1. Chapter 16:
Externalities

2. Objectives After studying this chapter, you will be able to:
Explain how externalities arise
Explain why negative externalities lead to overproduction and how property rights, emission charges, marketable permits, and taxes can be used to achieve a more efficient outcome
Explain why positive externalities lead to underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome

3. Greener and Smarter
Environmental issues are at the same time everybody’s problem and nobody’s problem.
Human beings are learning more and more every day.
But are we learning more at a fast enough pace?
How can we ensure that we use resources efficiently in the face of externalities?

4. Externalities in Our Lives
An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer.
A negative externality imposes an external cost and a positive externality creates an external benefit.
No man (or woman) is an island.
The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency:
Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, causing too much of the activity creating the externality to be produced.
Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, causing too little of the activity that creates the externality to be produced.
There are some correcting policies that the government can use to increase efficiency, but some are more effective than others.

5. Externalities in Our Lives
The four possible types of externality are:
Negative production externalities
Positive production externalities
Negative consumption externalities
Positive consumption externalities

6. Externalities in Our Lives
Negative Production Externalities
Negative production externalities are common.
Examples are noise from aircraft, logging and clearing of forests, and pollution

7. Externalities in Our Lives
Positive Production Externalities
Positive production externalities are less common than negative externalities.
Example: a beekeeper locates beehives in an orange-growing area

8. Externalities in Our Lives
Negative Consumption Externalities
Negative consumption externalities are a common part of everyday life.
Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.

9. Externalities in Our Lives
Positive Consumption Externalities
Positive consumption externalities are also common.
When you get a flu vaccination, everyone you come into contact with benefits.
When the owner of an historic building restores it, everyone who sees the building benefits.

10. Negative Externalities: Pollution
Pollution is an old problem and is faced by both rich industrial countries and poor developing countries.
It is an economic problem that is coped with by balancing benefits and costs.

11. Negative Externalities: Pollution
The Demand for a Pollution-Free Environment
The demand for a pollution-free environment is expressed through the political process. This demand has increased for two reasons:
Higher incomes: A high-quality environment is a “normal good,” the demand for which increases with income.
Greater awareness: greater knowledge about the causes of environmental problems raise understanding of environmental issues.

12. Negative Externalities: Pollution
The Sources of Pollution
Economic activity pollutes air, water, and land, and these individual areas of pollution interact through the ecosystem.
Air pollution
Emissions causing greenhouse gases are a tough problem to tackle
Water pollution
Output of sewage treatment plants, the use of herbicides, pesticides, and fertilisers
Land pollution
Toxic waste and ordinary household garbage

13. Trends in Air Pollution

14. Negative Externalities: Pollution
Private Costs and Social Costs
A private cost of production is a cost that is borne by the producer, and marginal private cost (MC) is the private cost of producing one more unit of a good or service.
An external cost of production is a cost that is not borne by the producer but is borne by others.
Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

15. Negative Externalities: Pollution
Private Costs and Social Costs
Marginal social cost (MSC) is the marginal cost incurred by the entire society and is the sum of marginal private cost and marginal external cost.
MSC = MC + Marginal external cost.
Marginal private cost, marginal external cost, and marginal social cost increase with output.

16. Cost ( dollars per tonne)
An External Cost
Figure 16.2
300
Marginal
Social cost
MSC
225
Marginal External
cost
Cost ( dollars per tonne)
150 MC
100 75
Marginal
Private cost 2 4 6
Quantity (thousands of tonnes per month)

17. Negative Externalities: Pollution
Production and Pollution: How Much?
In an unregulated market with an externality, the pollution created depends on the market equilibrium price and quantity of the good produced.

18. Inefficiency with an External Cost
Figure 16.3
300
Marginal
Social cost
Social
Benefit
MSC
225
Inefficient
Market
equilibrium
Deadweight loss
Efficient
equilibrium
D=MSB
Price and cost ( dollars per tonne)
150
S= MC
100 75
Efficient
quantity 2 4 6
Quantity (thousands of tonnes per month)

19. Negative Externalities: Pollution
Property Rights
Externalities arise because of the absence of property rights.
Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.
Establishment of property rights achieves an efficient outcome.

20. Property Rights Achieve an Efficient Outcome
Figure 16.4
300
Price equals
marginal social
cost and MSB
S = MC =MSC
225
Cost of pollution
Borne by polluter
Efficient market
equilibrium
D=MSB
Price and cost ( dollars per tonne)
MC excluding
pollution cost
150
100 75 2 4 6
Quantity (thousands of tonnes per month)

21. Negative Externalities: Pollution
The Coase Theorem
The Coase theorem is a proposition that if property rights exist, if only a small number of parties are involved, and if transactions costs (defined below) are low, then private transactions are efficient.
There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights.

22. Negative Externalities: Pollution
Transactions costs are the opportunity cost of conducting a transaction.
Example: the transactions costs of buying a home include fees for a real estate agent, and the legal cost associated with the transfer.
When a large number of people are involved and transactions costs are high, the Coase solution is not available

23. Negative Externalities: Pollution
Government Actions in the Face of External Costs
There are three main methods that the government uses to cope with external costs:
Taxes
Emission charges
Licences and marketable permits
The best government policies emulate, rather than replace, the market process. Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it.
Make the polluters discover (and bear) the social costs of pollution. In the case of cost externalities like pollution, the government can choose from three policies: emissions charges, pollution taxes, or marketable pollution permits. All three policies require the government to initially assess the social marginal costs and benefits from pollution activities to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.

24. Negative Externalities: Pollution
Taxes
The government can set a tax equal to the marginal external cost.
The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost:
MC + Tax = MSC.
This tax is called Pigovian Tax, in honour of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.

25. Price and cost ( dollars per tonne)
A Pollution Tax
Figure 16.5
300
Marginal social
cost and MSB
S = MC + tax = MSC
225
Pollution tax
Efficient market
equilibrium
D=MSB
Price and cost ( dollars per tonne)
150
Tax
revenue MC 88 75 2 4 6
Quantity (thousands of tonnes per month)

26. Negative Externalities: Pollution
Emissions Charges
The government sets a price per unit of pollution, so that the more a firm pollutes, the higher are its emissions charges.
For the emissions charge to induce the firm to generate the efficient level of pollution, the government would need a lot of information that is usually unavailable.

27. Negative Externalities: Pollution
Marketable Permits
Each firm is assigned a permitted amount of pollution per time period, and firms trade permits.
The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome.

28. Positive Externalities: Knowledge
Private Benefits and Social Benefits
A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the private benefit from consuming one more unit of a good or service.
An external benefit is a benefit that someone other than the consumer receives. Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy.

29. Positive Externalities: Knowledge
Marginal social benefit is the marginal benefit enjoyed by the entire society and is the sum of marginal private benefit and marginal external benefit. That is:
MSB = MB + Marginal external benefit.

30. Price (thousands of dollars per student per year)
An External Benefit
Figure 16.6 40
MSB
Marginal
Social benefit
External
benefit
Private 30 25
Price (thousands of dollars per student per year) 20 MB 10 50
100
150
200
300
Quantity (thousands of students per year)

31. Inefficiency With an External Benefit
Figure 16.7 40
MSB
S=MSC
Deadweight
loss 38
Inefficient
Market
equilibrium
Marginal
Social
benefit 30 25
Price (thousands of dollars per student per year)
Efficient quantity 20
D=MB 15
Marginal
Social cost 10 50
100
150
200
300
Quantity (thousands of students per year)

32. Positive Externalities: Knowledge
Government Action in the Face of External Benefits
There are four main methods that the government uses to cope with external benefits:
Public provision
Private subsidies
Vouchers
Patents and copyrights
Consumers Versus Private Producers Versus Government as Monitor in the Face of an Externality. In the case of benefit externalities like education, the government has three policy choices: public provision, subsidize private producer, subsidize private consumer with vouchers. All three policies require the government to initially assess the social marginal costs and benefits to find the optimal level of education to be consumed. But only the public provision policy forces the government to continually assess what type of education should be provided in a dynamic world of ever-changing technology. The policies of private education subsidies or educational vouchers force schools or students to determine what types of education would be best, because they now face an opportunity cost for their decisions as to what school to attend. An informed and motivated clientele, armed with vouchers to allocate across the different qualifying educational institutions, would drive the composition of educational opportunities supply by the different educational institutions.

33. Positive Externalities: Knowledge
Public Provision
Under public provision, a public authority that receives its revenue from the government produces the good or service.
Education services produced by the public universities and schools are examples of public provision

34. Public Provision to Achieve an Efficient Outcome
Figure 16.8(a) 40
MSB
S=MSC 38
Efficient
market
equilibrium 30
MSB = MSC 25
Efficient quantity
Paid by taxpayer
Price and costs (thousands of dollars per student per year) 20
D=MB 15 10
Tuition 50
100
150
200
300
Quantity (thousands of students per year)

35. Positive Externalities: Knowledge
Private Subsidies
A subsidy is a payment by the government to private producers. The government can induce private decision makers to consider external benefits by making the subsidy depend on the level of output
If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced increases to that at which marginal cost equals marginal social benefit—an efficient outcome.

36. Private Subsidy to Achieve an Efficient Outcome
Figure 16.8(b) 40
MSB
S=MSC
S=MSC 38
Efficient
market
equilibrium
S=MSC-subsidy 30
MSB = MSC 25
Efficient quantity
Subsidy of $15,000 per student
Price and costs (thousands of dollars per student per year) 20
D=MB 15 10
Dollar price 50
100
150
200
300
Quantity (thousands of students per year)

37. Positive Externalities: Knowledge
Vouchers
A voucher is a token that the government provides to households, which can be used to buy specified goods or services.
A school voucher allows parents to choose the school their children will attend and to use the voucher to pay part of the cost. The school cashes the voucher to pay its bills.

38. Vouchers Achieve Efficiency
Figure 16.9 40
MSB
S=MSC
S=MSC 38
Efficient
market
equilibrium 30
MSB = MSC 25
Value of voucher
Price and costs (thousands of dollars per student per year) 20
D=MB 15 10
Dollar price 50
100
150
200
300
Quantity (thousands of students per year)

39. Positive Externalities: Knowledge
Patents and Copyrights
Knowledge is productive and generates external benefits and public policies are required to ensure an efficient level of effort.
Intellectual property rights give the creator of knowledge the property right to the use of that knowledge.
The legal device for granting intellectual property rights are through patent or copyright.

40. END
CHAPTER 16