Microeconomics
ECON 2302
May 2011
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 5
CHAPTER
5
Externalities,
Environmental Policy,
and Public Goods
How should government
policy deal with the problem
of pollution?
Can economic analysis help in
formulating more efficient
pollution policies?
CHAPTER
5
Externalities, Environmental Policy & Public Goods
Chapter Outline and Learning Objectives
5.1 Externalities and Economic Efficiency
Identify examples of positive and negative externalities and
use graphs to show how externalities affect economic
efficiency.
5.2 Private Solutions to Externalities: The Coase Theorem
Discuss the Coase theorem and explain how private
bargaining can lead to economic efficiency in a market with
an externality.
5.3 Government Policies to Deal with Externalities
Analyze government policies to achieve economic efficiency
in a market with an externality.
5.4 Four Categories of Goods
Explain how goods can be categorized on the basis of
whether they are rival or excludable, and use graphs to
illustrate the efficient quantities of public goods and common
resources.
Externalities, Environmental
Policy, and Public Goods
Externality A benefit or cost that affects someone who is
not directly involved in the production or consumption of
a good or service.
5.1 LEARNING OBJECTIVE
Identify examples of positive and negative externalities and use graphs
to show how externalities affect economic efficiency.
Externalities and Economic Efficiency
The Effect of Externalities
Private cost The cost borne by the producer of a good or
service.
Social cost The total cost of producing a good, including
both the private cost and any external cost.
Private benefit The benefit received by the consumer of a
good or service.
Social benefit The total benefit from consuming a good
or service, including both the private benefit and any
external benefit.
The Effect of Externalities: How a Negative Externality in Production
Because utilities do not bear
the cost of acid rain, they
produce electricity beyond
the economically efficient
level. Supply curve S1
represents just the marginal
private cost that the utility
has to pay.
Reduces Economic Efficiency
FIGURE 5-1
The Effect of Pollution on
Economic Efficiency
Supply curve S2 represents
the marginal social cost,
which includes the costs to
those affected by acid rain.
If the supply curve were S2,
rather than S1, market
equilibrium would occur at
price PEfficient and quantity
QEfficient, the economically
efficient level of output.
But when the supply curve is S1, the market equilibrium occurs at price PMarket
and quantity QMarket, where there is a DWL equal to the area of the yellow
triangle. Because of the deadweight loss, this equilibrium is not efficient.
The Effect of Externalities: How a Positive Externality in Consumption
Reduces Economic Efficiency
People who do not consume
college educations can still
benefit from them. As a
result, the marginal social
benefit from a college
education is greater than the
marginal private benefit
seen by college students.
FIGURE 5-2 The Effect of a Positive
Externality on Efficiency
Because only the marginal
private benefit is
represented in the market
demand curve D1, the
quantity of college
educations produced,
QMarket, is too low.
If the market demand curve were D2 instead of D1, the level of college educations
produced would be QEfficient, which is the efficient level. At the market equilibrium
of QMarket, there is a DWL equal to the area of the yellow triangle.
Externalities and Economic Efficiency
Externalities and Market Failure:
Market failure A situation in which the market fails to
produce the efficient level of output.
What Causes Externalities?
Property rights The rights individuals or businesses have
to the exclusive use of their property, including the right
to buy or sell it.
5.2 LEARNING OBJECTIVE Discuss the Coase Theorem and explain how private bargaining
can lead to economic efficiency in a market with an externality.
Private Solutions to Externalities: The Coase Theorem
The Problem of Transactions Costs
Transactions costs The costs in time and other resources
that parties incur in the process of agreeing to and carrying
out an exchange of goods or services.
The Coase Theorem
Coase theorem The argument of economist Ronald Coase
that if (1) transactions costs are low AND (2) all interested
parties can be identified, then private bargaining will
result in an efficient solution to the problem of
externalities.
Making
the
The Fable of the Bees
Connection
If there are positive
externalities in both apple
growing and bee-keeping,
the market may not supply
enough apple trees and
beehives.
Some apple growers and beekeepers
make private arrangements to arrive
at an economically efficient outcome.
Government intervention,
however, may not be
necessary because
beekeepers and apple
growers arrive at private
agreements.
5.3 LEARNING OBJECTIVE
Analyze government policies to achieve economic
efficiency in a market with an externality.
Government Policies to Deal with Externalities
Because utilities do not bear the
cost of acid rain, they produce FIGURE 5-5 When There Is a Negative Externality, a Tax
Can Bring about the Efficient Level of Output
electricity beyond the
economically efficient level. If
the government imposes a tax
equal to the cost of acid rain,
the utilities will internalize the
externality.
As a consequence, the supply
curve will shift up, from S1 to
S2.
The market equilibrium
quantity changes from QMarket,
where an inefficiently high
level of electricity is produced,
to QEfficient, the economically
efficient equilibrium quantity.
The price of electricity will rise from PMarket—which does not include the cost of acid
rain—to PEfficient—which does include the cost. Consumers pay the price PEfficient, while
producers receive a price P, which is equal to PEfficient minus the amount of the tax.
Government Policies to Deal with Externalities: The Economically
Efficient Level of Pollution Reduction
If the reduction of SO2
emissions is at 7.0 M
tons/year, the MB of $250
per ton is > the MC of
$175/ton. Further
reductions in emissions will
increase the net benefit to
society.
If the reduction of SO2
emissions is at 10.0 M tons,
the MC of $225/ton is > the
MB of $150/ton. An increase
in SO2 emissions will
increase the net benefit to
society.
Only when the reduction is at
8.5 M tons is the MB = MC.
This level is the
economically efficient level
of pollution reduction.
FIGURE 5-3
Government Policies to Deal with Externalities: The Economically
Efficient Level of Pollution Reduction
Increasing the reduction in SO2
emissions from 7.0 M tons to 8.5 M
tons results in total benefits equal
to the sum of the areas A and B
under the MB curve.
FIGURE 5-4
The TC of this decrease in pollution
is equal to the area B under the MC
curve.
TB > TC by an amount equal to the
area of triangle A.
Because the TB from reducing
pollution are > the TC, it’s possible
for those receiving the benefits to
arrive at a private agreement with
polluters to pay them to reduce
pollution.
Don’t Let This Happen to YOU!
Remember That It’s the Net Benefit That Counts
Making
the
Connection
The Clean Air Act:
How a Government Policy
Reduced Infant Mortality
The benefit of reducing air pollution in 1970 was much higher than
the benefit from a proportional reduction in air pollution would be
today, when the level of pollution is much lower. In the two years
following passage of the Clean Air Act, there was a sharp reduction
in air pollution and also a reduction in infant mortality.
Government Policies to Deal with Externalities:
Command and Control versus Market-Based Approaches
Command-and-control approach An approach that
involves the government imposing quantitative limits on
the amount of pollution firms are allowed to emit or
requiring firms to install specific pollution control
devices.
Pigovian taxes and subsidies Government taxes and
subsidies intended to bring about an efficient level of
output in the presence of externalities.
Solved Problem
5-3
Using a Tax to Deal with a Negative Externality
People who do not consume
college educations can
benefit from them. As a
result, the social benefit from
a college education is > the
private benefit seen by
college students. If the
government pays a subsidy
equal to the external benefit,
students will internalize the
externality.
The subsidy will cause the
demand curve to shift up,
from D1 to D2. The result
will be that market
equilibrium quantity shifts
from QMarket, where an
inefficiently low level of
college educations is
supplied, to QEfficient, the
economically efficient
equilibrium quantity.
Government Policies to Deal with Externalities:
Using a Subsidy to Reach the Economically
Efficient Level of Higher Education
FIGURE 5-6
When There Is a Positive Externality, a Subsidy
Can Bring about the Efficient Level of Output
Producers receive the price PEfficient, while
consumers pay a price P, which is equal to
PEfficient minus the amount of the subsidy.
Making
the
Connection
Can a Cap-and-Trade System
Reduce Global Warming?
Policymakers and economists have debated the mechanism by which
reductions in CO2 emissions should occur. The United States has favored a
global system of tradable emission permits for CO2 that would be similar to
the system for SO2 discussed earlier in this chapter.
5.4 LEARNING OBJECTIVE
Explain how goods can be categorized on the basis of whether they are rival or
excludable, & use graphs to illustrate the efficient quantities of public goods &
common resources.
Four Categories of Goods
Rivalry The situation that occurs when one person’s
consuming a unit of a good means no one else can
consume it.
Excludability The situation in which anyone who does
not pay for a good cannot consume it.
Four Categories of Goods
Goods and services can
be divided into four
categories on the basis
of whether people can
be excluded from
consuming them and
whether they are rival
in consumption.
A good or service is
rival in consumption if
one person consuming
a unit of a good means
that another person
cannot consume that
unit.
FIGURE 5-7
Four Categories of Goods
Four Categories of Goods
1. Private good A good that is both rival and excludable.
2. Public good A good that is both nonrivalrous and
nonexcludable.
Free riding Benefiting from a good without paying for it.
3. Quasi-public goods Goods that are excludable but not rival.
4. Common resource A good that is rival but not excludable.
Making
the
Connection
Should the Government
Run the Health Care System?
Because health care is so important to consumers and because
health care spending looms so large in the U.S. economy, the
role of the government in the health care system is likely to
be the subject of intense debate for some time to come.
Four Categories of Goods:
The Demand for a Public Good
FIGURE 5-9 Constructing the Market Demand Curve for a Private Good
The market demand curve for private goods is determined by adding horizontally the
quantity of the good demanded at each price by each consumer. For instance, in panel (a),
Jill demands 2 hamburgers when the price is $4.00; and in panel (b), Joe demands 4
hamburgers when the price is $4.00. So, a quantity of 6 hamburgers and a price of $4.00 is
a point on the market demand curve in panel (c).
FIGURE 5-10
Constructing the Market
Demand Curve for a
Public Good
To find the D
curve for a public
good, we add up
the prices for all
consumers, for
their willing to
purchase each Q
of the good.
In panel (a), Jill is
willing to pay $8/hr
for a security guard to
provide 10 hrs of
protection.
In panel (b), Joe
is willing to pay
$10 for that level
of protection.
Therefore, in panel
(c), the price of $18
per hour and the
quantity of 10 hours
will be a point on the
market demand
curve for security
guard services.
Four Categories of Goods:
The Optimal Quantity of a Public Good
The optimal
quantity of a
public good is
produced where
the sum of
consumer surplus
and producer
surplus is
maximized, which
occurs where the
D curve intersects
the S curve.
The Optimal Quantity
FIGURE 5-10 of a Public Good
In this case, the optimal quantity of security guard
services is 15 hours, at a price of $9 per hour.
5-4
Solved Problem
Determining the Optimal
Level of Public Goods
JILL
PRICE
(DOLLARS PER HOUR)
JOE
PRICE
(DOLLARS PER HOUR)
$20
18
16
14
12
10
8
6
4
2
QUANTITY (HOURS
OF PROTECTION)
0
1
2
3
4
5
6
7
8
9
$20
18
16
14
12
10
8
6
4
2
1
2
3
4
5
6
7
8
9
10
DEMAND OR MARGINAL SOCIAL BENEFIT
PRICE
(DOLLARS PER HOUR)
To calculate the marginal social
benefit of guard services, we
need to add the prices that Jill
and Joe are willing to pay at
each quantity.
QUANITY (HOURS
OF PROTECTION)
$38
34
30
26
22
18
14
10
6
QUANTITY (HOURS
OF PROTECTION)
1
2
3
4
5
6
7
8
9
5-4
Solved Problem
DEMAND OR MARGINAL SOCIAL
BENEFIT
PRICE
(DOLLARS PER
HOUR)
QUANTITY
(HOURS
OF PROTECTION)
$38
34
30
26
22
18
14
10
6
1
2
3
4
5
6
7
8
9
SUPPLY
PRICE
(DOLLARS PER
HOUR)
QUANTITY (HOURS
OF PROTECTION)
$8
10
12
14
1
2
3
4
16
18
20
5
6
7
22
24
8
9
Determining the Optimal
Level of Public Goods (continued)
For a common resource,
such as wood from a
forest, the efficient level
of use, QEfficient, is
determined by the
intersection of the D curve
- which represents the MB
received by consumers and S2, which represents
the MSCof cutting the
wood.
Because each individual
tree cutter ignores the
external cost, the
equilibrium quantity of
wood cut is QActual, which
is greater than the
efficient quantity. At the
equilibrium level of
output, there is a
deadweight loss, as shown
by the yellow triangle.
Common Resources
Tragedy of the commons
The tendency for a common
resource to be overused
FIGURE 5-11
Overuse of a Common Resource
AN INSIDE
LOOK
>> The Carbon Cap Dilemma
Using a carbon tax to reduce CO2 emissions.
KEY TERMS
Coase theorem
Command-and-control
approach
Private cost
Private good
Property rights
Common resource
Excludability
Externality
Public good
Rivalry
Free riding
Market failure
Pigovian taxes & subsidies
Private benefit
Social benefit
Social cost
Tragedy of the commons
Transactions costs
Before we begin Ch. 6 in class,
pre-read Ch. 6, including:
 Review Questions:
 3rd ed., p.194, 1.1-1.4; p 196 2.1, 2.2; p 198, 4.1, 4.2; p 200, 5.1;
p 201, 6.1 and “If demand for orange juice (OJ) is inelastic, will
a rise in the price of OJ increase or decrease the revenue
received by orange juice sellers?” (2nd ed., p. 200, 1.1-1.4; p. 202,
2.1 & 2.2; p. 204, 4.1 & 4.2; pp. 205-6, 5.1; p. 206, 6.1; 1st edition:
1-10, p. 193);
 Problems and Applications:
 3rd ed., p196, 2.5; p 197, 3.3; p 200, 5.2; p 201, 6.6 and “During 2001 in
Afghanistan, the Taliban outlawed growing poppies, from which opium
is made. Opium output fell by 95%, and the price of opium rose from
2,000 rupees/kg to 40,000 rupees/kg. What was the price elasticity of
demand for opium in Afghanistan?” (2nd ed., p. 202, 3.3; p. 206, 5.2; p.
202, 2.4; p. 207, 6.6; and 1st edition: 2, 3, 5, 6 & 18, pp. 193-195).