Externalities and Market Inefficiency

Consider the market for aluminum. The demand curve reflects the value of
aluminum to consumers, measured by the prices they are willing to pay.

At a given quantity, the height of the demand curve measures the willingness
to pay of the marginal buyer the one who would leave the market if price was
any higher.

The supply curve reflects the cost of producing aluminum. At any given
quantity the height of the supply curve is the cost of the marginal seller.
When there is no externality from the production or consumption of alu-
minum, the buyers and sellers of aluminum are the only ones whose welfare is
affected by the equilibrium price and quantity of aluminum. Thus total surplus
equals consumer surplus plus producer surplus, and this measures the total ben-
efit to society from the existence of an aluminum market.

Now suppose aluminum factories emit a certain amount of smoke into the
atmosphere for each unit of aluminum produced. This smoke worsens the health
of those who breathe the air, so it is a negative externality.

Because of the externality the cost to society of producing aluminum is

higher than the cost to the firm of producing aluminum. We can draw the
marginal cost to society curve above the marginal cost the the firm (supply)
curve. If the cost to health due to the smoke is proportional to the amount of
smoke in the atmosphere, the marginal social cost curve will be the marginal
private (firms) cost curve shifted vertically up. The marginal social cost at each
quantity equals the marginal private cost to the firm plus the external cost to
those who breathe the air.

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 P Marginal Social
Cost
Supply
(Marginal Private cost)

Private demand

To see what quantity of aluminum should be produced, consider what the

benevolent social planner would do. The planner wants to maximize total sur-
plus from the market. In this case, to get total surplus, we must add to consumer
surplus and producer surplus the surplus from those who are not in the market
but who are affected by the externality.

The planner chooses the level of aluminum Q at the intersection of the

social cost curve and the (private) demand curve.
This level of aluminum is optimal because:

At any level of aluminum above Q , the marginal social cost of producing

additional aluminum is higher than the marginal social benefit (measured by the
demand curve) of producing additional aluminum. If the economy is at a point
of aluminum production above Q , total surplus can be increased by decreasing
aluminum production to the point where marginal social cost equals marginal
social benefit, which is Q . If the economy is at a point of aluminum production
below Q , total surplus can be increased by increasing aluminum production to
the point where marginal social cost equals marginal social benefit, which is Q .

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 In particular, the equilibrium point Qe at the intersection between the pri-
vate cost curve and the demand curve does not maximize total surplus.
Note that equilibrium quantity of aluminum, Qe is larger than the socially
optimal quantity Q . This is because the externality is negative, so the marginal
social cost curve lies to the left of the marginal private cost curve. Therefore the
intersection of the demand curve with the marginal social cost curve lies to the
left of the intersection of the demand curve with the marginal private cost curve.

How can the government achieve the social optimum level of aluminum pro-
duction? There are several methods. One is to tax aluminum production by an
amount per unit that equals the cost to peoples health per unit of aluminum
produced. That would shift the supply curve vertically up by the amount of the
tax so that marginal the private cost curve with tax equals the marginal social
cost curve. Then the equilibrium quantity would be the optimal quantity.
Positive Externalities

Example: Education. Much of the benefit due to education is private. The

buyer of education becomes more productive as a worker as gets higher wages.
But there are also positive externalities. More educated population may en-
courage development of technological advances leading to higher productivity
and wages for all society.

Consider the market for education. Assume that the true value to society of
each unit of education is higher by the same amount at every quantity of edu-
cation. Then the marginal benefit to society curve equals the private marginal
benefit curve (demand) shifted up vertically by the marginal external benefit.
The optimal quantity Q is at the intersection of the marginal social benefit
curve with the marginal cost (supply) curve. This quantity is higher than the
quantity Qe at the intersection of the private social benefit curve with the supply
curve because the marginal social benefit curve lies to the right of the marginal
private benefit curve.

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 P
Supply

Marginal
Social benefit
Demand
(Private benefit)

To move the market equilibrium closer to the socially optimal point of pro-
duction, the government can subsidize education. A subsidy shifts the demand
curve vertically up by the amount of the subsidy per unit. If the subsidy causes
the demand curve to equal the marginal social benefit curve, then the socially
optimal level of education is reached.
Technology spillovers, industrial policy and patent protection

One type of positive externality is called a technology spillover. This is the

effect of one firms research and production activities on other firms access to
technological advance.

Solutions to externalities

Private (non-government) solutions

In some cases of externalities the government need not intervene to reach an

efficient outcome. People may develop solutions privately.

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 One example of a case of externality with private solution is littering. People
are taught as children not to litter because if everyone did it, then places would
look bad. Not littering because of this thought is an example of internalizing
an externality taking into account effect of ones actions on everyone.
Another example of private solutions to externalities is charities. Many char-
ities are set up due to externalities. The Sierra Club, whose mission is to protect
the environment from degradation, is funded with private donations. Also, col-
leges and universities receive gifts from alumni, foundations and corporations
in part because of the positive externalities that education creates.

Government encourages private solutions to externalities by giving income

tax deductions to charitable donations.
Sometimes the externality can be removed by integrating different businesses
that affect each other.

Consider an apple grower and a beekeeper located next to each other. The
bees help the orchard produce apples by pollinating the apple trees. The trees
help the bees get pollen to make honey. Thus, each business has a positive
externality on the other.

If the firms are separate, then the beekeeper and the apple grower will each
neglect the externality when deciding how many bees to keep and how many
trees to plant. Therefore they do not get the efficient outcome. If each produced
more, the other could produce more as a result.

If the firms were merged, the effect of the bees on the apple trees and the
effect of the apple trees on the bees would be taken into account when making
production decisions. The single firm would choose the optimal number of bees
and of trees.
Another way for an externality to be removed is for interested parties to
negotiate over the externality. The only role that the government may have in
this process is setting property rights over the externality.

In the bees and trees example, the beekeeper and the apple grower could
agree on a contract the would specify the number of trees grown and number
of bees kept and if necessary, how much one would pay the other for the use it
gets from the others property. For this, it is necessary that property rights be
decided on does the beekeeper or the apple grower own the pollen extracted
by the bees from the trees or does the apple grower own it?
The Coase theorem states that if bargaining is costless, then the parties af-
fected by an externality will arrive at an efficient outcome on their own. The

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rationale is that if there are mutual gains to be made, the affected people will
exploit them.

The Coase theorem also states that the efficient outcome reached does not
depend on the initial distribution of property rights. This part holds only under
special circumstances, though.

An illustration of the Coase theorem.

Dick and Jane are neighbors. Dick owns a dog named Spot who barks and
disturbs Jane. Should Dick be forced to give away his dog, or should Jane be
forced to suffer sleepless nights because of the barking?
To find the socially efficient outcome, compare the benefit to Dick of having
the dog with the cost to Jane of the barking. If the benefit exceeds the cost, it
is efficient for Dick to keep Spot. If the cost exceeds the benefit, it is efficient for
Dick to give Spot away to his uncle who lives in the country where the barking
wont disturb anyone.
According to the Coase theorem, Jane and Dick will arrive at the efficient
outcome by themselves. If Dick has the right to own a barking dog, Jane can
pay Dick to give Spot away. Dick will accept if the amount Jane offers is greater
than the benefit to him of keeping the dog.

Suppose that Dick has a $500 benefit from Spot and Jane bears an $800 cost
from the barking. Then Jane can offer Dick, say, $600 to give Spot away. An
efficient outcome is reached, as the dog is given away when the benefit to Dick
from the dog is less than the cost to Jane of the barking.

If Dick does not have the right to have a barking dog, there is no price he is
willing to pay Jane to keep the dog, and Spot is given away as well.
Now suppose Dick gets a $1000 benefit from the dog and Jane bears an $800
cost from the barking. Now there is no price Jane is willing to pay that Dick
would be willing to accept to give away the dog. Then Dick keeps the dog. This
outcome is efficient in this case.

If Jane has the right to quiet (Dick has no right to have a barking dog), he
will pay her, say, $900 to keep the dog, and again the efficient outcome will be
reached.

Who has the property rights determines who gets how much money. Each of
them will be better off having the property rights than without them. However
the distribution of property rights does not affect whether the dog is given away

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or kept.
In cases where bargaining or transaction costs exist, an efficient outcome
may not be reached by private bargaining.

Suppose Dick and Jane speak different languages and have to hire a transla-
tor. Assume Dicks benefit from the dog is $1000, Janes cost from the barking
is $800, and the cost of the translator is $400. Then there is no amount that
Dick could pay Jane to keep the dog (if she has the right to quiet), because the
cost of the bargaining would be more than the difference between their value
and cost from the dog. So Dick is forced to give the dog away, even though
his valuation of the dog is higher than Janes cost from the dog, an inefficient
outcome. More realistically, transactions costs would be the costs of lawyers
needed to draft and enforce a contract.
Another problem might be that they simply cannot reach an agreement. If
Dicks benefit from the dog is $500, Dick might demand $750, and Jane might
offer only $550. Then the bargaining would break down and the inefficient out-
come would persist.

When the number of interested parties is large reaching an agreement is

especially difficult, because coordination is costly and difficult.
Public solutions to externalities

The government can respond with command-and-control policies or market-

based policies.

Command and control policies regulate the level of the externality directly.
For instance it can make it a crime to dump poisonous chemicals into the water
supply.

In most cases of pollution it is too costly to society to ban pollution com-

pletely. For instance most forms of transportation cause some pollution, but
government cannot ban all transportation.

Instead weights costs and benefits of transportation and the resulting pollu-
tion to decide how much pollution will be allowed.
In US, EPA is the government agency that develops and enforces regulations
for pollution. Sometimes EPA dictates a maximum level of pollution. Or it
requires firms to adopt a technology to reduce emissions. Needs to know costs
of specific industries and the costs and benefits of alternative technologies.
Market-based policies

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 1. Corrective taxes and subsidies

Government can tax activities that have a negative externality and subsidize
activities that have a positive externality.

Such taxes are called corrective taxes or Pigovian taxes.

To get the socially efficient level of production, the tax per unit should equal
the external cost per unit: The difference between the marginal social cost and
the marginal private cost.
Economists tend to prefer corrective taxes to regulations because they can
deal with pollution at a lower cost to society.

Consider an example. Two factories, a steel mill and a paper mill, are each
dumping 500 tons of glop into a river each year. The EPA decides it wants to
reduce the amount of pollution. Two possible solutions:

Regulation: EPA tells each factory to reduce its pollution to 300 tons per
year.

Corrective tax: EPA could levy a tax on each factory of $50, 000 per ton of
glop emitted.
Most economists would prefer the tax. Any level of pollution can be achieved
by setting the tax appropriately. The tax reduces pollution more efficiently.

The regulation would require each firm to reduce pollution to the same
amount. But it may cost more for one firm to reduce pollution than for the
other. Then the most efficient way to reduce pollution would be to allow one
firm to reduce pollution more than the other.

The corrective tax places a price on the right to pollute. It allocates pollu-
tion to those firms who have a highest cost of reducing it.

Another reason for corrective taxes over command-and control policies: Un-
der the command-and control policy, the firms have no incentive to reduce
pollution further than the legal limit. Under the tax, they have an incentive to
develop cleaner technology to pay less of the tax.

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 Unlike other taxes, corrective taxes may not have a deadweight loss. They
restore efficiency instead of creating inefficiency.
2. Tradeable pollution permits

Suppose the EPA adopts the limit requiring each factory to reduce pollution
to 300 tons of glop each year.

The firms propose a deal to the EPA: steel mill wants to increase its emis-
sions by 100 tons. Paper mill will reduce emissions by 100 tons if steel mill pays
it 5 million.

The deal must improve the well-being of both factories because they agree
to it. Therefore improves economic efficiency. No effect on pollution.

This is the logic of tradeable pollution permits.