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. The marginal social cost of pollution is the additional cost
imposed on society as a whole by the additional unit.
b. 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. This is because it is progressively harder and therefore
more expensive, to achieve further reduction in
pollution as the total amount of pollution falls
c. 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?
a. 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 best-known 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. Economist and Nobel laureate
b. Pointed out that in an ideal world the private sector could
indeed deal with all externalities.
c. 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. Even if Mick has the legal right to play his music,
Christina could pay him not to.
ii. Or if Mick can’t play his music without an okay from
Christina, he can offer to pay her to give that OK.
c. 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.