Introduction to Externalities
1. The Economics of Pollution
a. Cost and Benefits of Pollution
i.
How much pollution should a society allow?
1.
This involves comparing the marginal benefit from an
additional unit of something with the marginal cost of
that additional unit
2. The same is true of pollution
a.
b.
The marginal social cost of pollution is the
additional cost imposed on society as a whole by the
additional unit.
The marginal social benefit of pollution is the
additional benefit to society from an additional unit of
pollution.
i.
Keep in mind that to avoid pollution requires the use
of money and inputs that could otherwise be used for
other purposes.
ii. Socially optimal quantity of pollution
1. This is the quantity of pollution that makes society
as well off as possible, taking all costs and benefits
into account.
2. Graphing and finding the socially optimal quantity
a.
Marginal Social Cost (MSC) is upward sloping.
i.
This shows how the marginal cost to society of an
additional ton of pollution emissions varies with
the quantity of emissions
b. Marginal Social Benefit (MSB) is downward
sloping.
i.
c.
This is because it is progressively harder and
therefore more expensive, to achieve further
reduction in pollution as the total amount of
pollution falls
The socially optimal output can be found where
MSB curve crosses the MSC curve.
3. The next questions to consider is will a market
economy, left to its self, arrive at the socially optimal
quantity of pollution?
i.
This answer is it won’t.
b. Pollution: An External Cost
i.
In a market economy without government
intervention, those who benefit from pollution (i.e.
owners of power companies) decide how much
pollution will occur.
1.
They have no incentive to take into account the costs
of pollution that they impose on others
ii. The cost of pollution fall on people who have no say
in the decision about how much pollution takes place.
iii. With the absence of government intervention, those
who derive the benefit of pollution do not have to
compensate those who bear the costs.
iv. The environmental cost of pollution is perhaps the bestknown and most important example of external cost.
1.
The uncompensated cost that an individual or firm
imposes on others.
v. Also keep in mind there are examples of external
benefits (benefits that individuals or firms confer on
others without receiving compensation).
vi. External costs and external benefits are jointly known as
externalities.
1. External cost are called negative externalities
2. External benefits are called positive externalities
c. The Inefficiency of Excess Pollution
i.
With the absence of government action, the
quantity of pollution will be inefficient: polluters
will pollute up to the point at which the marginal
benefit of pollution is zero.
1. Recall: that an outcome is inefficient if some
people could be made better off without making
others worse off.
d. Private Solutions to Externalities
i.
Can the private sector solve the problems of
externalities without government intervention?
1.
Ronald Coase
a.
b.
c.
Economist and Nobel laureate
Pointed out that in an ideal world the private sector
could indeed deal with all externalities.
Coase Theorem
i.
Even in the presence of externalities, an economy can
reach an efficient solution, provided that the legal
rights of the parties are clearly defined and the costs of
making a deal are sufficiently low.
2. The costs of making a deal are known as transaction
costs.
ii. Example to understand Coase Theorem
1. Imagine two neighbors, Mick and Christina, who
both like to barbecue in their backyards on
summer afternoons. Mick likes to play golden
oldies on his radio while barbecuing, but this
annoys Christina, who can’t stand that kind of
music.
2. Who prevails?
a.
There can be an outcome determined that does not
need to be based on legal rights.
b. Christina and Mick can make a private deal as long
as the legal rights are clearly defined.
i.
ii.
c.
Even if Mick has the legal right to play his music,
Christina could pay him not to.
Or if Mick can’t play his music without an okay
from Christina, he can offer to pay her to give that
OK.
These payments allow them to reach an efficient
solution.
iii. The implication of Coase’s analysis is that
externalities need not lead to inefficiency because
individuals have an incentive to make mutually
beneficial deals.
iv. When individuals do take externalities into account
when making decisions, economists say that they
internalize the externalities.
1. If externalities are fully internalized, the outcome
is efficient even without government intervention.
v. So why can’t individuals always internalize
externalities?
1. In many situations involving externalities,
transaction costs prevent individuals from making
efficient deals.
vi. Examples of transactions costs:
1. The cost of communication among the interested
parties
a.
Such cost may be very high if many people are
involved.
2. The cost of making legally binding agreements.
a.
Such cost may be high if expensive legal services
are required.
3. Costly delays involved in bargaining.
a.
Even if there is a potentially beneficial deal, both
sides may hold out in an effort to extract more
favorable terms, leading to increased effort and
forgone utility.
vii. When transaction costs prevent the private sector
from dealing with externalities, it is time to look for
government solutions.