Diploma in Management Studies

Microeconomics ECO001
Lecture 12 Externalities
Topics to be discussed:
Definition of Positive and Negative
Externalities
Effects of Positive and Negative Externalities
Methods to Solve Problems of Positive and
Negative Externalities
Coarse Theorem and Property Right
Ref: Parkin, Chapter 15

Learning Outcomes
After this lecture, students should be able to:
Explain how externalities arise
Explain why negative externalities lead to
inefficient overproduction and how property
rights, emission charges, marketable
permits, and taxes can be used to achieve a
more efficient outcome
Explain why positive externalities lead to
inefficient underproduction and how public
provision, subsidies, vouchers, and patents
can increase economic efficiency
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Externalities in Our Lives

An externality is a cost or benefit that arises from
production and falls on someone other than the
producer, or a cost or benefit that arises from
consumption and falls on someone other than
the consumer.
A negative externality imposes a cost and a
positive externality creates a benefit.
The four types of externality are
Negative production externalities
Positive production externalities
Negative consumption externalities
Positive consumption externalities
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Negative Production Externalities

Negative Production Externalities
Negative production externalities are
common.
Some examples are noise from aircraft and
trucks, polluted rivers and lakes, the
destruction of animal habitat, and air
pollution in major cities from auto exhaust.

Positive Production Externalities

Positive Production Externalities
Positive production externalities are less
common that negative externalities.
Two examples arise in honey and fruit
production. By locating honeybees next to a fruit
orchard, fruit production gets an external benefit
from the bees, which pollinate the fruit orchards
and boost fruit output; and honey production
gets an external benefit from the orchards.

Negative Consumption Externalities

Negative Consumption Externalities
Negative consumption externalities are a
common part of everyday life.
Smoking in a confined space poses a
health risk to others; noisy parties or loud
car stereos disturb others.

Positive Consumption Externalities

Positive Consumption Externalities
Positive consumption externalities are also
common.
When you get a flue vaccination, everyone
you come into contact with benefits.
When the owner of an historic building
restores it, everyone who sees the building
gets pleasure.

Private Costs and Social Costs

Private Costs and Social Costs
A private cost of production is a cost that is
borne by the producer, and marginal private
cost (MC) is the private cost of producing one
more unit of a good or service.
An external cost of production is a cost that is
not borne by the producer but is borne by
others.
Marginal external cost is the cost of producing
one more unit of a good or service that falls on
people other than the producer.
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Marginal Social Cost

Marginal social cost is the marginal cost
incurred by the entire societyby the
producer and by everyone else on whom the
cost fallsand is the sum of marginal private
cost and marginal external cost.
That is, MSC = MC + Marginal external cost.
We express costs in dollars but must
remember that the dollars represent the value
of a forgone opportunity. Marginal private
cost, marginal external cost, and marginal
social cost increase with output.
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Marginal Social and Private Costs

The figure
illustrates the MC
curve,
the MSC curve,
and marginal
external cost as
the vertical
distance between
the MC and MSC
curves.
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Negative Externalities: Pollution

In the market for a good with an externality that is unregulated,
the amount of pollution created depends on the equilibrium
quantity of the good produced.
The figure shows
the equilibrium in an
unregulated market
with an external
cost.
The quantity
produced is where
marginal private cost
equals marginal
social benefit.
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Efficient Quantity
MSB is less than MSC
in the market
equilibrium, so the
market equilibrium is
inefficient.
The efficient quantity is
where marginal social
cost equals marginal
benefit.
The competitive market
overproduces and
creates a deadweight
loss.
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Property Right
Property Rights
Externalities arise because of the absence
of 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.

13

Property Right and Efficiency

The figure illustrate
how the
establishment of
property rights
achieves an efficient
outcome.
The polluter bears
all the costs.
The market
equilibrium is
efficient because
MSC = MSB.

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The Coase Theorem

The Coase Theorem
The Coase theorem is a proposition that if
property rights exist, if only a small number
of parties are involved, and if transactions
costs (defined below) are low, then private
transactions are efficient.
There are no externalities because all
parties take into account the externalities
involved. The outcome is independent of
who has the property rights.
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Transaction Costs
The Coase solution works only if transaction
costs are low.
Transactions costs are the cost of conducting
a transaction.
An example is the transactions costs of buying
a home include fees for a realtor, a mortgage
loan advisor, and legal assistance.
When a large number of people are involved in
an externality and transactions costs are high,
the Coase solution of establishing property
rights doesnt work and governments try to deal
with the externality.
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Government Actions
Government Actions in the Face of
External Costs
There are three main methods that the
government uses to cope with external
costs:
Taxes
Emission charges
Marketable permits
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Taxes
The government can set a tax equal
marginal external cost.
The effect of such a tax is to make
marginal private cost plus the tax equal to
marginal social cost,
MC + tax = MSC.
This tax is called Pigovian tax, in honor of
the British economist Arthur Cecil Pigou,
who first proposed dealing with
externalities in this fashion.
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Negative Externalities: Taxes

The figure shows
how a pollution tax
equal to the marginal
external cost
can achieve an
efficient outcome
because
MSC = MSB.
The government
collect a tax
revenue.
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Emission Charges
The government sets a price per unit of
pollution, so that the more a firm pollutes,
the higher are its emissions charges.
For the emissions charge to induce the firm
to generate the efficient level of pollution,
the government would need a lot of
information that is usually unavailable.

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Marketable Permits
Each firm is assigned a permitted amount
of pollution per period and firms trade
permits.
The market price of a permit confronts
polluters with the social marginal cost of
their actions and leads to an efficient
outcome.
This method was used successfully to
decrease lead pollution in the United
States.
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Positive Externalities: Knowledge

Knowledge comes from education and research and
creates external benefits.
Private Benefits and Social Benefits
A private benefit is a benefit that the consumer of a
good or service receives, and marginal private
benefit (MB) is the private benefit from consuming one
more unit of a good or service.
An external benefit is a benefit that someone other than
the consumer receives. Marginal external benefit is
the benefit from consuming one more unit of a good or
service that people other than the consumer enjoy.

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Marginal Social Benefit

Marginal social benefit is the marginal
benefit enjoyed by the entire societyby the
consumer and by everyone else on whom the
benefit falls.
Marginal social benefit is the sum of marginal
private benefit and marginal external benefit.
That is:
MSB = MB + Marginal external benefit.

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Marginal Social and Private Benefit

The figure illustrates
the marginal private
benefit,
marginal external
benefit,
and marginal social
benefit.
It identifies marginal
external benefit as
the vertical distance
between the MB and
MSB curves.
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Positive Externalities
The figure shows
how a private
market
underproduces an
item that
generates an
external benefit
and creates a
deadweight loss.

25

Government Action
Four devices that the government can use to
achieve a more efficient allocation of
resources in the presence of external
benefits are
Public provision
Private subsidies
Vouchers
Patents and copyrights

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Public Provision
Under public
provision, a public
authority that
receives payment
from the government
produces the good
or service.
The figure shows
how public provision
can achieve an
efficient outcome.
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Private Subsidies
A subsidy is a payment by the government to
private producers.
If the government pays the producer an
amount equal to the marginal external benefit
for each unit produced, the quantity produced
is efficient.

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Positive Externalities: Knowledge

The figure shows
how a subsidy
can achieve an
efficient outcome.

29

Vouchers
A voucher is a
token that the
government
provides to
households, which
they can use to buy
specified goods or
services.
The figure shows
how vouchers can
achieve a more
efficient outcome.

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Patents and Copyrights

Intellectual property rights give the
creator of knowledge the property right to
the use of that knowledge.
The legal device for establishing an
intellectual property right is the patent or a
copyright.
A patent or copyright is a governmentsanctioned exclusive right given to an
inventor of a good, service or productive
process to use to produce, use and sell the
invention for a given number of years.
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Exercise 12.1
If the equilibrium quantity is less than the
socially optimal quantity, one can infer that

A)
the supply curve for the activity is
below the socially optimal supply curve.

B)
the demand curve for the activity is
above the socially optimal demand.

C)
the production of this good has a
positive externality.

D)
the production of this good has a
negative externality.

E)
firm are not maximizing profits.
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Answers to Exercise 12.1

The correct answer is (C).
When there is positive externality, the
external benefits enjoy by outsides
make the society prefer to have a larger
quantity of output.
But the market equilibrium quantity will
not consider this external benefit and
will produce a smaller quantity.
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Exercise 12.2
Assume that reading economics produces a
positive externality. It will be the case that the
__________ than the socially optimal amount.

A)
supply curve for reading will be greater

B)
price of reading will be greater

C)
supply curve for reading will be less

D)
demand curve for reading will be
greater

E)
demand curve for reading will be less
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Answers to Exercise 12.2

The correct answer is (E).
With positive externality, there is
external benefit and the marginal social
benefit exceeds marginal private
benefit.
The demand curve for reading is
marginal private benefit will be less than
the social optimal amount.
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Exercise 12.3
Suppose coal mining produces a negative
externality in the form of polluted streams.
One can deduce that the unregulated

A) price of coal is too high.

B) quantity is too small.

C) quantity is too large.

D) supply curve is lower than the

regulated supply curve.

E) demand curve is higher than the

regulated demand curve.
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Answers to Exercise 12.3

The correct answer is (C).
Producers will ignore the external cost
and produces where MPC = MPB.
The society as a whole incur a higher
cost and prefer a smaller quantity of
output.
Thus the market quantity is too large
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Negative Externality

Point A is market outcome

Point B is social optimal outcome
MSC

Price
B

MPC

P2
P1

MSB=MPB

Q1

Q2

Quantity

Exercise 12.4
After correcting an externality, the
equilibrium price and quantity both rose.
What type of externality is this and what
are the likely actions that are
implemented to correct this externality?

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Answers to Exercise 12.4

This is a positive externality.
When there is external benefit, the marginal social
benefit exceeds marginal private benefit.
The marginal social cost intersects the marginal
social benefit at a larger quantity and a higher
price compared to the market outcome.
When the positive externality is corrected, both
price and quantity rise.
The action needed is a government subsidy to
increase the marginal private benefit to be the
same as marginal social benefit.
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Exercise 12.5
Consider the benefit and cost of industrial
production, is the ideal amount of
pollution equals zero? Explain.

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Answers to Exercise 12.5

The ideal amount of pollution is not zero
but the amount where marginal social
benefit equals marginal social cost.
Production of goods and services are
beneficial to society but bound to create
some pollution. So long as the benefits of
having output exceeds the cost of
pollution it is efficient to have a small
amount of pollution
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