Externalities CHAPTER 8

When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome. 1 Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome. 2

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 EXTERNALITIES IN OUR DAILY LIVES

8.1 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.

8.1 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

8.1 NEGATIVE EXTERNALITIES Figure 8.1 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.

8.1 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.

8.1 NEGATIVE EXTERNALITIES 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 Marginal benefit. Figure 8.2 shows inefficiency with an external cost.

8.1 NEGATIVE EXTERNALITIES 5. The gray triangle shows the dead- weight loss created by the pollution externality. 4. The efficient quantity is 2,000 tons of chemical, where marginal social cost equals marginal benefit.

8.1 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.

8.1 NEGATIVE EXTERNALITIES Figure 8.3 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.

8.1 NEGATIVE EXTERNALITIES 2. The marginal private cost curve includes the cost of pollution, and the supply curve is S = MC.

8.1 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.

8.1 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.

8.1 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.

8.1 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

8.1 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.

8.1 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.

8.1 NEGATIVE EXTERNALITIES Taxes 1. A pollution tax is imposed that is equal to the marginal external cost arising from pollution. Figure 8.4 shows the effects of a pollution tax.

8.1 NEGATIVE EXTERNALITIES The supply curve becomes the marginal private cost curve, MC, plus the tax—the curve labeled S = MC + tax.

8.1 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.

8.1 NEGATIVE EXTERNALITIES 4. The government collects tax revenue shown by the purple rectangle.

8.2 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.

8.2 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

8.2 POSITIVE EXTERNALITIES Figure 8.5 shows an external benefit. When 15 million students attend college: 2. Marginal external benefit is $15,000 per student. 1. Marginal private benefit is $10,000 per student. 3. Marginal social benefit is $25,000 per student.

8.2 POSITIVE EXTERNALITIES Figure 8.6 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 … 3. Marginal cost. 2. Marginal social benefit exceeds …

8.2 POSITIVE EXTERNALITIES 5. The gray triangle shows the deadweight loss created because too few students enroll in college. 4. The efficient number of students is 15 million.

8.2 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

8.2 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.

8.2 POSITIVE EXTERNALITIES Figure 8.7(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. Public provision

8.2 POSITIVE EXTERNALITIES Figure 8.7(b) shows how a subsidy achieves an efficient outcome. 1.A $15,000 subsidy per student shifts the supply curve to S = MC – subsidy. 2. The equilibrium price is $10,000 a student. The efficient number of students is 15 million. Private Subsidies

8.2 POSITIVE EXTERNALITIES 3. The market equilibrium is efficient with 15 million students enrolled in college. 4. Marginal social benefit equals marginal cost.

8.2 POSITIVE EXTERNALITIES Figure 8.8 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. Vouchers

8.2 POSITIVE EXTERNALITIES 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. 2. Market equilibrium is efficient with 15 million students enrolled in college.

8.2 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. 1.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. 2.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 you attitude as a citizen-voter to these two externalities: Should the gas tax be higher? Should tuition be even lower?