Chapter 10
Externalities
In this chapter, look for the answers to these questions:
• What is an externality?
• Why do externalities make market outcomes inefficient?
• What public policies aim to solve the problem of
externalities?
• How can private solutions help with the problem of
externalities?
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INTRODUCTION
• Two Principles of Economics: Markets are usually a good way
to organize economy activity, but governments can sometimes
improve market outcomes.
• Externalities are a form of market failure - the uncompensated
impact of one person’s actions on the well-being of a bystander.
• Externalities can be negative or positive
• Private individuals and public policymakers may remedy this
type of market failure.
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Welfare Economics: A Recap
• The market equilibrium maximizes consumer and producer surplus.
• The supply curve shows private cost – the costs directly incurred by
sellers.
• Demand curve shows private value – the value to buyers (the prices
they are willing to pay).
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Negative Externalities
Example: Aluminum factories emitting pollution
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Internalizing Externalities
• Internalizing the externality: altering incentives so that people
take account of the external effects of their actions.
• For example, tax aluminum production for each tonne sold, so that
market Q equals optimal Q.
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Positive externalities
Example: Education
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Positive externalities
• 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.
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Public policies toward externalities
• Command-and-control policies
• Regulate behavior directly
• Examples:
• Limits on quantity of pollution emitted
• Requirements to 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 (Pigovian) taxes or subsidies
• Tradeable pollution permits
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Market-based policy 1: Corrective taxes and
subsidies
• Corrective taxes and 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.
• For negative externalities: Corrective tax = external cost
• For positive externalities: Corrective subsidy = external benefit
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Market-based policy 2: Tradable pollution permits
• Tradable pollution permits
• Voluntary trade of the right to pollute from one firm to another
• Firms that can reduce pollution at low cost sell their unused permits
• Firms that can only reduce pollution at high cost buy permits
• Reduces pollution at lower cost than regulation
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Corrective taxes versus tradable pollution
permits
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Active Learning 1
A. Regulating lower SO2 emissions
• Acme and US Electric run coal-burning power plants. Each emits 40
tonnes of sulfur dioxide per month. Total emissions = 80 tonnes/month.
• Goal: Reduce SO2 emissions 25%, to 60 tonnes/month
• Cost of reducing emissions: $100/tonne for Acme, $200/tonne for US
Electric
Policy option 1: Regulation
Every firm must cut its emissions 25% (10 tonnes).
Your task: Compute the cost to each firm and total cost of achieving goal
using this policy.
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Active Learning 1
A. Answers
• Each firm must reduce emissions by 10 tonnes.
• Cost of reducing emissions: $100/tonne for Acme, $200/tonne for US
Electric.
• Compute cost of achieving goal with this policy:
Cost to Acme: (10 tonnes) x ($100/tonne) = $1,000
Cost to US Electric: (10 tonnes) x ($200/tonne) = $2,000
Total cost of achieving goal = $3,000
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Active Learning 2
B. Tradable pollution permits
A. Initially, Acme and US Electric each emit 40 tonnes SO2/month.
B. Goal: Reduce SO2 emissions to 60 tonnes/month total.
Policy option 2: Tradable pollution permits
A. Issue 60 permits. Each allows one tonne SO2 emissions. Give 30 permits to
each firm. Establish market for trading permits.
B. Each firm may use all its permits to emit 30 tonnes,
may emit < 30 tonnes and sell leftover permits
or may purchase extra permits to emit > 30 tonnes.
Your task: Compute the cost of achieving the goal if Acme
uses 20 permits and sells 10 to US Electric for $150 each.
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Active Learning 2
B. Answers
• Goal: Reduce emissions from 80 to 60 tonnes
• Cost of reducing emissions: $100/tonne for Acme, $200/tonne for
US Electric
• Compute cost of achieving goal with this policy:
Acme
• Sells 10 permits to US Electric for $150 each, gets $1,500
• Uses 20 permits, emits 20 tonnes SO2
• Spends $2,000 to reduce emissions by 20 tonnes
• Net cost to Acme: $2,000 − $1,500 = $500
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Active Learning 2
B. Answers (cont’d)
US Electric
• Buys 10 permits from Acme, spends $1,500
• Uses these 10 plus original 30 permits, emits 40 tonnes.
• Spends nothing on abatement.
• Net cost to US Electric = $1,500.
Total cost of achieving goal = $500 + $1,500 = $2,000.
Using tradable permits, goal is achieved at lower total cost and lower cost
to each firm than using regulation.
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Private solutions to externalities
• Types of private solutions
• Moral codes and social sanctions
• Charities
• Integrating different types of businesses
• Contracts between market participants and the affected
bystanders
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The Coarse Theorem
• If private parties can costlessly bargain over the allocation of
resources, they can solve the externalities problem on their own
• Example:
• Mujab likes to play the saxophone.
• Negative externality: Mujab’s playing disturbs Sahar, Mujab’s neighbor.
• The socially efficient outcome maximizes Mujabs’s and Sahar’s well-
being.
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The Coase Theorem: An Example
• CASE 1:
• Benefit to Mujab of playing the saxophone = $500.
• Cost to Sahar of Mujab’s playing = $800.
• Socially efficient outcome: Mujab stops playing and gets rid of the
saxophone.
• Private outcome: Sahar pays Mujab $600 to get rid of the saxophone,
both Mujab and Sahar are better off.
• Private outcome = efficient outcome.
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The Coase Theorem: An Example
• CASE 2:
• Benefit to Mujab of playing saxophone = $1,000
• Cost to Sahar of Mujab’s playing = $800
• Socially efficient outcome: Mujab continues to play.
• Private outcome: Sahar not willing to pay more than $800, Mujab not
willing to accept less than $1,000, so the saxophone stays.
• Private outcome = efficient outcome.
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Active Learning 3
Applying Coase
Collectively, the 1,000 residents of Green Valley value swimming
in Blue Lake at $100,000.
A nearby factory pollutes the lake water and would have to pay
$50,000 for non-polluting equipment.
A. Describe a Coase-like private solution.
B. Can you think of any reasons why this solution might not
work in the real world?
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Why private solutions do not always work
1. Transaction costs: The costs parties incur in the process of
agreeing to and following through on a bargain. These costs may
make it impossible to reach a mutually beneficial agreement.
2. Stubbornness: Even if a beneficial agreement is possible, each
party may hold out for a better deal.
3. Coordination problems: If there are many parties involved,
coordinating them may be costly, difficult or impossible.
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Summary
• An externality occurs when a market transaction affects a third
party.
• If the transaction yields negative externalities, the market
quantity exceeds the socially optimal quantity.
• If the externality is positive, the market quantity falls short of the
social optimum.
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Summary
• The government can attempt to internalize externalities, for
example by using corrective taxes and subsidies or tradable
pollution permits.
• The Coase theorem states that the private market can reach the
socially optimal allocation of resources as long as people can
bargain without cost.
• In practice, bargaining is often costly or difficult, and the Coase
theorem does not apply.
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