10 Externalities

4
THE ECONOMICS OF THE PUBLIC SECTOR
10
Externalities
Market Failure
Recall from Chapter 7:
Adam Smith had argued that the
invisible hand of the marketplace leads
self-interested buyers and sellers to an
outcome in which the total surplus of
society is maximized.
But markets can fail. Why?
CHAPTER 10 EXTERNALITIES
EXTERNALITIES AND MARKET

INEFFICIENCY
An externality is the uncompensated
impact of one persons actions on the
well-being of a bystander.
Als action may affect the well-being of
Betty, a bystander.
If Al pays no compensation (when his
action has a negative effect on Betty) nor
receives a reward (when his action has a
positive effect on Betty), the effect of Als
action on Betty is called an externality.
In this case, Al will ignore the effects of

his action on Betty when deciding
whether or not to take the action
Therefore, Al may take this action even if
it is undesirable for society
And, conversely, Al may refuse to take
this action even if it is desirable for
society
In other words, when actions have
external effects, societys total surplus
might not be maximized in the free
market equilibrium
Government intervention may be able to
increase total surplus

INEFFICIENCY
When the impact of a persons action
on a bystander is harmful, the
externality is called a negative
externality.
When the impact on the bystander is
beneficial, the externality is called a
positive externality.
Society and the Individual

Socially desirable activity
Individually desirable activity
To figure out the

extent of an activity
that is ideal for
society, we need to
compare the benefits
and coststo society
of an additional unit
of that activity
To figure out the

extent of an activity
that is ideal for an
individual, we need to
compare the benefits
and coststo the
individualof an
additional unit of that
activity

An additional unit of
an activity is socially
desirable if and only if
its social benefit
exceeds its social cost
an activity is
individually desirable
if and only if its
individual benefit
exceeds its individual
cost

its social benefit
an activity is
if and only if its
individual benefit
cost
Social
benefits
Social
costs
Individu
al
benefits
Individu
al costs

its social benefit
an activity is
if and only if its
individual benefit
exceeds
individual
When there are no externalities,
there is its
no difference
between social benefits and individual
cost benefits, and no
difference between
social costs and
individual costs.
Individu
Individu
Social
Social
benefits
costs
al
benefits
al costs

its social benefit
an activity is
if and only if its
individual benefit
exceeds
individual
When there are no externalities,
there is its
no difference
between social benefits and individual
cost benefits, and no
difference between
social costs and
individual costs.
Individu
Individu
Individu
Individu
al
benefits
al costs
al
benefits
al costs
Therefore, in this case, whats individually ideal is also whats

socially ideal. Therefore, the equilibrium quantity is also the
optimum quantity, as Adam Smith had argued.

its social benefit
an activity is
if and only if its
individual benefit
But when there are positive and negative externalities,
social benefits = individual benefits + positive externalities,
and cost
social costs = individual
costs + negative externalities.
Individual
Individual
benefits +
positive
externalities
costs +
negative
externaliti
es
Individu
al
benefits
Individu
al costs
Therefore, whats ideal for the individual may not be whats

When there are positive externalities,

and
social costs = individual costs.
Individual
benefits +
positive
externalities
Individual
costs
Individu
al
benefits
Individu
al costs
Therefore, the individual ignores positive externalities that affect

bystanders. Therefore, an activity may be undesirable to the
individual but desirable to society. Therefore, when there are
positive externalities, the equilibrium quantity of an activity
will be less than the optimum quantity of that activity.

When there are positive externalities,

and
social costs = individual costs.
Individual
benefits +
positive
externalities
Individual
costs
Individu
al
benefits
Individu
al costs
Therefore, the individual ignores positive externalities that affect

bystanders. Therefore, an activity may be undesirable to the
individual but desirable to society. Therefore, when there are
positive externalities, the equilibrium quantity of an activity
will be less than the optimum quantity of that activity. But
this problem can be fixed (a) with corrective subsidies and (b)

When there are negative externalities,

social benefits = individual benefits, and
social costs = individual costs + negative externalities.
Individua
l benefits
Individual
costs +
negative
externaliti
es
Individu
al
benefits
Individu
al costs
The individual ignores negative externalities that affect bystanders.

Therefore, an activity may be desirable to the individual but
undesirable to society. Therefore, when there are negative
externalities, the equilibrium quantity of an activity will be
more than the optimum quantity of that activity.


social benefits = individual benefits, and
social costs = individual costs + negative externalities.
Individua
l benefits
Individual
costs +
negative
externaliti
es
Individu
al
benefits
Individu
al costs
The individual ignores negative externalities that affect bystanders.

Therefore, an activity may be desirable to the individual but
undesirable to society. Therefore, when there are negative
externalities, the equilibrium quantity of an activity will be
more than the optimum quantity of that activity. But this
problem can be fixed (a) with corrective taxes and (b)
Corrective Taxes and Subsidies

We have just seen that when externalities
exist the equilibrium outcome may not be
the same as the optimum outcome
But we have seen before that a tax
reduces the equilibrium output and a
subsidy increases the equilibrium output
Therefore, any gap between the
equilibrium and optimum outputs can be
closed with taxes and subsidies
17

When the individual receives a subsidy equal to the positive

external effects of the activity,
Individual
benefits +
positive
externalities
Individual
costs
Individual
benefits +
subsidy
(positive
externalities)
Individu
al costs
the individual can no longer ignore the positive externalities that

affect bystanders. Therefore, in this case, whats individually
ideal is also whats socially ideal, and the equilibrium quantity
is also the optimum quantity.
A subsidy like this is unusual because it increases the total surplus.
Such corrective subsidies are called Pigovian subsidies .

When the individual has to pay a tax equal to the negative

external effects of the activity,
Individua
l benefits
Individual
costs +
negative
externaliti
es
Individu
al
benefits
Individual
costs +
Tax
(negative
externalitie
s)
the individual can no longer ignore the negative externalities that

affect bystanders. Therefore, in this case, whats individually
ideal is also whats socially ideal, and the equilibrium quantity
is also the optimum quantity.
A tax like this is unusual because it increases the total surplus. Such
corrective taxes are called Pigovian taxes.
Coase Theorem: Private

Bargaining
When private citizens can bargain
with each other without too much
difficulty, the equilibrium and
optimum outcomes may be brought
closer to each other without the need
for government intervention (in the
form of Pigovian taxes and
subsidies).
20
Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
The Club, an anti-theft device for cars
21
Dealing with negative

externalities
Should we completely ban an activity

that has negative externalities?
Should we
Should we
spaces?
Should we
Should we
buildings?
Should we
ban all cars?

ban all smoking in public
muzzle all dogs?
ban stereos in apartment
ban The Club?
22
Dealing with negative

externalities
How should we determine the extent

to which activities that have negative
externalities should be tolerated?
We can evaluate virtually any policy
proposal by asking how it would
affect total surplus.
Recall from Chapter 7, the concept of
total surplus.
23
Positive Externalities
Immunizations
Education
Restored historic buildings
Research into new technologies
LoJack, an anti-theft device for cars
24

INEFFICIENCY
Externalities can cause markets to
become inefficient.
We saw in chapter 7 that total surplus is
maximized in a perfectly competitive
economy.
But when there are externalities, this is no
longer true:
total surplus might be less than the maximum
achievable.
This might provide a justification for

government intervention.
25

INEFFICIENCY
Negative externalities from the
production or consumption of a good
can cause markets to produce more
than is socially desirable.
Positive externalities cause markets to
produce less than is socially desirable.
If and when markets fail (to produce the
socially desirable quantity), government
intervention may be necessary.
26
Figure 1 The Market for Aluminum

When there are no externalities in
aluminum production or
consumption, the equilibrium
quantity (QMARKET) maximizes social
surplus.
Price of
Aluminum
Supply
(private cost)
Equilibrium
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
Welfare Economics Without Externalities: A

Recap
When there are no externalities, the

equilibrium quantity:
is efficient
maximizes total surplus
Total surplus = total benefits total costs
is the socially desirable quantity
28
Social, private, and external costs

When the production of aluminum causes
pollution
Social cost of aluminum = private cost +
external cost
Private cost is the cost to aluminum
producers of the raw materials and labor
used in production
External cost is the cost to bystanders of
having to deal with the effects of
pollution
30
Figure 2 Pollution and the Social Optimum

Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
Aluminum

Price of
Aluminum
Social
cost
Unit Cost of
pollution
Optimum
G
B
E F
C
D
H I
Equilibrium
Supply
(private cost)
Total
Surplus
Equilibriu ABCD G
m
Optimum ABCD
L
Demand
(private value)
QOPTIMUM
QMARKET
Quantity of
Aluminum
Public Policies for Negative

Externalities
What can be done to get the market
to reduce production to the socially
optimal level?
Social
Price of
Aluminum
cost
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
Aluminum
35
Market-Based Policy: Put a Tax on Negative

Externalities
Either the producers or the consumers (or
both) of aluminum can be taxed
We saw in chapter 6 that a tax reduces the
equilibrium output, and that is exactly what we
want.
A tax solves the problem by forcing the

consumers and producers of aluminum to
internalize the externality of aluminum
Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
36
Recall: The Effect of a Tax

Price
Price buyers pay

Supply
Tax
Price without tax
Price sellers
receive
Demand
0
Quantity after
tax
Quantity before
tax
Quantity
Negative externalities should be

taxed
the free market equilibrium output
exceeds the socially optimum output
Therefore, it is socially desirable to
reduce output
A tax would reduce output
Therefore, a tax is a socially desirable
response to a negative externality
But how big should the tax be?
38
Tax > External Cost is too much

Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Tax
Equilibrium
Desired output
reduction
Demand
(private value)
0
The tax is too large and

reduces output too much
QOPTIMUM
QMARKET
Quantity of
Aluminum
Tax < External Cost is too little

Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Tax
Equilibrium
Desired output
reduction
The tax is too small and

reduces output too little
QOPTIMUM
QMARKET
Demand
(private value)
Quantity of
Aluminum
Tax = External Cost solves the problem!

Price of
Aluminum
Social
cost
Unit Cost of
pollution
Optimum
Tax
Equilibrium
Now the tax is exactly

equal to the external
cost. It reduces the
quantity by exactly the
ideal amount.
QOPTIMUM
QMARKET
Supply
(private cost)
We saw earlier that reducing
output from QMARKET to QOPTIMUM
increases total surplus.
Now we see that a tax can do
this. (So, unlike what we saw in
Chapter 8, not all taxes reduce
total surplus.) This is a
Pigovian tax.
Demand
(private value)
Quantity of
Aluminum

Price of
Aluminum
Social
cost
Unit Cost of
pollution
Optimum
Equilibrium
Supply
(private cost)
Another way to
ensure that QOPTIMUM
is produced is to
use tradable
pollution permits.
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
Aluminum
Tradable Pollution Permits

The government can do the following:
require permits for aluminum production
issue QOPTIMUM permits by auctioning them
off
Each permit will sell for a price equal to

the unit cost of pollution
The effect will be identical to a Pigovian
tax equal to the unit cost of pollution
43
Tradable Pollution Permits

The price of each tradable pollution
permit will be equal to the unit cost
of pollution
Why?
44
Positive Externalities: Examples
A technology spillover is a positive

externality that is created when a
firms innovation not only benefits the
firm, but enters societys pool of
technological knowledge and benefits
society as a whole.
Education benefits the student and
also all members of society who are
affected by the student
46
Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Optimum
Equilibrium
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
Total
Surplus
Figure 3 Education and the Social Optimum
Equilibriu AB
m
Price of
Education
Optimum ABF
Supply
(private cost)
F
E
Equilibrium
Optimum
D
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
Supply-Demand and Positive Externalities
The intersection of the supply curve

and the social-value curve determines
the optimal output level.
The optimal output level is more than the
equilibrium quantity.
The market produces a smaller quantity
than is socially desirable.
The social value of the good exceeds the
private value of the good.
50
Subsidies for positive externalities

What can be done to get the market
to increase education to the optimal
level?
A subsidy for either students (buyers
of education) or educational
institutions (sellers) will work.
A subsidy will make students and
educational institutions internalize
the positive externality of education
51
Subsidies for Positive Externalities: example
Recall that technology spillovers are

positive externalities
Therefore, the equilibrium level of
spending on research will be less than the
socially desirable level
Government intervention may promote
technology-enhancing industries
Patent laws are a form of technology policy
that give the individual (or firm) with patent
protection a property right over its invention.
The patent is then said to internalize the
externality.
52
PRIVATE SOLUTIONS TO
EXTERNALITIES
Government action is not always
needed to solve the problem of
externalities.
In some cases, the free market ends
up maximizing total surplus even
when there are externalities
53
PRIVATE SOLUTIONS TO
EXTERNALITIES
Moral codes and social sanctions
Charitable organizations
Integrating different types of
businesses
Contracting (bargaining, negotiations)
between those causing the
externalities and those affected by
the externalities
54
The Coase Theorem

The Coase Theorem is the
propositiondue to Ronald Coase
that if people can bargain without
transaction costs over the
allocation of resources, they can
solve the problem of externalities
on their own.
Transaction costs are the costs that
people incur in the process of agreeing
to and following through on a bargain.
55
Bob, Spot, and Jane and Ronald Coase

Bob and Jane are room mates. Bob gets Spot, a noisy dog, as a
birthday gift.
Benefit = $500;
Benefit = $1000;
Cost = $800
Cost = $800
Social optimum
Bob returns Spot
Bob keeps Spot
Government
solution
Bob forced to pay

$800 tax. Bob returns
Spot
No action required.
Bob keeps Spot
Private solution:
Jane has right to
quiet
Jane sues to enforce

Bob pays Jane $800.
her right. Bob cant
Bob keeps Spot
afford to pay Jane a
big enough bribe. Bob
returns Spot
Private solution:
Jane pays Bob $500.
Jane cant afford to
Bob has right to
Bob returns Spot
pay Bob a big enough
keep Spot
bribe. Bob keeps Spot
Coase Theorem: Private solutions to externalities can work
56
Dick, Spot, and Jane and Ronald Coase

Note that when the free market
outcome is not optimal, bargaining
between Bob and Jane will bring about
the optimal outcome, irrespective of
who is favored by the law
The law is important in other ways,
however. For example, in one case in
which the law favors Bob , Jane has to
pay a $500 compensation to Bob to get
him to return Spot
57
Coase Theorem: Exercise

In the case of pollution by an
aluminum factory, how might
production of the socially desirable
amount be brought about without
taxation by the government?
Why might Coases solution fail, as a
practical matter, in this case?
58
Why Private Solutions Do Not Always Work
Sometimes the private solution fails

because transaction costs are so high
that private agreement is not possible.
Bob might get greedy and try to haggle
with Jane for more than $500
Change the story by substituting three
people (Jan, Jeanne and Joan) instead of
Jane. Jan, Jeanne and Joan may find it hard
to raise $500 for Bobs compensation. Each
might try to free ride on the others.
59
PUBLIC POLICY TOWARD

EXTERNALITIES
When externalities are significant and
private solutions are not found,
government may attempt to solve the
problem through
command-and-control policies.
market-based policies.
60
PUBLIC POLICY: Command-andControl Policies

Such policies usually take the form of
regulations:
Forbid certain behaviors.
Require certain behaviors.
Examples:
Requirements that all students be
immunized.
Stipulations on pollution emission levels set
by the Environmental Protection Agency
(EPA).
61
PUBLIC POLICY: MARKET-BASED

POLICIES
Taxes and subsidies can align
private incentives with social
efficiency.
We have seen this already
These corrective taxes and
subsidies are called Pigovian
taxes and subsidies.
They were originally proposed by
the British economist, A. C. Pigou.
62

POLLUTION: Command-andControl
If the EPA decides it wants to reduce

the amount of pollution coming from
a specific plant, it could
tell the firm to reduce its pollution by a
specific amount (i.e. regulation).
levy a tax of a given amount for each
unit of pollution the firm emits (i.e.
Pigovian tax).
63

POLLUTION: Market-Based
Pigovian Taxes on the producers or
consumers of pollution
Tradable pollution permits that allow
the voluntary transfer of the right to
pollute from one firm to another.
A firm that can reduce pollution at a low
cost may prefer to sell its permit to a firm
that can reduce pollution only at a high
cost.
64
Figure 4 The Equivalence of Pigovian Taxes and

Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigovian
tax sets the
price of
pollution . . .
Demand for
pollution rights
0
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
Figure 4 The Equivalence of Pigovian Taxes and

Pollution Permits
(b) Pollution Permits
Price of
Pollution
Supply of
pollution permits
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
Policy Exercises
Should we punish the use of SUVs
and promote the use of smaller cars?
Should we force car makers to sell
cars with higher mileage?
Should we limit the use of gasoline
by each car owner?
Should we tax gasoline?
Should we tax all fuels based on the
damage each fuel causes?
67
Any Questions?
68
Summary
When a transaction between a buyer and
a seller directly affects a third party, the
effect is called an externality.
Negative externalities cause the socially
optimal quantity in a market to be less
than the equilibrium quantity.
Positive externalities cause the socially
optimal quantity in a market to be greater
than the equilibrium quantity.
69
Summary
Those affected by externalities can
sometimes solve the problem
privately.
The Coase theorem states that if
people can bargain without a cost,
then they can always reach an
agreement in which resources are
allocated efficiently.
70
Summary
When private parties cannot
adequately deal with externalities,
then the government steps in.
The government can either regulate
behavior or internalize the externality
by using Pigovian taxes or by issuing
pollution permits.
71

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4

THE ECONOMICS OF THE PUBLIC SECTOR

But markets can fail. Why?

EXTERNALITIES AND MARKET

In this case, Al will ignore the effects of

EXTERNALITIES AND MARKET

Society and the Individual

Individually desirable activity

To figure out the

To figure out the

Society and the Individual

Individually desirable activity

Society and the Individual

Individually desirable activity

Society and the Individual

Individually desirable activity

Society and the Individual

Individually desirable activity

Therefore, in this case, whats individually ideal is also whats

Society and the Individual

Individually desirable activity

Therefore, whats ideal for the individual may not be whats

Society and the Individual

Individually desirable activity

When there are positive externalities,

Therefore, the individual ignores positive externalities that affect

Society and the Individual

Individually desirable activity

When there are positive externalities,

Therefore, the individual ignores positive externalities that affect

Society and the Individual

Individually desirable activity

When there are negative externalities,

The individual ignores negative externalities that affect bystanders.

Society and the Individual

Individually desirable activity

When there are negative externalities,

The individual ignores negative externalities that affect bystanders.

Corrective Taxes and Subsidies

Society and the Individual

Individually desirable activity

When the individual receives a subsidy equal to the positive

the individual can no longer ignore the positive externalities that

Society and the Individual

Individually desirable activity

When the individual has to pay a tax equal to the negative

the individual can no longer ignore the negative externalities that

Coase Theorem: Private

Dealing with negative

Should we completely ban an activity

ban all cars?

Dealing with negative

How should we determine the extent

EXTERNALITIES AND MARKET

This might provide a justification for

EXTERNALITIES AND MARKET

Figure 1 The Market for Aluminum

Welfare Economics Without Externalities: A

When there are no externalities, the

is the socially desirable quantity

Social, private, and external costs

Figure 2 Pollution and the Social Optimum

Figure 2 Pollution and the Social Optimum

Public Policies for Negative