Chapter
10
Externalities
Market Failure
• Market Failure
– When the free market may not provide
economically efficient (ideal) outcome
• Sources
– Too little competition
• Monopoly/Cartels
– Too little output/total surplus (deadweight loss)
– Goods produced at too high a cost
– Asymmetric Information
Financial Markets (insider trading – Facebook IPO)
– Externalities (positive and negative)
2
Externalities
• Externality
– The uncompensated impact of one person’s
actions on the well-being of a bystander
– Negative externality
• Impact on the bystander is adverse
– Positive externality
• Impact on the bystander is beneficial
3
Externalities
• A more technical definition
A cost that is suffered by a third party as a
result of an economic transaction. In a
transaction, the producer and consumer are
the first and second parties, and third parties
include any individual, organization, property
owner, or resource that is indirectly affected by
the production or consumption of the good by
first/second parties.
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Externalities and Market Inefficiency
• Externalities
• Cause markets to allocate resources inefficiently
• Welfare economics: a recap
– Demand curve – value to consumers
• Prices they are willing to pay
– Supply curve – cost to suppliers
– Equilibrium quantity and price
• Efficient
– Maximizes sum of producer & consumer surplus
– Without externalities present
5
Negative Externalities – A Graph
A Cost Which is Incurred by Society That Should Be Accounted For
But those in the Market (1st and 2nd Parties) Don’t Have to Pay For It
6
Market Failure
Negative Externality – Not Accounted For in the
Market’s Pricing/Costing of the Good
Creates Deadweight Loss – Inefficient Use of Resources
7
Increased Health Care Costs
• Harvard Study: Coal Costs America $330-500 Billion Annually
• A Harvard University study published on Feb 17, 2011, has
determined that the true costs of using coal to generate
electricity in America are between $330 and $500 billion dollars
annually. The study, "Mining Coal, Mounting Costs -- The Life
Cycle Consequences of Coal" by the Harvard Medical School's
Center for Health and the Global Environment examines the
costs for so-called "cheap coal" that don't show up on the
monthly electric bill: the so-called "externalities" or hidden
costs.
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Graphically
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Externalities and Market Inefficiency
• Negative externalities - Pollution
– Cost to society (of producing electricity from
coal)
• Larger than the cost to the electric utilities
• Does not include damage from acid rain
– Social cost - supply
• Private costs of the producers
• Plus the costs to those bystanders affected
adversely by the negative externality
– Social cost curve – above the supply curve
(private costs)
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Figure 2
Pollution and the social optimum
Price of
Electricity
External
Cost
Social cost (private cost
and external cost)
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
Megawatts
of
Electricity
In the presence of a negative externality, such as pollution, the social cost of the good
exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the
equilibrium quantity, QMARKET.
QOPTIMUM QMARKET
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Externalities and Market Inefficiency
• Negative externalities
– Markets - produce a larger quantity than is
socially desirable
• Positive externalities
– Markets - produce a smaller quantity than is
socially desirable
• Government: “internalize” the externality
– Taxing goods that have negative externalities
– Subsidizing goods that have positive
externalities
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Public Policies Toward Externalities
• Command-and-control policies: regulation
– Regulate behavior directly
• Making certain behaviors either required or
forbidden
• Cannot eradicate pollution
– Environmental Protection Agency (EPA)
• Develop and enforce regulations
– Protecting the environment
• Dictates maximum level of pollution
• Requires that firms adopt a particular technology
to reduce emissions
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Public Policies Toward Externalities
• Market-based policies
– Provide incentives
• Private decision makers - choose to solve the
problem on their own
1. Corrective taxes and subsidies
– Corrective tax
• Induce private decision makers to take account of
the social costs that arise from a negative
externality
• Places a price on the right to pollute
• Reduce pollution at a lower cost to society
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Why is gasoline taxed so heavily?
• The gas tax = corrective tax
– Three negative externalities
• Congestion
• Accidents
• Pollution
– Doesn’t cause deadweight losses
– Makes the economy more efficient
• Less traffic congestion, safer roads, and cleaner
environment
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Why is gasoline taxed so heavily?
• How high should the tax on gasoline be?
– Most European countries
• Gasoline taxes - much higher than those in the U.S.
– 2007 study, Journal of Economic Literature
• Optimal corrective tax on gasoline was $2.10 per gallon
• Actual tax in the United States: 40 cents
• Tax revenue from a gasoline tax
– Lower taxes that distort incentives and cause
deadweight losses
– Some government regulations
• Production of fuel-efficient cars – unnecessary
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Public Policies Toward Externalities
• Market-based policies
2. Tradable pollution permits
– Voluntary transfer of the right to pollute from
one firm to another
– New scarce resource: pollution permits
– Market to trade permits
– Firm’s willingness to pay
• Depend on its cost of reducing pollution
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Public Policies Toward Externalities
2. Tradable pollution permits
– Advantage of free market for pollution permits
• Initial allocation of pollution permits
– Doesn't matter
• Firms - reduce pollution at a low cost
– Sell whatever permits they get
• Firms - reduce pollution only at a high cost
– Buy whatever permits they need
• Efficient final allocation
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Controlling Pollution
The following table shows the marginal costs for each of four firms (A, B, C, and D) to eliminate units of pollution from their
production processes. For example, for Firm A to eliminate one unit of pollution, it would cost $54, and for Firm A to eliminate a
second unit of pollution it would cost an additional $67.
Firm
Unit to be eliminated
A
B
C
D
First unit
54
57
54
62
Second unit
67
68
66
73
Third unit
82
86
82
91
Fourth unit
107
108
107
111
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Three Policy Approaches
• Suppose that the government determines that the optimal level
of pollution is 8 total units for the entire industry
• A) If the government requires each firm to reduce its current
level of pollution (4 units) by 50% (2 units each), what would be
the total cost of the industry (and to society) of reducing
pollution?
• B) What per-unit tax on emissions could the government set to
reduce pollution by 50%?
• C) Suppose that the government issues 2 tradable (can be sold
to another firm) to each firm. The firm can either use it to
reduce pollution by 50% (2 units) or can resell the permit to
another firm. But then will have to pay the marginal cost of
treating the unit for which the permit would have been used.
What would be the market price for the permit and how many
would be sold?
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Public Policies Toward Externalities
• Reducing pollution using pollution permits or
corrective taxes
– Firms pay for their pollution
• Corrective taxes - to the government
• Pollution permits, - buy permits
– Internalize the externality of pollution
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Figure 4
The equivalence of corrective taxes & pollution permits
(a) Corrective tax
Price of
pollution
(b) Pollution permits
Price of
pollution
1. A corrective tax sets
the price of pollution . . .
Supply of
pollution permits
1. Pollution
permits set
the quantity
of pollution . . .
Corrective tax
P
P
Demand for
pollution rights
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
0
Q
Quantity of
pollution
2. . . . which, together
with the demand curve,
determines the price
of pollution.
0
Demand for
pollution rights
Q
Quantity of
pollution
In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand curve
determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by
limiting the number of pollution permits, and the demand curve determines the price of pollution.
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The price and quantity of pollution are the same in the two cases.
Public Policies Toward Externalities
• Objections to the economic analysis of
pollution
• “We cannot give anyone the option of
polluting for a fee.” - former Senator Edmund
Muskie
• People face trade-offs
– Eliminating all pollution is impossible
– Clean water and clean air – opportunity cost
• Lower standard of living
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Public Policies Toward Externalities
• Clean environment - is a normal good
– Positive income elasticity
• Rich countries can afford a cleaner environment
– More rigorous environmental protection
– Clean air and clean water - law of demand
• The lower the price of environmental protection
– The more the public will want
• Economic approach
– Pollution permits and corrective taxes
• Reduces the cost of environmental protection
• Increase demand for a clean environment
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Private Solutions to Externalities
• The Coase theorem
– If private parties can bargain without cost
over the allocation of resources
• They can solve the problem of externalities on
their own
– Private economic actors
• Can solve the problem of externalities among
themselves
– Whatever the initial distribution of rights
• Interested parties - reach a bargain:
– Everyone is better off & Outcome is efficient
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Private Solutions to Externalities
• Why private solutions do not always work
– High transaction costs
• Costs that parties incur in the process of agreeing
to and following through on a bargain
– Bargaining simply breaks down
– Large number of interested parties
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Technology spillovers, industrial
policy, and patent protection
• Technology spillover = Positive externality
– Impact of one firm’s research and production efforts
on other firms’ access to technological advance
– Government: internalize the externality
• Subsidy = value of the technology spillover
• Industrial policy
– Government intervention in the economy that aims
to promote technology-enhancing industries
• Patent law
– Protect the rights of inventors by giving them
exclusive use of their inventions for a period of time
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