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EXTERNALITIES

§ We have learned there are two types of market failure:

1- Externalities;
EXTERNALITIES 2- Market Power.
§ Externality: The uncompensated impact of one person’s
actions on the well-being of a bystander.
Chapter 10 § The government responds by trying to influence this
behaviour to protect the interests of bystanders.

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FIGURE 10.1
Learning Objectives The Market for Aluminum

§ Learn the meaning of externality.

Let’s consider the market for
§ See why externalities can make market outcomes aluminum.
inefficient.
§ Examine how people can sometimes solve the problem of § The demand curve for
externalities on their own. aluminum reflects the value of
§ Consider why private solutions to externalities sometimes aluminum to consumers.
do not work.
§ The supply curve reflects the
§ Examine various government policies aimed at solving the costs of producing aluminum.
problem of externalities.
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FIGURE 10.2
Externalities and Market Inefficiency Pollution and the Social Optimum

NEGATIVE EXTERNALITIES The cost to society of

producing aluminum is
§ Suppose that aluminum larger than the cost to
factories emit pollution. the aluminum producers.

§ The smoke creates a health For each unit of

risk for those who breathe aluminum produced, the

Nickolay Khoroshkov /Shutterstock

the air; it is a negative social cost includes the
externality. private costs plus the
costs to those bystanders
§ How does this externality affected adversely by
affect the efficiency of the the pollution.
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FIGURE 10.3
Negative Externalities Deadweight Loss of a Negative Externality

§ The equilibrium quantity of aluminum QMARKET > QOPTIMUM.

How to Eliminate Deadweight Losses?
§ This inefficiency occurs because the market equilibrium Tax aluminum producers for each tonne of aluminum
reflects only the private costs of production. sold.

§ At market equilibrium, the marginal consumer values Internalize the externality: Alter incentives so that
aluminum less than the social cost of producing it as the people take account of the external effects of their
demand curve lies below the social-cost curve. actions.

§ Thus, reducing aluminum production and consumption

below the market equilibrium level raises total
economic well-being.
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FIGURE 10.4
Positive Externalities Education and the Social Optimum

§ Although some activities impose costs on third parties,

§ To move the market
others yield benefits. For example, Education.
equilibrium closer to the
§ Beyond its private benefits, education also yields social optimum, a positive
positive externalities. externality requires a subsidy.
§ More informed voters § Government subsidizes
§ Less crime education through public
§ Higher productivity and wages for everyone schools and government
scholarships.

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Positive Externalities QuickQuiz

Quick
Quiz
§ Negative externalities lead markets to produce a
larger quantity than is socially desirable.
ü Give an example of a negative externality and a
§ Positive externalities lead markets to produce a positive externality.
smaller quantity than is socially desirable. ü Explain why market outcomes are inefficient in
§ The government can internalize the externality by the presence of externalities.
taxing goods that have negative externalities and
subsidizing goods that have positive externalities.

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Public Policies Toward Externalities Command-and-Control Policies: Regulation

§ As a general matter, the government can respond to § The government can remedy an externality by
externalities in one of two ways. making certain behaviours either required or
1. Command-and-control policies regulate forbidden.
behaviour directly. § It is a crime to dump poisonous chemicals
2. Market-based policies provide incentives so that into the water supply.
private decision makers will choose to solve the § Environment Canada enforces the regulations.
problem on their own.
§ Regulation dictates the level of pollution
whereas a tax gives factory owners an
economic incentive to reduce pollution.

Thinkstock
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Market-Based Policy 1: Market-Based Policy 1:

Corrective Taxes and Subsidies Corrective Taxes and Subsidies (continued)
§ Internalizing the externality by imposing taxes on activities
that have negative externalities and subsidizing activities § Economists usually prefer corrective taxes over
that have positive externalities. regulations as a way to deal with pollution because
such taxes can reduce pollution at a lower cost to
§ Corrective (Pigovian) taxes: (taxes enacted to correct
society.
the effects of negative externalities)
§ Regulation dictates the level of pollution.
i. Place a price on the right to pollute
§ A tax gives factory owners an economic incentive
ii. Are better for the environment
to reduce pollution.
iii. Raise revenue for the government; enhance
economic efficiency

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Market-Based Policy 2:
FIGURE 10.5
Tradable Pollution Permits The Equivalence of Corrective Taxes and Pollution Permits

§ An advantage of allowing a market for pollution permits

is that the initial allocation of pollution permits does not
matter from the standpoint of economic efficiency.
§ Those firms that can reduce pollution most easily
would be willing to sell whatever permits they get.
§ Those firms that can reduce pollution only at high cost
would be willing to buy whatever permits they need.
§ As long as there is a free market for the pollution rights,
the final allocation will be efficient whatever the initial
allocation.
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Objections to the
Economic Analysis of Pollution QuickQuiz
Quick
§ It is not right to allow someone to pollute for a fee. Quiz
§ The environment is so important, that we should protect it as
much as possible, regardless of the cost.
ü A glue factory and a steel mill emit smoke
Response: containing a chemical that is harmful if inhaled
§ People face tradeoffs. in large amounts.
§ The value of clean air and clean water must be weighted ü Describe three ways the town government
against their opportunity cost (i.e., what one must give up to might respond to this externality.
obtain them).
ü What are the pros and cons of each of your
§ Eliminating all pollution would reverse many of the solutions?
technological advances that allow us to enjoy a high
standard of living.
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Private Solutions to Externalities The Coase Theorem

§ Although externalities tend to cause markets to be § How effective is the private market in dealing with
inefficient, government action is not always needed externalities?
to solve the problem.
§ Coase theorem: The proposition that if private parties
§ Moral codes and social sanctions. can bargain without cost over the allocation of
§ Charities. (Green Peace) resources, they can solve the problem of externalities
on their own.
§ The self-interest of the relevant parties.
§ Whatever the initial distribution of rights, the interested
parties can reach a bargain in which everyone is better
off and the outcome is efficient.

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Why Private Solutions Do Not Always Work? QuickQuiz

Quick
§ In the real world, however, bargaining does not always
Quiz
work, even when a mutually beneficial agreement is
possible. ü Give an example of a private solution to an
§ Transaction costs: The costs that parties incur in the externality.
process of agreeing to and following through on a ü What is the Coase theorem?
bargain. ü Why are private economic actors sometimes
§ Bargaining simply breaks down. unable to solve the problems caused by an
§ The number of parties involved is large and externality?
coordination is costly.

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THE END

Chapter 10

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