Chapter 10 ExternalitiesExternalities © 2002 by Nelson, a division of Thomson Canada Limited.

Chapter 10Chapter 10Chapter 10Chapter 10

ExternalitiesExternalitiesExternalitiesExternalities

©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 10: page 2

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

In this chapter you will…In this chapter you will…


• Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

But market failures can still

happen!

• Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

But market failures can still

happen!

EXTERNALITIESEXTERNALITIES


• If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.– Externalities cause markets to

be inefficient, and thus fail.

• If a market system affects individuals other than buyers and sellers of that market, side-effects are created called Externalities.– Externalities cause markets to

be inefficient, and thus fail.



• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.



• In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . .

• … the well-being of third parties are considered.

• In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers in the market. . .

• … the well-being of third parties are considered.



• Positive Externality• The uncompensated benefits that are

received by individuals who are not directly involved in the production or consumption of goods.

• The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.

• Positive Externality• The uncompensated benefits that are

received by individuals who are not directly involved in the production or consumption of goods.

• The act of producing or consuming goods sometimes generates benefits to others who do not have to pay for them.



• Negative Externality• The uncompensated costs that are

imposed upon individuals who are not directly involved in the production or consumption of goods.

• The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.

• Negative Externality• The uncompensated costs that are

imposed upon individuals who are not directly involved in the production or consumption of goods.

• The act of producing or consuming goods sometimes generates costs to others who are not paid to endure them.



Negative Externality• Automobile exhaust• Cigarette smoking

Positive Externality• Immunizations• Restored historic buildings

Negative Externality• Automobile exhaust• Cigarette smoking

Positive Externality• Immunizations• Restored historic buildings



• The Market for Aluminum – The demand curve for aluminum

reflects the value to consumers of aluminum as measured by the prices they are willing to pay.

– The supply curve for aluminum reflects the costs of producing aluminum.

– Qmarket: the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

• The Market for Aluminum – The demand curve for aluminum

reflects the value to consumers of aluminum as measured by the prices they are willing to pay.

– The supply curve for aluminum reflects the costs of producing aluminum.

– Qmarket: the quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

Welfare Economics: A RecapWelfare Economics: A Recap


Demand (private value)

Supply (private costs)

0

Equilibrium

QmarketQuantity of Aluminium

Price of Aluminium

Figure 10-1: The Market for AluminiumFigure 10-1: The Market for Aluminium


• The Market for Aluminum (cont’d)

– If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

• The Market for Aluminum (cont’d)

– If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

Welfare Economics: A RecapWelfare Economics: A Recap


• The Market for Aluminum (cont’d)– For each unit of aluminum produced,

the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

• The Market for Aluminum (cont’d)– For each unit of aluminum produced,

the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

Negative Externalities in Negative Externalities in ProductionProduction


• The Market for Aluminum (cont’d)– What quantity of aluminum should

be produced?• Where the demand curve crosses the

social-cost curve. • Below Qoptimum the value of the

aluminum to consumers exceeds rgw social cost of producing it.

• Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers.

• The Market for Aluminum (cont’d)– What quantity of aluminum should

be produced?• Where the demand curve crosses the

social-cost curve. • Below Qoptimum the value of the

aluminum to consumers exceeds rgw social cost of producing it.

• Above Qoptimum the social cost of producing additional aluminum exceeds the value to consumers.




Supply (private costs)

0

Equilibrium

QmarketQuantity of Aluminium

Price of Aluminium

Social costs

Qoptimum

Cost of pollution

Optimum

Figure 10-2: Pollution and the Social Figure 10-2: Pollution and the Social OptimumOptimum


• The Market for Aluminum (cont’d)– Reducing aluminum production and

consumption below the market equilibrium level raises total economic well-being.

• The Market for Aluminum (cont’d)– Reducing aluminum production and

consumption below the market equilibrium level raises total economic well-being.



0 Quantity of Aluminium

Price of Aluminium

Social costs


Poptimum

Qoptimum

Figure 10-3: Deadweight Loss of a Negative Figure 10-3: Deadweight Loss of a Negative Production Externality Production Externality

Pmarket

Qmarket

a

b

HD + A + ED + A + E - H

A + B + C + HA + EE - (B + C + H)

- (A + B + C)DA + B + C + D

Total surplus

Producer surplus

Consumer surplus

ChangeAt QOptimumAt QMarket

D

A B C

E

F G

H


• The Market for Aluminum (cont’d)– How the can social optimum of aluminum

production be achieved?• Tax the producers of aluminum thus shifting the

private supply curve up by the amount of the tax so that it coincides with the social-cost curve.

– Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

– Pigovian taxes are taxes enacted to correct the effects of negative externalities.

– In Figure 10-3, the Pigovian tax is equal to the distance ab.

• The Market for Aluminum (cont’d)– How the can social optimum of aluminum

production be achieved?• Tax the producers of aluminum thus shifting the

private supply curve up by the amount of the tax so that it coincides with the social-cost curve.

– Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

– Pigovian taxes are taxes enacted to correct the effects of negative externalities.

– In Figure 10-3, the Pigovian tax is equal to the distance ab.



• When an externality benefits the bystanders, a positive externality exists.– The social value of the good exceeds the

private value.• Example:• A technology spillover is a type of positive

externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

• When an externality benefits the bystanders, a positive externality exists.– The social value of the good exceeds the

private value.• Example:• A technology spillover is a type of positive

externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

Positive Externalities in Positive Externalities in ProductionProduction


0

Optimum

Quantity of Robots

Price of Robots


Social costs

a

b

Qoptimum

Poptimum

Qmarket

Pmarket Equilibrium

Supply (private costs)Value of technology spillover

Deadweight loss

Figure 10-4: Technology Spillovers and the Figure 10-4: Technology Spillovers and the Social Optimum Social Optimum


• 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.

• 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.



• Internalizing Externalities: Subsidies– Used as the primary method for

attempting to internalize positive externalities.

• Internalizing Externalities: Subsidies– Used as the primary method for

attempting to internalize positive externalities.



– Government intervention in the economy that aims to 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.

• The patent system gives firms a greater incentive to engage in research and other activities that advance technology.

– Government intervention in the economy that aims to 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.

• The patent system gives firms a greater incentive to engage in research and other activities that advance technology.

CASE STUDY:CASE STUDY: The Debate Over Technology The Debate Over Technology PolicyPolicy


• Some externalities are associated with consumption.

• Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages.

• Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education.

• Some externalities are associated with consumption.

• Figure 10-5 (a) shows a market with a negative consumption externality such as the market for alcoholic beverages.

• Figure 10-5 (b) shows a market with a positive consumption externality such as the market for education.

Externalities in ConsumptionExternalities in Consumption


(a) Negative Consumption Externalities (b) Positive Consumption Externalities

Price of Alcohol

Quantity of Alcohol

0 0

Social value


Supply (private cost)

Quantity of Education

Price of Education

Social value


Supply (private cost)

Qmarket QoptimumQoptimum Qmarket

Figure 10-5: Consumption Externalities Figure 10-5: Consumption Externalities


• Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient.

• People can develop private solutions.– Moral codes and social sanctions– Charitable organizations– Integrating different types of

businesses– Contracting between parties

• Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient.

• People can develop private solutions.– Moral codes and social sanctions– Charitable organizations– Integrating different types of

businesses– Contracting between parties

PRIVATE SOLUTIONS TO PRIVATE SOLUTIONS TO EXTERNALITIESEXTERNALITIES


• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

• Private bargaining can internalize the external effects, resulting in efficient solutions.

• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

• Private bargaining can internalize the external effects, resulting in efficient solutions.

The Coase TheoremThe Coase Theorem


• In the real world bargaining does not always work.– Transactions Costs

• Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

– Bargaining breaks down.

• In the real world bargaining does not always work.– Transactions Costs

• Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

– Bargaining breaks down.

Why Private Solutions Do Not Why Private Solutions Do Not Always WorkAlways Work


• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .– Command-and-control policies that

regulate behaviour directly.– Market-based policies that provide

incentives so that private decisions makers will choose to solve the problem on their own.

• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .– Command-and-control policies that

regulate behaviour directly.– Market-based policies that provide

incentives so that private decisions makers will choose to solve the problem on their own.

PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES


• Command-and-Control 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).

• Command-and-Control 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).



• Market-Based Policies– Government can internalize an

externality by using taxes and subsidies to align private incentives with social efficiency.

– Pigovian taxes are taxes enacted to correct the effects of a negative externality.

• Market-Based Policies– Government can internalize an

externality by using taxes and subsidies to align private incentives with social efficiency.

– Pigovian taxes are taxes enacted to correct the effects of a negative externality.



• Why are gasoline taxes so common?• They are a Pigovian tax aimed at

correcting three negative externalities:– Congestion– Accidents– Pollution

• The tax makes the economy work better.

• Why are gasoline taxes so common?• They are a Pigovian tax aimed at

correcting three negative externalities:– Congestion– Accidents– Pollution

• The tax makes the economy work better.

CASE STUDY:CASE STUDY: Why Is Gasoline Taxed So Why Is Gasoline Taxed So Heavily?Heavily?


• Market-Based Policies– Tradable pollution permits allow the

voluntary transfer of the right to pollute from one firm to another.

– A market for these permits will eventually develop.

– 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.

• Market-Based Policies– Tradable pollution permits allow the

voluntary transfer of the right to pollute from one firm to another.

– A market for these permits will eventually develop.

– 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.



• Market-Based Policies– Reducing pollution using permits is quite

similar to imposing a Pigovian tax. – In both cases it is the firm who pays its

pollution. – With Pigovian taxes, polluting firms must pay

the government.– With pollution permits, polluting firm must pay

to buy the permit. – See Figure 10-6 for an illustration of the

similarities.

• Market-Based Policies– Reducing pollution using permits is quite

similar to imposing a Pigovian tax. – In both cases it is the firm who pays its

pollution. – With Pigovian taxes, polluting firms must pay

the government.– With pollution permits, polluting firm must pay

to buy the permit. – See Figure 10-6 for an illustration of the

similarities.



(a) Pigovian Tax (b) Pollution Permits

Price of Pollution

Quantity of Pollution

0

Pigovian Tax

P

1. A Pigovian sets the price of pollution…

2. … which together with the demand curve, determines the quantity of pollution…

Demand for pollution rights

QQuantity of

Pollution

0

Supply of pollution permits

1. … Pollution permits set the quantity of pollution…

Q

2. … which together with the demand curve, determines the price of pollution…

Demand for pollution rights

P

Figure 10-6: The Equivalence of Pigovian Figure 10-6: The Equivalence of Pigovian Taxes and Pollution Permits. Taxes and Pollution Permits.


• 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.

• 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.

SummarySummary


• 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.

• 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.

• 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.

• 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.

SummarySummary


The EndThe End

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