1. Chapter 10
Externalities

2. Principle 6 and 7 Revisited
Markets are usually a good way to organize economic activity.
In absence of market failures, the competitive market outcome is efficient, maximizes total surplus.
Governments can sometimes improve market outcomes.
Protect property rights
Limit market failure/market inefficiencies
Externalities
Market power
Public goods
Promote equality

3. Externalities Defined
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 are benefits/costs received by neither the seller or the buyer but by third parties.
Private benefits + external benefits = social benefits
Private costs + external costs = social costs
Since external benefits/costs are not perceived by buyers and sellers they are not captured in markets.
Therefore, markets may fail to allocate resources efficiently and government may improve market outcomes

5. 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
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6. 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.
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7. 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)
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8. 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.
“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. D 25
EXTERNALITIES 8

9. 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
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10. “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 equilibrium = 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 10

11. Positive Externalities
Examples:
Vaccinations
R&D
Education
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.
The textbook explains that a better educated population makes more informed voting decisions and elects higher quality lawmakers and leaders.
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12. Public Policies Toward Externalities
Two approaches:
Command-and-control policies regulate behavior directly. Examples:
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. Examples:
corrective taxes and subsidies
tradable pollution permits
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13. 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
The ideal corrective subsidy = external benefit
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.
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.
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14. Corrective Taxes vs. Regulations
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.
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15. Corrective Taxes vs. Regulations
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.
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