Externalities Ch10

ECO 230
J.F. O’Connor
Nature of externalities
Why do externalities cause market failure
Private solutions to an externality problem
Failure of private solutions
Government policies to solve externality
• An externality arises when the actions of a person
or business have an effect on a third party or
bystander. An externality is positive if the effect
on the bystander is beneficial and is negative if the
effect is harmful
• Examples: Acid rain, auto exhaust, barking dogs,
basic research, education, loud and nasty music
next door, cigarette smoke, wet lands, forests,
plant emissions into air or water supplies.
Essence of the Problem
• Person or firm making the decision does not
take account of the effects of its actions on
third parties.
• Plone producers use a pesticide which gets
into the rivers and reduces the volume of
fish that are caught
• A person investing in education does not
take account of the benefits that education
to other members of society
Private vs. Social Cost
• We need to distinguish between the firm’s
marginal cost, which we call the private
marginal cost (PMC) and society’s marginal
cost (SMC) which is the sum of the PMC
and the value of the fish lost by the
additional unit of output of plones. For a
competitive industry, the supply curve is the
sum of the private marginal costs of the
Market Failure
• Market solution: P = PMC
• Socially efficient solution, P = SMC
• Negative externality, PMC<SMC, so market
solution gives more output and a lower
price than is efficient. Hence, market
• See graph. Market solution: P=$.5, Q=70
Efficient solution: P=$.7, Q=60
Figure1. TheMarket for Plones
20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Quantity(bil. lb. per year)
Positive Externality
• Apple trees provide bees with nectar for
making honey. Apple trees generate a
positive externality for bee keepers but
apple growers don’t take account of that in
their decisions.
• Now, SMC < PMC. Market solution gives
less output and a higher price than is
• See graph.
Resolving Externality Problems
• Key is to internalize the cost or benefit of
the externality.
• Alternatives: private action or government
• Private solutions likely to work when
bargaining or transaction costs are low. That
is the essence of the Coase Theorem
Solving the Plone Problem
• The plone firms:
1. buy the fishing rights on the affected rivers
2. pay the fishermen $0.3 per unit of plones
• Government:
1. Limits the output of plones by means of quotas
2. imposes a tax of $0.3 per unit on plone producers
Private Solutions
• If the ownership of the fishing rights are
clear and they can be purchased without
major bargaining cost, then #1 will work.
• If fishermen are organized and negotiations
between the parties are not too costly, #2
will work.
• If both industries are perfectly competitive,
transaction costs are likely to be high
Government Solutions
• Number 1 will be costly to administer and if
quotas are not tradable will lead to
inefficiencies over time. If trading of quotas
is allowed, some of the inefficiencies are
• Number 2 will give a socially efficient
Solving the Apple Grower
• Apple grower generates a positive
externality and the beekeeper generates a
positive externality for the apple grower, it
seems likely that both can develop a
mutually beneficial arrangement without
incurring significant transaction cost.
• Other cases where private solution might
Other Examples of Externalities
Auto emissions of CO and CO2
Power plant emissions of SO2
Dogs – moral suasion?
Charitable giving
Power Plant Pollution
• Command and control – pollution quota or
emission permit – sets quantity of pollution
• Pigovian taxes – sets price of pollution
• Tradable pollution quotas or permits
• Note: the optimal level of pollution is not
• Economists favor taxes because it provides
an incentive to find ways to avoid the tax by
finding ways to reduce pollution
Tradable Pollution Permits
• Non tradable permits provide no incentive to
reduce pollution beyond the level in the permit.
• Steel mill and paper mill are both to reduce
pollution to 300 tons of glop per year
• Steel mill wants to increase emissions by 100
tons per year. Paper mill is willing to reduce its
emission by 100 tons in return for a payment of
$5 million. Should EPA allow the trade?
(Voluntary trade is mutually beneficial!)
Encourage activities with positive externalities
Discourage activities with negative externalities
Key is to internalize the externality
Private solutions likely to work if transaction
costs are low
• Taxes are usually better than regulations
• Tradable permits better than regulations