Externalities
CHAPTER
9
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Explain why negative externalities lead to inefficient
overproduction and how property rights, pollution
charges, and taxes can achieve a more efficient
outcome.
2
Explain why positive externalities lead to inefficient
underproduction and how public provision,
subsidies, vouchers, and patents can achieve a
more efficient outcome.
EXTERNALITIES IN OUR DAILY LIVES
An externality is a cost or a benefit that arises from:
• Production that falls on someone other than the
producer
• Consumption that falls on someone other than the
consumer
Negative externality
A production or consumption activity that creates an
external cost.
Positive externality
A production or consumption activity that creates an
external benefit.
EXTERNALITIES IN OUR DAILY LIVES
Four types of externalities:
•
•
•
•
Negative production externalities
Positive production externalities
Negative consumption externalities
Positive consumption externalities
EXTERNALITIES IN OUR DAILY LIVES
Negative Production Externalities
Pollution is the major example of this type of externality.
Others are noise and congestion.
Positive Production Externalities
Example: Orchards provide positive production
externalities to honey producers, who in turn provide
positive production externalities to orchards.
EXTERNALITIES IN OUR DAILY LIVES
Negative Consumption Externalities
Smoking tobacco in a confined space
Noisy parties
Positive Consumption Externalities
A flu vaccination
Restoration of an historic building
Education and research
9.1 NEGATIVE EXTERNALITIES
Private Costs and Social Costs
Marginal private cost
The cost of producing an additional unit of a good or
service that is borne by the producer of that good or
service.
Marginal external cost
The cost of producing an additional unit of a good or
service that falls on people other than the producer.
9.1 NEGATIVE EXTERNALITIES
Marginal social cost
The marginal cost incurred by the entire society—by the
producer and by everyone else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal
private cost (MC) and marginal external cost.
MSC = MC + Marginal external cost
9.1 NEGATIVE EXTERNALITIES
Figure 9.1 shows the
relationship between
cost and output.
When output is 4,000 tons
of chemicals a month:
1. Marginal private
cost is $100 a ton.
2. Marginal external
cost is $125 a ton.
3. Marginal social cost is
$225 a ton.
9.1 NEGATIVE EXTERNALITIES
Production and Pollution: How Much?
When an industry is unregulated, the amount of
pollution it creates depends on the market equilibrium
price and the quantity of the good produced.
If the industry creates an external cost, the market
equilibrium is inefficient. Too much of the good is
produced.
9.1 NEGATIVE EXTERNALITIES
Figure 9.2 shows
inefficiency with an
external cost.
1. The market is in
equilibrium at a
price of $100 a ton
and 4,000 tons of
chemical a month is
inefficient.
2. Marginal social cost
exceeds ...
3. Marginal benefit.
9.1 NEGATIVE EXTERNALITIES
4. The efficient
quantity is 2,000
tons of chemical,
where marginal
social cost equals
marginal benefit.
5. The gray triangle
shows the deadweight loss created
by the pollution
externality.
9.1 NEGATIVE EXTERNALITIES
Property Rights
Property rights
Legally established titles to the ownership, use, and
disposal of factors of production and goods and
services that are enforceable in the courts.
9.1 NEGATIVE EXTERNALITIES
Figure 9.3 shows
how property
rights achieve an
efficient outcome.
1. With property
rights, the MC
curve that
excludes pollution
costs shows only
part of the
producers’
marginal cost.
9.1 NEGATIVE EXTERNALITIES
2. The marginal
private cost
curve includes
the cost of
pollution, and
the supply curve
is S = MC.
9.1 NEGATIVE EXTERNALITIES
3. Market
equilibrium is at a
price of $150 a
ton and a quantity
of 2,000 tons of
chemical a month
and is efficient
because…
4. Marginal social
cost equals
marginal benefit.
9.1 NEGATIVE EXTERNALITIES
The Coase Theorem
Coase theorem
The proposition that if property rights exist, only a small
number of parties are involved, and transactions costs
are low, then private transactions are efficient and the
outcome is not affected by who is assigned the property
right.
Transactions costs
The opportunity costs of conducting a transaction.
9.1 NEGATIVE EXTERNALITIES
Application of the Coase Theorem
• If factories own homes and river, the rent people
willingly pay decreases as the amount of pollution
increases.
• If homeowners own the river, factories must pay
homeowners for any pollution, and the more they
pollute, the more they pay.
• Regardless of who owns the river, so long as someone
owns it, the factories bear the cost of pollution, and the
quantity of production and pollution are efficient.
9.1 NEGATIVE EXTERNALITIES
Government Actions in the Face of External
Costs
The three main methods that governments can use to
achieve a more efficient allocation of resources in the
presence of external costs are:
• Emission charges
• Marketable permits
• Taxes
9.1 NEGATIVE EXTERNALITIES
Emission Charges
Emission charges confront the producers with the
external cost of pollution and provide an incentive
to seek technologies that are less polluting.
To work out the emission charge that achieves
efficiency, the regulator needs a lot of information
about the industry, which is generally not available.
9.1 NEGATIVE EXTERNALITIES
Marketable Permits
A marketable permit assigns to each producer in
an industry an emission limit.
Producers can buy and sell permits in the market.
Producers with a low marginal cost of reducing
pollution will sell permits and producers with a high
marginal cost of reducing pollution will buy.
Producers will buy and sell permits until their
marginal cost of pollution equals the market price
of a permit.
9.1 NEGATIVE EXTERNALITIES
Taxes
Figure 9.4 shows
the effects of a
pollution tax.
1. A pollution tax
is imposed that
is equal to the
marginal
external cost
arising from
pollution.
9.1 NEGATIVE EXTERNALITIES
The supply curve
becomes the
marginal private
cost curve, MC,
plus the tax—the
curve labeled
S = MC + tax.
9.1 NEGATIVE EXTERNALITIES
2. Market
equilibrium is at a
price of $150 a
ton and a quantity
of 2,000 tons of
chemical a month
and is efficient
because…
3. Marginal social
cost equals
marginal benefit.
9.1 NEGATIVE EXTERNALITIES
4. The
government
collects tax
revenue shown
by the purple
rectangle.
9.2 POSITIVE EXTERNALITIES
Private Benefits and Social Benefits
Marginal private benefit
The benefit of an additional unit of a good or service
that the consumer of that good or service receives.
Marginal external benefit
The benefit of an additional unit of a good or service
that people other than the consumer of the good or
service enjoy.
9.2 POSITIVE EXTERNALITIES
Marginal social benefit
The marginal benefit enjoyed by society—by the
consumers of a good or service and by everyone else
who benefits from it.
Marginal social benefit (MSB) is the sum of marginal
private benefit (MB) and marginal external benefit.
MSB = MB + Marginal external benefit
9.2 POSITIVE EXTERNALITIES
Figure 9.5 shows an
external benefit.
When 15 million students
attend college:
1. Marginal private benefit is
$10,000 per student.
2. Marginal external benefit is
$15,000 per student.
3. Marginal social benefit is
$25,000 per student.
9.2 POSITIVE EXTERNALITIES
Figure 9.6 shows
inefficiency with an
external benefit.
1. Market equilibrium is
at a tuition of $15,000
a year and 7.5 million
students and is
inefficient
because …
2. Marginal social
benefit exceeds …
3. Marginal cost.
9.2 POSITIVE EXTERNALITIES
4. The efficient
number of students
is 15 million.
5. The gray triangle
shows the
deadweight loss
created because
too few students
enroll in college.
9.2 POSITIVE EXTERNALITIES
Government Actions In the Face of External
Benefits
Four devices that governments can use to achieve a
more efficient allocation of resources in the presence of
external benefits:
•
•
•
•
Public provision
Private subsidies
Vouchers
Patents and copyrights
9.2 POSITIVE EXTERNALITIES
Public provision
The production of a good or service by a public
authority that receives the bulk of its revenue from the
government.
Subsidy
A payment that the government makes to private
producers to cover part of the costs of production.
Voucher
A token that the government provides to households
that can be used to buy specified goods or services.
9.2 POSITIVE EXTERNALITIES
Public provision
Figure 9.7(a) shows how
public provision can achieve
an efficient outcome.
1. Marginal social benefit equals
marginal cost with 15 million
students enrolled in college.
2. The efficient quantity.
3. Tuition is $10,000 per year.
4. The taxpayers cover the
remaining $15,000 of
marginal cost per student.
9.2 POSITIVE EXTERNALITIES
Private Subsidies
Figure 9.7(b) shows
how a subsidy achieves
an efficient outcome.
The efficient number of
students is 15 million.
1. A $15,000 subsidy
per student shifts
the supply curve to
S = MC – subsidy.
2. The equilibrium price
is $10,000 a student.
9.2 POSITIVE EXTERNALITIES
3. The market
equilibrium is
efficient with 15
million students
enrolled in college.
4. Marginal social
benefit equals
marginal cost.
9.2 POSITIVE EXTERNALITIES
Vouchers
Figure 9.8 shows
how vouchers can
achieve an efficient
outcome.
The demand curve is
D = MSB because…
1. With vouchers,
buyers are willing to
pay MB plus the
value of the voucher.
9.2 POSITIVE EXTERNALITIES
2. Market equilibrium
is efficient with 15
million students
enrolled in college.
3. Price, marginal
social benefit, and
marginal cost are
equal.
4. Tuition equals the
dollar price of
$10,000 plus the
value of the
voucher.
9.2 POSITIVE EXTERNALITIES
Intellectual property rights
The property rights of the creators of knowledge and
other discoveries.
Patent or copyright
A government-sanctioned exclusive right granted to the
inventor of a good, service, or productive process to
produce, use, and sell the invention for a given number
of years.
Externalities in YOUR Life
 Think about the negative and positive externalities that
play a huge part in your life.
 And think about the sticks and carrots that attempt to
align your self-interest with the social interest.
 You respond to the stick of the gas tax by buying a bit
less gas. With a bigger gas tax, our roads and highways
would have less traffic.
 You respond to the huge carrot of subsidized tuition by
being in school. Faced with full-cost tuition, many people
would quit school.
 Think about your attitude as a citizen-voter to these two
externalities: Should the gas tax be higher? Should
tuition be even lower?