Externalities CHAPTER 10

CHAPTER CHECKLIST

When you have completed your study of this

chapter, you will be able to

1 Explain why negative externalities lead to inefficient

overproduction and how property rights, pollution
charges, and taxes can achieve a more efficient
outcome.
2 Explain why positive externalities lead to inefficient
underproduction and how public provision, subsidies,
vouchers, and patents can achieve a more efficient
outcome.
EXTERNALITIES IN OUR DAILY LIVES

An externality is a cost or a benefit that arises from:

Production that falls on someone other than the
producer
Consumption that falls on someone other than the
consumer
A negative externality is a production or
consumption activity that creates an external cost.
A positive externality is a production or consumption
activity that creates an external benefit.
 EXTERNALITIESIN
EXTERNALITIES INOUR
OURDAILY
DAILYLIVES
LIVES

Four types of externalities:

Negative production externalities
Positive production externalities
Negative consumption externalities
Positive consumption externalities
 EXTERNALITIESIN
EXTERNALITIES INOUR
OURDAILY
DAILYLIVES
LIVES

Negative Production Externalities

Pollution is the major example of this type of externality.
Others are noise and congestion.
Positive Production Externalities
Example: Orchards provide positive production
externalities to honey producers, who in turn provide
positive production externalities to orchards.
 EXTERNALITIESIN
EXTERNALITIES INOUR
OURDAILY
DAILYLIVES
LIVES

Negative Consumption Externalities

Smoking tobacco in a confined space
Noisy parties

Positive Consumption Externalities

A flu vaccination
Restoration of an historic building
Education and research
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Private Costs and Social Costs

Marginal private cost is the cost of producing an
additional unit of a good or service that is borne by the
producer of that good or service.
Marginal external cost is the cost of producing an
additional unit of a good or service that falls on people
other than the producer.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Marginal social cost is the marginal cost incurred by

the entire societyby the producer and by everyone
else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal
private cost (MC) and marginal external cost.
MSC = MC + Marginal external cost
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

Figure 10.1 shows the

relationship between
cost and output.

When output is 4,000 tons

of chemicals a month:
1. Marginal private
cost is $100 a ton.
2. Marginal external
cost is $125 a ton.
3. Marginal social cost is
$225 a ton.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Production and Pollution: How Much?

When an industry is unregulated, the amount of
pollution it creates depends on the market equilibrium
price and the quantity of the good produced.
If the industry creates an external cost, the market
equilibrium is inefficient. Too much of the good is
produced.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.2 shows
inefficiency with an
external cost.
1. The market is in
equilibrium at a
price of $100 a ton
and 4,000 tons of
chemical a month
is inefficient.
2. Marginal social
cost exceeds ...
3. Marginal benefit.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

4. The efficient
quantity is 2,000
tons of chemical,
where marginal
social cost equals
marginal benefit.
5. The gray triangle
shows the dead-
weight loss created
by the pollution
externality.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Property Rights
Property rights are legally established titles to the
ownership, use, and disposal of factors of production
and goods and services that are enforceable in the
courts.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.3 shows
how property
rights achieve an
efficient outcome.
1. With property
rights, the MC
curve that
excludes the cost
of pollution shows
only part of the
producers
marginal cost.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

2. The marginal
private cost
curve includes
the cost of
pollution, and
the supply curve
is S = MC.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION
3. Market
equilibrium is
at a price of
$150 a ton and
a quantity of
2,000 tons of
chemical a
month and is
efficient
because
4. Marginal social
cost equals
marginal benefit.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

The Coase Theorem

Coase theorem is the proposition that if property
rights exist, only a small number of parties are involved,
and transactions costs are low, then private transactions
are efficient and the outcome is not affected by who is
assigned the property right.
Transactions costs are the opportunity costs of
conducting a transaction.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Application of the Coase Theorem

If factories own homes and river, the rent people
willingly pay decreases as the amount of pollution
increases.
If homeowners own the river, factories must pay
homeowners for any pollution, and the more they
pollute, the more they pay.
Regardless of who owns the river, so long as someone
owns it, the factories bear the cost of pollution, and the
quantity of production and pollution are efficient.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Government Actions in the Face of External

Costs
The three main methods that governments can use to
achieve a more efficient allocation of resources in the
presence of external costs are:
Emission charges
Marketable permits
Taxes
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Emission Charges
Emission charges confront the producers with the
external cost of pollution and provide an incentive to
seek technologies that are less polluting.

To work out the emission charge that achieves

efficiency, the regulator needs a lot of information about
the industry, which is generally not available.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Marketable Permits
A marketable permit assigns to each producer in an
industry an emission limit.
Producers can buy and sell permits in the market.
Producers with a low marginal cost of reducing
pollution will sell permits and producers with a high
marginal cost of reducing pollution will buy.
Producers will buy and sell permits until their marginal
cost of pollution equals the market price of a permit.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

Taxes
Figure 10.4 shows
the effects of a
pollution tax.

1. A pollution tax is
imposed that is
equal to the
marginal external
cost arising from
pollution.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

The supply curve

becomes the marginal
private cost curve,
MC, plus the taxthe
curve labeled
S = MC + tax.

Because the tax

equals the marginal
external cost, the MSC
curve becomes the
supply curve.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

2. Market equilibrium
at a price of $150 a
ton and 2,000 tons
of chemical a month
is efficient
because
3. Marginal social cost
equals marginal
benefit.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

4. The government
collects tax
revenue shown by
the purple
rectangle.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Private Benefits and Social Benefits

Marginal private benefit is the benefit of an
additional unit of a good or service that the consumer of
that good or service receives.
Marginal external benefit is the benefit of an
additional unit of a good or service that people other
than the consumer of the good or service enjoy.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Marginal social benefit is the marginal benefit

enjoyed by societyby the consumers of a good or
service and by everyone else who benefits from it.
Marginal social benefit (MSB) is the sum of marginal
private benefit (MB) and marginal external benefit.
MSB = MB + Marginal external benefit
 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Figure 10.5 shows an

external benefit.
When 15 million students
attend college:
1. Marginal private benefit
is $10,000 per student.

2. Marginal external benefit

is $15,000 per student.

3. Marginal social benefit is

$25,000 per student.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Figure 10.6 shows

inefficiency with an
external benefit.
1. Market equilibrium
is at a tuition of
$15,000 a year and
7.5 million students
and is inefficient
because
2. Marginal social
benefit exceeds
3. Marginal cost.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

4. The efficient
number of students
is 15 million.

5. The gray triangle

shows the
deadweight loss
created because
too few students
enroll in college.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Government Actions In the Face of External

Benefits
Four devices that governments can use to achieve a
more efficient allocation of resources in the presence of
external benefits:
Public provision
Private subsidies
Vouchers
Patents and copyrights
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Public provision is the production of a good or

service by a public authority that receives the bulk of its
revenue from the government.
A subsidy is a payment that the government makes to
private producers to cover part of the costs of
production.
A voucher is a token that the government provides to
households that can be used to buy specified goods or
services.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Public provision
Figure 10.7(a) shows how
public provision can achieve
an efficient outcome.
1. Marginal social benefit equals
marginal cost with 15 million
students enrolled in college.
2. The efficient quantity.
3. Tuition is $10,000 per year.
4. The taxpayers cover the
remaining $15,000 of
marginal cost per student.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Private Subsidies
Figure 10.7(b) shows
how a subsidy
achieves an efficient
outcome of 15 million
students.
1. A $15,000 subsidy
per student shifts
the supply curve to
S = MC subsidy.
2. The dollar price is
$10,000 a student.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

3. The market
equilibrium is
efficient with 15
million students
enrolled in college.

4. Marginal social
benefit equals
marginal cost.
 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Vouchers
Figure 10.8 shows
how vouchers can
achieve an efficient
outcome.
The MSB curve
becomes the demand
curve because
1. With vouchers,
buyers are willing to
pay MB plus the
value of the voucher.
 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
2. Market equilibrium is
efficient with 15
million students
enrolled.
3. Price, marginal
social benefit, and
marginal cost are
equal.
4. Tuition equals the
dollar price of
$10,000 plus the
value of the voucher.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Intellectual property rights are the property rights of

the creators of knowledge and other discoveries.
A patent or copyright is a government-sanctioned
exclusive right granted to the inventor of a good,
service, or productive process to produce, use, and sell
the invention for a given number of years.