© 2007 Thomson South-Western
Pollution
• Think about air pollution from
a factory.
• The firm does not have to
pay the costs associated with
pollution
• The firm will produce
more than the
socially efficient quantity.
• This is an example of a negative externality
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Education
• Private benefits of education
• Median income of college graduates $46,285
• $20,000 more than those with only high school diploma
• External benefits of education
• lower crime rates: educated people have more
opportunities, so less likely to rob and steal
• better government: educated people make better-informed
voters
• Result: Market equilibrium quantity of education will
be too low
• This is an example of a positive externality
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EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality refers to the uncompensated
impact of one person’s actions on the wellbeing of a bystander.
• Externalities cause markets to be inefficient,
and thus fail to maximize total surplus.
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EXTERNALITIES AND MARKET
INEFFICIENCY
• When the impact on the bystander is adverse,
the externality is called a negative externality.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.
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NEGATIVE EXTERNALITIES
• Examples:
– Automobile exhaust
– Barking dogs (loud
pets)
– Loud stereos in an
apartment building
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POSITIVE EXTERNALITIES
• Examples:
– Immunizations
– Restored historic buildings
– Research into new technologies
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Recap of Welfare Economics
The market for aluminum
P
$5
4
3
$2.50
2
1
0
0
10
20 25 30 Q
(tons)
Demand Curve reflects the
value of that product to those
consuming it, measured by
price that consumers are
willing (and able) to pay
 Assumed it captures all the
benefits associated with
consuming the next unit of a
good. (Private Value)
Supply Curve reflects the cost
to producers of making the
good
 Assumed it captures all
costs associated with creating
the next unit of the good
(Private Costs)
© 2007 Thomson South-Western
Recap of Welfare Economics
The market for aluminum
P
$5
The market eq’m
maximizes consumer
+ producer surplus
(or total surplus)
4
3
$2.50
 all units for which the
value placed on
production is greater
than the cost of creating
are produced
2
1
0
0
10
20 25 30 Q
(tons)
© 2007 Thomson South-Western
Application to Externalities
• The Market for Production of Aluminum
• Since the production of aluminum results in
pollution (a negative externality), the cost to society
of making aluminum is larger than the cost to
aluminum producers.
• For each unit of aluminum consumed, the social
cost includes the private costs of the producers plus
the cost to people/environment adversely affected
by the pollution (external costs).
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Analysis of a Negative Externality in Production
The market for aluminum
P
$5
Social cost
= private + external cost
4
External
cost
Supply (private cost)
3
External cost
= value of the
negative impact
on bystanders
2
1
0
0
10
20
30 Q
(tons)
= $1 per ton
(value of harm
from pollution)
© 2007 Thomson South-Western
Analysis of a Negative Externality in Production
The market for aluminum
P
$5
DWL
4
Social
cost
The socially
optimal quantity
is 20 gallons.
S At any Q < 20,
value of additional ton
exceeds social cost
3
2
D
1
0
0
10
At any Q > 20,
social cost of the
last ton is
greater than its value
Dead Weight Loss as
20 25 30 Q a result of externality?
(tons)
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Negative Externalities
• The intersection of the demand curve and the
social-cost curve determines the optimal output
level.
• The socially optimal output level is less than the
market equilibrium quantity.
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Analysis of a Negative Externality
The market for aluminum
P
$5
Social
cost
4
S
3
2
D
1
0
0
10
20 25 30 Q
(tons)
Market eq’m
(Q = 25)
is greater than
social optimum
(Q = 20)
One solution:
tax sellers
$1/ton,
would shift
supply curve
up $1.
© 2007 Thomson South-Western
Negative Externalities
• Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
• To achieve the socially optimal output…
• the government can internalize an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable
quantity.
© 2007 Thomson South-Western
Negative Externalities
• In the previous example, the $1/ton tax on
sellers makes sellers’ costs equal to social costs.
• When market participants must pay both the
private and external costs (social costs), the
market eq’m matches the social optimum.
(Imposing the tax on buyers would achieve the
same outcome; market Q would equal optimal
Q.)
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Analysis of a positive externality in consumption
P The market for flu shots
External benefit
= $10/shot
• Draw the social
value curve.
• Find the socially
optimal Q.
• What is the DWL?
• What policy would
internalize this
externality?
$50
40
S
30
20
10
D
0
Q
0
10
20
30
© 2007 Thomson South-Western
Answers
Socially optimal Q
= 25 shots
DWL = ½(10*5)=25
To internalize the
externality, use
subsidy = $10/shot.
P The market for flu shots
$50
external
benefit
40
DWL
30
S
Social value
= private value
+ external benefit
20
10
D
0
Q
0
10
20 25 30
© 2007 Thomson South-Western
PRIVATE SOLUTIONS TO
EXTERNALITIES
• Can people solve these problems on their own
(without government involvement)?
• Types of Private Solutions
– Moral codes and social sanctions (ex/littering)
– Charitable organizations (Sierra Club to protect
environment)
– Integrating different types of businesses (ex/Bees
and Orchard)
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The Coase Theorem
• The Coase theorem is a proposition that
• if private parties can bargain without cost over the
allocation of resources, they can solve the problem
of externalities on their own.
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The Coase Theorem: An Example
Dick owns a dog named Spot.
Negative externality:
Spot’s barking disturbs Jane,
Dick’s neighbor.
The socially efficient outcome
maximizes Dick’s + Jane’s well-being.
• If Dick values having Spot more
than Jane values peace & quiet,
the dog should stay.
See Spot bark.
Coase theorem: The private market will reach the
efficient outcome on its own…
© 2007 Thomson South-Western
The Coase Theorem: An Example
• CASE 1: Dick has the right to keep Spot.
Benefit to Dick of having Spot = $500
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome:
Spot goes bye-bye.
• Private outcome:
Jane pays Dick $600 to get rid of Spot,
both Jane and Dick are better off.
• Private outcome = Efficient outcome.
© 2007 Thomson South-Western
The Coase Theorem: An Example
• CASE 2: Dick has the right to keep Spot.
Benefit to Dick of having Spot = $1000
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome:
See Spot stay.
• Private outcome:
Jane not willing to pay more than $800,
Dick not willing to accept less than $1000,
so Spot stays.
• Private outcome = Efficient outcome.
© 2007 Thomson South-Western
The Coase Theorem: An Example
• CASE 3:
Benefit to Dick of having Spot = $800
Cost to Jane of Spot’s barking = $500
But Jane has the legal right to peace & quiet.
• Socially efficient outcome: Dick keeps Spot.
• Private outcome:
Dick pays Jane $600 to put up with Spot’s barking.
• Private outcome = Efficient outcome.
The private market achieves the efficient outcome
regardless of the initial distribution of rights.
© 2007 Thomson South-Western
ACTIVE LEARNING
2:
Brainstorming
Collectively, the 1000 residents of Green Valley value
swimming in Blue Lake at $100,000.
A nearby factory pollutes the lake water, and would have
to pay $50,000 for non-polluting equipment.
A. Describe a Coase-like private solution.
B. Can you think of any reasons why this solution
might not work in the real world?
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ACTIVE LEARNING
2:
Brainstorming
A. Describe a Coase-like private solution.
A good Coasian solution would be for each of the
1000 residents to chip in $75, so the town can offer
$75,000 to the factory to stop polluting.
© 2007 Thomson South-Western
ACTIVE LEARNING
2:
Brainstorming
B. Can you think of any reasons why this solution
might not work in the real world?
1. Transaction costs (cost of hiring lawyers)
2. Bargaining breakdown
3. Difficult to get so many people to agree on
something
© 2007 Thomson South-Western
Why Private Solutions Do Not Always
Work
• Transaction costs are the costs that parties incur in the
process of agreeing to and following through on a
bargain.
• Holdouts occur when a beneficial agreement is
possible but some parties hold out for a better deal.
• Coordination costs when the number of parties is very
large.
© 2007 Thomson South-Western
PUBLIC POLICIES TOWARD
EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through . . .
– command-and-control policies.
• limits on quantity of pollution emitted
• requirements that firms adopt a particular technology
to reduce emissions
– market-based policies.
• provide incentives so that private decision-makers will
choose to solve the problem on their own.
© 2007 Thomson South-Western
Command-and-Control Policies:
Regulation
• Usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
• Examples:
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
• Regulations are often used when the costs are so
high that the optimal quantity is zero (ex/dumping
poisonous chemicals into the water supply)
© 2007 Thomson South-Western
Market-Based Policy 1: Corrective Taxes
and Subsidies
• Corrective taxes are taxes enacted to correct
the effects of a negative externality.
• The ideal corrective tax = external cost
• Also known as Pigouvian Taxes after Arthur Pigou (18771959)
• Corrective subsidies are subsidies enacted to
adjust for the effects of a positive externality.
• The ideal corrective subsidy = external benefit
© 2007 Thomson South-Western
Regulation vs. Corrective Tax
• If the EPA decides it wants to reduce the
amount of pollution coming from a specific
plant. The EPA could…
• tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
• levy a tax of a given amount for each unit of
pollution the firm emits (i.e. corrective tax).
• Lets compare the costs associated with these
two approaches
© 2007 Thomson South-Western
Regulation vs. Corrective Tax
• Example Two Firms:
Acme and US Electric run coal-burning power plants.
Each emits 40 tons of sulfur dioxide per month. SO2
causes acid rain & other health issues.
• Policy goal: reducing SO2 emissions 25% (from 80-60)
• Policy options:
(1) Regulation
require each plant to cut emissions by 25%
(2) Corrective Tax
Make each plant pay a tax on each ton of SO2
emissions. Set tax at level that achieves goal.
© 2007 Thomson South-Western
Regulation vs. Corrective Tax
• Firms have different costs for reducing emissions:
• Acme – cost of reducing emissions is $100/ton
• US Electric – cost of reducing emissions is $200/ton
• Socially efficient outcome: Acme reduces emissions more
than US Electric.
(1) Regulation: Both firms will reduce missions by the
same amount.
(2) Taxation: Tax allocates this “good” to the firms who
value it most highly (ex/Tax of $150)
• US Electric will continue polluting and pay tax
• Acme will choose to reduce pollution rather than pay tax
© 2007 Thomson South-Western
Regulation vs. Corrective Tax
• Under regulation, firms have no incentive to reduce
emissions beyond the 25% target.
• A tax on emissions gives firms incentive to continue
reducing emissions as long as the cost of doing so is
less than the tax.
• If a cleaner technology becomes available,
the tax gives firms an incentive to adopt it.
© 2007 Thomson South-Western
Challenges associated with corrective tax
A lot of information is needed to get the tax right
 If tax is too high will restrict production too much,
causing inefficiency
 If tax is too low will not adequately reduce pollution.
 Is there a way that we can set the quantity and let the
market choose the price?
 Yes! Tradable Permits
© 2007 Thomson South-Western
Market-Based Policy 2: Tradable Pollution
Permits
• Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another.
• A market for these permits will eventually
develop.
• A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
© 2007 Thomson South-Western
Market-Based Policy #2:
Tradable Pollution Permits
• Alternative:
• issue 60 permits, each allows its bearer one ton of
SO2 emissions (so total emissions = 60 tons)
• give 30 permits to each firm
• establish market for trading permits
• Each firm can choose among these options:
• emit 30 tons of SO2, using all its permits
• emit < 30 tons, sell unused permits
• buy additional permits so it can emit > 30 tons
© 2007 Thomson South-Western
Market-Based Policy #2:
Tradable Pollution Permits
Suppose market price of permit = $150
US Electric
• buys 10 permits from Acme for $1,500
• emissions remain at 40 tons
• net cost to USE: $1,500
Acme
• sells 10 permits to US Electric for $1,500
• spends $2,000 to cut emissions by 20 tons
• net cost to Acme: $500
Total cost of achieving goal: $2,000
Total cost through regulation: $3,000
© 2007 Thomson South-Western
Market-Based Policy #2:
Tradable Pollution Permits
• A system of tradable pollution permits achieves goal at
lower cost than regulation.
• Firms with low cost of reducing pollution
sell whatever permits they can.
• Firms with high cost of reducing pollution
buy permits.
• Result: Pollution reduction is concentrated among
those firms with lowest costs.
© 2007 Thomson South-Western
Tradable Pollution Permits
in the Real World
• SO2 permits traded in the U.S. since 1995.
• Nitrogen oxide permits traded in the northeastern
U.S. since 1999.
• Carbon emissions permits traded in Europe since
January 1, 2005.
© 2007 Thomson South-Western