollution the
firm(s) emits (Pigovian Tax). This reduces number of firms
in the market
OR
• create pollution permits that allow the voluntary transfer of
the right to pollute from one firm to another. (Cap and Trade
Permits). This creates a market for firms to continue in.
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PRIVATE SOLUTIONS TO
NEGATIVE EXTERNALITIES
• Government action is not always needed to
internalize a negative externality, or to solve the
problem of externalities.
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THE COASE THEOREM
• The Coase Theorem (1960) is a proposition
that if private parties can bargain over the
allocation of resources, they can solve the
problem of externalities on their own.
• Cost/Benefit Analysis needs to include
Transaction Costs
• Transaction costs –the costs that parties incur in
the process of agreeing to and following through on
a bargain
• Lawyer fees, surveying lands, monitoring equip, etc, are
examples of transaction costs
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WHEN THE COASE THEOREM
FAILS
• Sometimes the private solution approach fails
because transaction costs can be so high that
private agreement is not possible.
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Positive Externalities
• Immunizations
• Restored historic buildings
• Research into new technologies
Copyright © 2004 South-Western
POSITIVE EXTERNALITIES
• In analyzing Positive Externalities, we use an
S & D graph of the market
• We call the Supply curve the MPC curve,
representing the Private cost
• We call the Demand curve the MPB (Marginal
Private Benefit) curve
• We show a shift in the Demand curve to show
the greater amount of Demand of this good
that we want, and call that new Demand curve
the MSB (Marginal Social Benefit) curve
Copyright © 2004 South-Western
Education and the Social Optimum
Price of
Education
Supply
Demand
0
QMARKET
QOPTIMUM
(Marginal Social
Benefit—MSB)
Quantity of
Education
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© 2004
South-Western
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© 2004
South-Western
Positive Externalities
Left alone, the market produces a lesser
quantity than is socially desirable.
• The intersection of the supply curve—the MPC
curve—and the social-value curve—the MSB curve—
determines the optimal output level.
• For a positive externality, the socially optimal output
level is ALWAYS more than the market equilibrium
quantity.
• The social benefit or value of the good exceeds the
private value of the good.
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PUBLIC POLICY TOWARD
EXTERNALITIES
When positive externalities are significant and
private solutions are not found, government
may attempt to solve the problem through . . .
Subsidies.
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Achieving the Socially Optimal Output
The government can internalize a positive
externality by:
Providing a subsidy for the production of
more of the desired good
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