0. Externalities & Policies
Explain in English
N. Gregory Mankiw
Externalities & Policies
The Economics of Green Growth
This chapter is slightly below average in length, and, for most students, in difficulty.
For variety, this PowerPoint presentation uses different examples from the textbook in its analysis of externalities.
Premium PowerPoint Slides by Ron Cronovich

1. In this presentation, look for the answers to these questions:
What is an externality?
Why do externalities make market outcomes inefficient?
What public policies aim to solve the problem of externalities?
How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? 1

2. 1) How the price affects consumer surplus
I. Foundations
1) How the price affects consumer surplus
(a) Consumer surplus at price P1
(b) Consumer surplus at price P2
Price
Price A A
Demand
Demand
Additional consumer surplus to initial consumers
Initial
consumer
surplus
Consumer
surplus C C P1 P1
Consumer surplus
to new consumers B B Q1 Q1 F P2 D E Q2
Quantity
Quantity
In panel (a), the price is P1, the quantity demanded is Q1, and consumer surplus equals the area of the triangle ABC. When the price falls from P1 to P2, as in panel (b), the quantity demanded rises from Q1 to Q2, and the consumer surplus rises to the area of the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area BCED) and in part because new consumers enter the market at the lower price (area CEF).

3. 2) Consumer and producer surplus in the market equilibrium
Price A
Supply
Demand D
Consumer
surplus
Equilibrium
price E
Equilibrium
quantity
Producer
surplus B C
Quantity
Total surplus—the sum of consumer and producer surplus—is the area between the supply and demand curves up to the equilibrium quantity

4. 3) The effects of a tax Price Demand Price buyers pay Supply Quantity
with tax
Size
of tax
Price without tax
Quantity
without tax
Price sellers receive
Quantity
A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls.

5. 4) How a tax affects welfare
Price
Demand
Price
buyers
pay
=PB
Supply A
A tax on a good reduces consumer surplus (by the area B + C) and producer surplus
(by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). Q2 C B
Price
without
tax
=P1 E Q1 D
Price
sellers
receive
=PS F
Quantity
The area C + E shows the fall in total surplus and is the deadweight loss of the tax
Without Tax
With Tax
Change
Consumer Surplus
Producer Surplus
Tax Revenue
Total Surplus
A+B+C
D+E+F
None
A+B+C+D+E+F A F
B+D
A+B+D+F
-(B+C)
-(D+E)
+(B+D)
-(C+E)

6. 5) The market for aluminum
Price of
Aluminum
Supply
(private cost)
Demand
(private value)
Equilibrium
QMARKET
Quantity of Aluminum
The demand curve reflects the value to buyers, and the supply curve reflects the costs of sellers. The equilibrium quantity, QMARKET, maximizes the total value to buyers minus the total costs of sellers. In the absence of externalities, therefore, the market equilibrium is efficient.

7. 6) Pollution and the social optimum
Price of
Aluminum
Social cost (private cost
and external cost)
External
Cost
Supply
(private cost)
Demand
(private value)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of Aluminum
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.

8. 7) Education and the social optimum
Price of
Aluminum
Supply
(private cost)
Social value
(private value
and external benefit)
Optimum
Demand
(private value)
External
Benefit
QOPTIMUM
Equilibrium
QMARKET
Quantity of Aluminum
In the presence of a positive externality, the social value of the good exceeds the private value. The optimal quantity, QOPTIMUM, is therefore larger than the equilibrium quantity, QMARKET.

9. 8) Equivalence of corrective taxes & pollution permits
(a) Corrective tax
(b) Pollution permits
Price of
pollution
Price of
pollution
1. A corrective tax sets
the price of pollution . . . Q
Supply of
pollution permits
Demand for
pollution rights
Demand for
pollution rights
1. Pollution
permits set
the quantity
of pollution . . . P
Corrective tax P Q
which, together
with the demand curve,
determines the price
of pollution.
which, together with the demand curve, determines the quantity of pollution.
Quantity of
pollution
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. The price and quantity of pollution are the same in the two cases.

10. II. Introduction
One of the principles from Textbook: Markets are usually a good way to organize economy activity. In absence of market failures, the competitive market outcome is efficient, maximizes total surplus.
One type of market failure: externality, the uncompensated impact of one person’s actions on the well-being of a bystander.
Externalities can be negative or positive, depending on whether impact on bystander is adverse or beneficial.
EXTERNALITIES 10

11. Self-interested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient.
Another principle from Chapter 1: Governments can sometimes improve market outcomes. In presence of externalities, public policy can improve efficiency.
EXTERNALITIES 11

12. Examples of Negative Externalities
Air pollution from a factory
The neighbor’s barking dog
Late-night stereo blasting from the dorm room next to yours
Noise pollution from construction projects
Health risk to others from second-hand smoke
Talking on cell phone while driving makes the roads less safe for others
EXTERNALITIES 12

13. Recap of Welfare Economics1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
The market eq’m maximizes consumer + producer surplus.
Supply curve shows private cost, the costs directly incurred by sellers.
$2.50 25
Demand curve shows private value, the value to buyers (the prices they are willing to pay).
For many students, the concepts are easier to learn in the context of a specific example with numerical values.
Note that maximizing consumer + producer surplus is NOT the same as maximizing TOTAL surplus when the trades impose external costs (or benefits) on bystanders.
EXTERNALITIES 13

14. Analysis of a Negative Externality1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
Social cost = private + external cost
external cost
Supply (private cost)
External cost
= value of the negative impact on bystanders
= $1 per gallon (value of harm from smog, greenhouse gases)
EXTERNALITIES 14

15. Analysis of a Negative Externality1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
The socially optimal quantity is 20 gallons.
Social cost S
At any Q < 20,
value of additional gas exceeds social cost.
At any Q > 20,
social cost of the last gallon is greater than its value to society. D
“At any Q < 20, value of additional gas exceeds social cost.”
For example, at Q = 10, the value to buyers of an additional gallon equals $4, while the social cost is only $2. Therefore, total surplus (society’s well-being) would increase with a larger quantity of gas.
“At any Q > 20, social cost of the last gallon is greater than its value.”
For example, at Q = 25 - the market equilibrium - the last gallon cost $3.50 (including the external cost) but the value of it to buyers was only $ Hence, total surplus would be higher if Q were lower.
Only at Q = 20 is society’s welfare maximized. 25
EXTERNALITIES 15

16. Analysis of a Negative Externality1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
Market eq’m (Q = 25)
is greater than
social optimum (Q = 20).
Social cost S
One solution: tax sellers $1/gallon,
would shift S curve up $1. D 25
EXTERNALITIES 16

17. “Internalizing the Externality”
Internalizing the externality: altering incentives so that people take account of the external effects of their actions
In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs.
When market participants must pay social costs, market eq’m = social optimum.
(Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)
The parenthetical remark at the bottom of the slide follows from a lesson in Chapter 6: tax incidence and the allocation of resources is the same whether a tax is imposed on buyers or sellers.
EXTERNALITIES 17

18. Examples of Positive Externalities
Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you.
R&D creates knowledge others can use.
People going to college raise the population’s education level, which reduces crime and improves government.
The textbook explains that a better educated population makes more informed voting decisions and elects higher quality lawmakers and leaders.
Thank you for not contaminating the fruit supply!
EXTERNALITIES 18

19. Positive Externalities
In the presence of a positive externality, the social value of a good includes
private value – the direct value to buyers
external benefit – the value of the positive impact on bystanders
The socially optimal Q maximizes welfare:
At any lower Q, the social value of additional units exceeds their cost.
At any higher Q, the cost of the last unit exceeds its social value.
Since you have just walked students through the analysis of a negative externality, let’s see if they can do the analysis of a positive externality.
This slide provides the introductory information they will need to do the analysis. The following slide provides the exercise.
EXTERNALITIES 19

20. A C T I V E L E A R N I N G 1 Analysis of a positive externality10 20 30 40 50 P Q $
The market for flu shots
External benefit = $10/shot
Draw the social value curve.
Find the socially optimal Q.
What policy would internalize this externality? S D 20

21. Answers Socially optimal Q = 25 shots.
To internalize the externality, use subsidy = $10/shot. 10 20 30 40 50 P Q $
The market for flu shots
external benefit S 25
Social value = private value + $10 external benefit D 21

22. Effects of Externalities: Summary
If negative externality
market quantity larger than socially desirable
If positive externality
market quantity smaller than socially desirable
To remedy the problem, “internalize the externality”
tax goods with negative externalities
subsidize goods with positive externalities
Effects of Externalities: Summary
EXTERNALITIES 22

23. III. Public Policies Toward Externalities
Two approaches:
Command-and-control (C&C) policies regulate behavior directly. Examples:
limits on quantity of pollution emitted
requirements that firms adopt a particular technology to reduce emissions
Market-based (MB) policies provide incentives so that private decision-makers will choose to solve the problem on their own. Examples:
corrective taxes and subsidies
tradable pollution permits
EXTERNALITIES 23

24. Corrective Taxes & Subsidies
Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality
Also called Pigouvian taxes after Arthur Pigou ( ).
The ideal corrective tax = external cost
For activities with positive externalities, ideal corrective subsidy = external benefit
Greg Mankiw’s blog ( has semi-regular posts on Pigou taxes, some of which are worth using in class (either as assigned or recommended reading or fodder for class discussion). On the main page, look under “A Few Timeless Posts” for “the Pigou Club Manifesto.”
In the textbook, a new “In the News” box includes Mankiw’s 2007 New York Times piece arguing for carbon taxes to fight global warming. The piece contrasts corrective taxes with regulations and with cap-and-trade systems.
EXTERNALITIES 24

25. Corrective Taxes & Subsidies
Other taxes and subsidies distort incentives and move economy away from the social optimum.
Corrective taxes & subsidies
align private incentives with society’s interests
make private decision-makers take into account the external costs and benefits of their actions
move economy toward a more efficient allocation of resources.
EXTERNALITIES 25

26. Corrective Taxes vs. Regulations(C&C)
Different firms have different costs of pollution abatement.
Efficient outcome: Firms with the lowest abatement costs reduce pollution the most.
A pollution tax is efficient:
Firms with low abatement costs will reduce pollution to reduce their tax burden.
Firms with high abatement costs have greater willingness to pay tax.
In contrast, a regulation requiring all firms to reduce pollution by a specific amount not efficient.
Some of your students may not know that pollution “abatement” simply means taking measures to cut pollution.
Regarding the last bullet point: If all firms must reduce emissions by a fixed amount (or fixed percentage), then abatement is NOT concentrated among firms with the lowest abatement costs, and so the total cost of abatement will be higher.
EXTERNALITIES 26

27. Corrective Taxes vs. Regulations(C&C)
Corrective taxes are better for the environment:
The corrective tax gives firms incentive to continue reducing pollution 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.
In contrast, firms have no incentive for further reduction beyond the level specified in a regulation(C&C).
EXTERNALITIES 27

28. Example of a Corrective Tax: The Gas Tax
The gas tax targets three negative externalities:
Congestion The more you drive, the more you contribute to congestion.
Accidents Larger vehicles cause more damage in an accident.
Pollution Burning fossil fuels produces greenhouse gases.
Again, see Mankiw’s blog for more well-argued opinion pieces by him and others in favor of gas or carbon taxes.
EXTERNALITIES 28

29. A C T I V E L E A R N I N G 2 A. Regulating lower SO2 emissions
Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month, total emissions = 80 tons/month.
Goal: Reduce SO2 emissions 25%, to 60 tons/month
Cost of reducing emissions: $100/ton for Acme, $200/ton for USE
Policy option 1: Regulation Every firm must cut its emissions 25% (10 tons).
Your task: Compute the cost to each firm and total cost of achieving goal using this policy.
This first exercise is simple. 29

30. Cost to Acme: (10 tons) x ($100/ton) = $1000
A. Answers
Each firm must reduce emissions by 10 tons.
Cost of reducing emissions: $100/ton for Acme, $200/ton for USE.
Compute cost of achieving goal with this policy:
Cost to Acme: (10 tons) x ($100/ton) = $1000
Cost to USE: (10 tons) x ($200/ton) = $2000
Total cost of achieving goal = $3000 30

31. A C T I V E L E A R N I N G 2 B. Tradable pollution permits
Initially, Acme and USE each emit 40 tons SO2/month.
Goal: reduce SO2 emissions to 60 tons/month total.
Policy option 2: Tradable pollution permits
Issue 60 permits, each allows one ton SO2 emissions. Give 30 permits to each firm. Establish market for trading permits.
Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons.
Your task: Compute cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each. 31

32. B. Answers Goal: reduce emissions from 80 to 60 tons
Cost of reducing emissions: $100/ton for Acme, $200/ton for USE.
Compute cost of achieving goal:
Acme
sells 10 permits to USE for $150 each, gets $1500
uses 20 permits, emits 20 tons SO2
spends $2000 to reduce emissions by 20 tons
net cost to Acme: $ $1500 = $500
continued… 32

33. B. Answers, continued Goal: reduce emissions from 80 to 60 tons
Cost of reducing emissions: $100/ton for Acme, $200/ton for USE.
USE
buys 10 permits from Acme, spends $1500
uses these 10 plus original 30 permits, emits 40 tons
spends nothing on abatement
net cost to USE = $1500
Total cost of achieving goal = $500 + $1500 = $2000
Using tradable permits, goal is achieved at lower total cost and lower cost to each firm than using regulation. 33

34. Tradable Pollution Permits
A tradable pollution permits system reduces pollution 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.
EXTERNALITIES 34

35. 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.
As of June 2008, Barack Obama and John McCain each propose “cap and trade” systems to reduce greenhouse gas emissions.
Nitrogen oxides increase ground-level ozone, which has adverse health effects.
For more information, see
For information about Europe’s new carbon emissions trading program, see the Financial Times article featured in this chapter’s new “In the News” box. You can also find lots of good articles on this program at the website of the Financial Times,
Under Obama’s cap-and-trade proposal, permits will be auctioned to polluters. As Mankiw notes in his New York Times piece reprinted in the textbook, such a system is equivalent to a tax. In contrast, under McCain’s proposed cap-and-trade system, “permits will eventually be auctioned…” (my emphasis).
EXTERNALITIES 35

36. Corrective Taxes vs. Tradable Permits
Like most demand curves, firms’ demand for the ability to pollute is a downward-sloping function of the “price” of polluting.
A corrective tax raises this price and thus reduces the quantity of pollution firms demand.
A tradable permits system restricts the supply of pollution rights, has the same effect as the tax.
When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely.
EXTERNALITIES 36

37. Objections to the Economic Analysis of Pollution
Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment.
However, people face tradeoffs. The value of clean air & water must be compared to their cost.
The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment.
EXTERNALITIES 37

38. Private Solutions to Externalities
Types of private solutions:
Moral codes and social sanctions, e.g., the “Golden Rule”
Charities, e.g., the Sierra Club
Contracts between market participants and the affected bystanders
The textbook gives a nice example of a contract in which a beekeeper and apple orchard manager each agree to boost production, as each producer’s activity confers an external benefit on the other.
EXTERNALITIES 38

39. Private Solutions to Externalities
The Coase theorem: If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own.
EXTERNALITIES 39

40. 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.
Coase theorem: The private market will reach the efficient outcome on its own…
See Spot bark.
EXTERNALITIES 40

41. 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.
Both Jane and Dick are better off. (What about Spot? Doesn’t anyone care about Spot???)
EXTERNALITIES 41

42. Socially efficient outcome: See Spot stay.
<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.
EXTERNALITIES 42

43. Socially efficient outcome: Dick keeps Spot.
<CASE 3> Jane has the legal right to peace & quiet. Benefit to Dick of having Spot = $800 Cost to Jane of Spot’s barking = $500
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.
EXTERNALITIES 43

44. A C T I V E L E A R N I N G 3 Applying Coase
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?
Have students work together – in small groups, or as a class (with you as moderator). If working in groups, allow 5 minutes, then solicit responses from the class.
If you wish, insert a blank slide after this one and use it to type students’ responses as they share them.
Most students should find part A very straight-forward. 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.
The second part involves brainstorming: students try to come up with a list of reasons why it might be difficult to implement Coase-like solutions in the real world. Brainstorming engages students and is shown to increase learning outcomes and student satisfaction. And it provides a break from what otherwise would be a long stretch of lecture.
I have not provided a slide with answers. Instead, the following slide lists the reasons why private solutions don’t always work, and the “notes” section (what you’re reading right now) gives some examples of each in the context of this scenario. 44

45. Why Private Solutions Do Not Always Work
1) Transaction costs: The costs parties incur in the process of agreeing to and following through on a bargain.
These costs may make it impossible to reach a mutually beneficial agreement.
2) Stubbornness: Even if a beneficial agreement is possible, each party may hold out for a better deal.
3) Coordination problems: If # of parties is very large, coordinating them may be costly, difficult, or impossible.
An example for each bullet point in the context of the brainstorming activity on the previous slide:
1. Transactions costs: Suppose lawyers charge $60,000 to represent the two parties and draw up a contract that is enforceable in a court. Then it will be impossible for both parties to come to a mutually beneficial agreement, and the factory will continue polluting the lake.
2. Stubbornness: Suppose the town offers $55,000 to the factory. The factory would be better off taking this offer than nothing at all, but the factory may counter with a $95,000 price. Both parties hold out in hopes that the other will cede, but neither does. The factory keeps polluting, and the residents of Green Valley continue to be denied the joy of swimming in the lake.
3. Coordination problems: Getting all 1000 residents to agree to a specific offer will be difficult. Moreover, each resident has an incentive to free-ride off his neighbors.
EXTERNALITIES 45

46. CHAPTER SUMMARY
An externality occurs when a market transaction affects a third party. If the transaction yields negative externalities (e.g., pollution), the market quantity exceeds the socially optimal quantity. If the externality is positive (e.g., technology spillovers), the market quantity falls short of the social optimum. 46

47. Sometimes, people can solve externalities on their own
Sometimes, people can solve externalities on their own. The Coase theorem states that the private market can reach the socially optimal allocation of resources as long as people can bargain without cost. In practice, bargaining is often costly or difficult, and the Coase theorem does not apply. 47

48. The government can attempt to remedy the problem
The government can attempt to remedy the problem. It can internalize the externality using corrective taxes. It can issue permits to polluters and establish a market where permits can be traded. Such policies often protect the environment at a lower cost to society than direct regulation. 48