1. ©2016 by McGraw-Hill Education Limited.
EXTERNALITIES
Chapter 5
©2016 by McGraw-Hill Education Limited.

2. Learning Objectives
Describe how positive externalities differ from negative externalities.
Demonstrate how the presence of an externality may lead to an inefficient allocation of resources.
Explain how private responses could remedy the externality problem.
Evaluate the advantages and limitations of various private responses that seek to remedy the externality problem.
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3. Learning Objectives (cont)
Explain how public responses (government policies) could remedy the externality problem.
Evaluate the advantages and limitations of various public responses to the externality problem.
Identify potential distributional implications of private and public responses to the externality problem.
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4. The Nature of Externalities
LO1
The Nature of Externalities
Externality – when the activity of one entity (a person or a firm) directly affects the welfare of another in a way that is not transmitted by market prices
Externalities can be produced by consumers and firms
Externalities are reciprocal in nature
Externalities can be positive or negative
The distinction between public goods and externalities is a bit fuzzy
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5. LO2
Negative Externalities and Economic Inefficiency A Negative Externality Problem
SMC = PMC + MD $
PMC MD
PMB Q* Q1
Q per year
Socially efficient output
Actual output
Figure 5.1

6. Negative Externalities and Economic Inefficiency Gains and Losses from Moving to an Efficient Level of Output
Reduction from 60 to 45 means dcg profit loss for Bart and cdhg welfare gain for Lisa.
SMC = Q $
200
PMC = 20 + Q h
140 MD d
110 g 80 c 60 45 f b 20
PMB a e 45 60
Q – output per year
Figure 5.2

7. What Activities Produce Pollutants?
Need to identify types and quantities of harmful pollution
Transboundry problem
Smog
GHG
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8. Which Pollutants Do Harm?
Total suspended particles (TSPs) are widely considered to be he air pollutant most damaging to health
Empirical research on correlation between TSPs and mortality rates
Difficult to measure because of inability to perform randomized studies on pollution effects
Must rely on cross-sectional or time-series analysis
Studies unable to measure lifetime exposure to air pollution
Chay and Greenstone (2003) and Currie and Neidell (2005): impact of air pollution on infant mortality
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9. What is the Value of the Damage Done?
Marginal damage schedule
Willingness to pay
Measurement problem
GHG and Global warming
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10. LO2
Positive Externalities and Economic Inefficiency A Positive Externality Example $
PMC b c a d
SMB = PMB + EMB e
PMB
EMB g f R1 R*
Research per year
Figure 5.3

11. Private Responses to Externalities Bargaining and the Coase Theorem
LO3, LO4
Private Responses to Externalities Bargaining and the Coase Theorem
Coase Theorem
If property rights are assigned and
The costs to the parties of bargaining are low
The owners of resources can identify the source of damages to their property and legally prevent damages
Then
An efficient solution to an externality problem can be achieved without government intervention
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12. Private Responses to Externalities Other Private Solutions
LO3, LO4
Private Responses to Externalities Other Private Solutions
Mergers
Way to internalize the externality
The externality transmitter and recipient become one company
Social conventions
Littering is irresponsible and not “nice”
“Do unto others as you would have others do unto you”
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13. Public Responses to Externalities Taxes and Negative Externalities
LO5, LO6
Public Responses to Externalities Taxes and Negative Externalities
SMC = PMC + MD $
(PMC + cd)
Pigouvian tax revenues
PMC d i j c MD MB Q* Q1
Q per year
Figure 5.4

14. Public Responses to Externalities Subsidies and Negative Externalities
LO5, LO6
Public Responses to Externalities Subsidies and Negative Externalities
SMC = PMC + MD $
(PMC + cd)
PMC
Pigouvian subsidy d k i f g j c h MD
PMB e Q* Q1
Q per year
Figure 5.5

15. LO5, LO6
Public Responses to Externalities Using an Emissions Fee to Reduce Pollution $ MD b a f*
MAC d c E* E0
Emissions
Figure 5.6

16. LO5, LO6
Public Responses to Externalities An Emissions Fee with Multiple Polluters $ $
The Outcome is Cost-Effective
225
180
MACB
MACH
Homer’s tax savings
Bart’s tax savings 75 a d
f*=50 30 c b f e 65 75 90 60 70 90
Bart’s Emissions
Homer’s Emissions
Figure 5.7

17. LO5, LO6
Public Responses to Externalities A tradable Permit Scheme and Negative Externalities $ $
A Cap and Trade Scheme is Cost-Effective
225
180
MACB
MACH a
112.5
f*=50 c b 65 90 45 70 90
Bart’s Emissions
Homer’s Emissions
Figure 5.8

18. LO5, LO6
Public Responses to Externalities Regulation and Negative Externalities
Command-and-control regulations require a given amount of pollution reduction and they are less flexible than incentive-based approaches
Technology standard
Performance standard
Unlikely to be cost-effective
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19. Public Responses to Externalities Positive Externalities
LO5, LO6
Public Responses to Externalities Positive Externalities
Subsidies
Pigouvian subsidy
Regulation
For example: vaccinations
Herd immunity
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20. Implications for Income Distribution
LO7
Implications for Income Distribution
Who Benefits?
Low- or High-Income Individuals?
Who Bears the Cost?
Workers of firms who must reduce output
Buyers of firms’ output
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21. Chapter 5 Summary
An externality occurs when the activity of one person affects another person outside of the market mechanism. Externalities may generally be traced to the absence of property rights.
Externalities cause market price to diverge from social cost, bringing about an inefficient allocation of resources. Negative externalities generally lead to too much of an activity while positive externalities typically result in too little.
The Coase Theorem indicates that private parties may bargain toward the efficient output if property rights are established. However, bargaining costs must be low and the source of the externality easily identified.
A Pigouvian tax is a tax levied on pollution in an amount equal to the marginal damage at the efficient level. Such a tax gives the producer a private incentive to pollute the efficient amount.
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22. Chapter 5 Summary (cont)
An emissions fee (a tax levied on each unit of pollution) achieves a given amount of pollution reduction at the lowest feasible cost (i.e., is cost-effective).
The cost of emissions reductions is capped by the emissions fee but the level of pollution reduction can be uncertain.
Pollution rights may be traded in markets; A cap and trade system grants permits to pollute, but allows the permits to be traded.
Like the emissions fee, this approach is cost-effective. A cap and trade scheme is cost-effective and ensures a particular amount of pollution reduction, an advantage when administrators are uncertain how polluters will respond to Pigouvian taxes or emissions fees.
However, the price of permits is uncertain.
Command and control regulations are less flexible than incentive-based approaches, like emissions fees and permit schemes, and therefore tend to be more costly.
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