Chapter 10

10/16/21
N. GREGORY MANKIW
Look for the answers to these questions:
PRINCIPLES OF
ECONOMICS • What is an externality?
Eighth Edition • Why do externalities make market outcomes
inefficient?
• What public policies aim to solve the
CHAPTER problem of externalities?
Externalities • How can people sometimes solve the
10 problem of externalities on their own? Why
do such private solutions not always work?
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Eastern Illinois University
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
1
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management system for classroom use. management system for classroom use.
1 2
Externalities Externalities
• ‘Markets are usually a good way to • Negative externality
organize economy activity’ – Impact on the bystander is adverse
– In absence of market failures, the • Positive externality
competitive market outcome is efficient, – Impact on the bystander is beneficial
maximizes total surplus
• Self-interested buyers and sellers
• Externality: one type of market failure
– Neglect the external costs or benefits of
– The uncompensated impact of one their actions
person’s actions on the well-being of a
bystander – So the market outcome is not efficient
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 3 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 4
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Externalities Negative Externalities

• ‘Government action can sometimes • Examples of negative externalities
improve upon market outcomes’ • Air pollution from a factory
– Why markets sometimes fail to allocate • The neighbor’s barking dog
resources efficiently • Late-night stereo blasting from the dorm room
next to yours
– How government policies can potentially
• Noise pollution from construction projects
improve the market’s allocation
• Health risk to others from second-hand
– What kinds of policies are likely to work smoke
best
• Talking on cell phone while driving makes the
roads less safe for others
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Recap of Welfare Economics Analysis of a Negative Externality
P The market for gasoline The market equilibrium P The market for gasoline
$5 maximizes consumer $5 Social cost
+ producer surplus. = private + external cost
4 4 external
Supply curve shows Supply (private cost)
cost
private cost, the costs
3 3 External cost
directly incurred by
$2.50 = value of the
sellers.
2 2 negative impact
Demand curve shows on bystanders
1 private value, the value 1 = $1 per gallon
to buyers (the prices they (value of harm
0 are willing to pay). 0 from smog,
0 10 20 25 30 Q 0 10 20 30 Q
greenhouse gases)
(gallons)
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
(gallons)
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Analysis of a Negative Externality Analysis of a Negative Externality
P The market for gasoline P The market for gasoline Market equilibrium
The socially
$5 optimal quantity $5 (Q = 25)
Social Social
cost is 20 gallons. cost is greater than
4 4 social optimum
S At any Q < 20, S (Q = 20).
3
value of additional gas 3
exceeds social cost.
2 At any Q > 20, 2 One solution:
D social cost of the D tax sellers $1/gallon,
1 last gallon is 1 would shift S curve
greater than its value up $1.
0 to society. 0
0 10 20 25 30 Q 0 10 20 25 30 Q
(gallons)
(gallons)
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Externalities Positive Externalities

• Internalizing the externality: • Examples of positive externalities
– Altering incentives so that people take into • Being vaccinated against contagious
account the external effects of their diseases protects not only you, but people
who visit the salad bar or produce section
actions
after you
– In our example, the $1/gallon tax on • Research and development creates
sellers makes sellers’ costs = social costs. knowledge others can use
• If market participants pay social costs • People going to college raise the population’s
– Market equilibrium = social optimum education level, which reduces crime and
improves government
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Positive Externalities Active Learning 1 Analysis of a positive externality

P The market for flu shots
• With a positive externality $50 • External benefit
= $10/shot
– The social value of a good includes
40 – Draw the social
• Private value – the direct value to buyers
S
value curve.
• External benefit – the value of the positive 30
– Find the socially
impact on bystanders
optimal Q.
• The socially optimal Q maximizes welfare: 20
– What policy would
• At any lower Q, the social value of internalize this
10
additional units exceeds their cost. D externality?
• At any higher Q, the cost of the last unit 0 Q
exceeds its social value. 0 10 20 30
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Active Learning 1 Answers

Effects of Externalities: Summary
P The market for flu shots
Socially optimal Q
$50 = 25 shots.
• If negative externality
external – Market quantity larger than socially desirable
benefit To internalize the
40
externality, use • If positive externality
S subsidy = $10/shot. – Market quantity smaller than socially
30
desirable
Social value
20 = private value • To remedy the problem, “internalize the
+ $10 external benefit externality”
10
D
– Tax goods with negative externalities
0 Q – Subsidize goods with positive externalities
0 10 20 25 30
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Public Policies Toward Externalities Public Policies Toward Externalities

• Command-and-control policies • Corrective taxes and subsidies
– Regulate behavior directly – Corrective taxes (Pigovian taxes)
• Limits on quantity of pollution emitted – Induce private decision makers to take
• Requirements that firms adopt a particular account of the social costs that arise from
technology to reduce emissions a negative externality
• Market-based policies – Places a price on the right to pollute
– Incentives so that private decision makers – Reduce pollution at a lower cost to society
will choose to solve the problem on their own
– Raise revenue for the government
• Corrective taxes and subsidies
• Tradable pollution permits
– Enhance economic efficiency
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Corrective Taxes vs. Regulations Corrective Taxes vs. Regulations

• Different firms • A pollution tax is efficient:
– Have different costs of pollution – Firms with low abatement costs will
abatement reduce pollution to reduce their tax
• Efficient outcome burden.
– Firms with the lowest abatement costs – Firms with high abatement costs have
reduce pollution the most greater willingness to pay tax.
• Regulation requiring all firms to reduce
pollution by a specific amount
– Is not efficient
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Example of a Corrective Tax: The Gas Tax

Corrective Taxes vs. Regulations
The gas tax targets three negative
• Corrective taxes are better for the externalities:
environment: – Congestion
– The corrective tax gives firms incentive to The more you drive, the more you contribute to
continue reducing pollution as long as the congestion.
cost of doing so is less than the tax – Accidents
• If a cleaner technology becomes available, Larger vehicles cause more damage in an
the tax gives firms an incentive to adopt it accident.
– In contrast, firms have no incentive for – Pollution
further reduction beyond the level Burning fossil fuels produces greenhouse gases.
specified in a regulation
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 23 permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 24
23 24
Active Learning 2 Reducing pollution Active Learning 2 A. Regulation

Acme and US Electric run coal-burning power • Policy option 1: Regulation
plants. Each emits 40 tons of sulfur dioxide Every firm must cut its emissions 25% (10
per month, total emissions = 80 tons/month. tons).
• Goal: Reduce SO2 emissions 25%, to 60 • Your task: Compute the cost to each firm
tons/month and total cost of achieving goal using this
• Cost of reducing emissions: policy.
– $100/ton for Acme
– $200/ton for US Electric
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Active Learning 2 A. Answers Active Learning 2 B. Tradeable pollution permits

Each firm must reduce emissions by 10 tons. • Policy option 2: Tradable pollution permits
– Issue 60 permits, each allows one ton SO2
Cost of reducing emissions: $100/ton for
emissions.
Acme, $200/ton for US Electric.
– Give 30 permits to each firm.
• Compute cost of achieving goal with this – Establish market for trading permits.
policy: – Each firm may use all its permits to emit 30 tons,
– Cost to Acme: (10 tons) x ($100/ton) = $1000 may emit < 30 tons and sell leftover permits,
– Cost to USE: (10 tons) x ($200/ton) = $2000 or may purchase extra permits to emit > 30 tons.
– Total cost of achieving goal = $3000 • Your task: Compute cost of achieving goal if
Acme uses 20 permits and sells 10 to USE
for $150 each.
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Active Learning 2 B. Answers Active Learning 2 B. Answers

Goal: reduce emissions from 80 to 60 tons • Compute cost of achieving goal for USE:
Cost of reducing emissions: $100/ton for – Buys 10 permits from acme, spends $1500
Acme, $200/ton for USE. – Uses these 10 plus original 30 permits, emits 40
tons
• Compute cost of achieving goal for Acme:
– Spends nothing on abatement
– Sells 10 permits to USE for $150 each, gets
$1500 – Net cost to USE = $1500
– Uses 20 permits, emits 20 tons SO2 Total cost of achieving goal =$500+$1500=$2000
– Spends $2000 to reduce emissions by 20 tons • Using tradable permits, goal is achieved at
– Net cost to Acme: $2000 − $1500 = $500 lower total cost and lower cost to each firm than
using regulation.
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• Tradable pollution permits system • Reducing pollution using pollution permits
– Reduces pollution at lower cost than or corrective taxes
regulation – Firms pay for their pollution
• Firms with low cost of reducing pollution • Corrective taxes: pay to the government
do so and sell their unused permits • Pollution permits: pay to buy permits
• Firms with high cost of reducing pollution
– Internalize the externality of pollution
buy permits
– Result: Pollution reduction is concentrated
among those firms with lowest costs
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• Objections to the economic analysis of • Clean environment is a normal good
pollution – Positive income elasticity
– “We cannot give anyone the option of • Rich countries can afford a cleaner
polluting for a fee.” - by late Senator environment
Edmund Muskie • More rigorous environmental protection
• People face trade-offs – Clean air and clean water - law of demand
• The lower the price of environmental
– Eliminating all pollution is impossible
protection
– Clean water and clean air – opportunity • The more the public will want it
cost: lower standard of living
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Private Solutions to Externalities Private Solutions to Externalities

• The types of private solutions • The Coase theorem
– Moral codes and social sanctions – If private parties can bargain without cost
– Charities over the allocation of resources
• They can solve the problem of externalities
– Self-interest of the relevant parties
on their own
• Integrating different types of businesses
• Whatever the initial distribution of rights
– Interested parties can enter into a contract
– Interested parties can reach a bargain:
• Everyone is better off
• Outcome is efficient
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Private Solutions to Externalities Private Solutions to Externalities

1. Dick has the legal right to keep a barking 2. Dick has the legal right to keep a barking
dog (Spot). dog (Spot).
– Dick gets a $500 benefit from the dog – Dick gets a $1,000 benefit from the dog
– Jane bears an $800 cost from the barking – Jane bears an $800 cost from the barking
– Efficient outcome: – Efficient outcome:
• Jane can offer Dick $600 to get rid of the dog • Dick turns down any offer below $1,000
• Dick will gladly accept • Jane will not offer any amount above $800
• Bye-bye Spot! • Dick keeps the dog
• Both are better off
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Private Solutions to Externalities Active Learning 3 Applying Coase
3. Jane can legally compel Dick to get rid of Collectively, the 1000 residents of Green
the dog (Spot) Valley value swimming in Blue Lake at
$100,000.
– Dick gets a $800 benefit from the dog
A nearby factory pollutes the lake water, and
– Jane bears an $500 cost from the barking
would have to pay $50,000 for non-polluting
– Efficient outcome equipment.
• Dick keeps Spot
A. Describe a Coase-like private solution.
• Private outcome: Dick pays Jane $600 to put
up with Spot’s barking B. Can you think of any reasons why this
solution might not work in the real world?
The private market achieves the efficient outcome
regardless of the initial distribution of rights © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
41 42
Private Solutions to Externalities Summary

Why private solutions do not always work • When a transaction between a buyer and seller
– High transaction costs directly affects a third party, the effect is called
an externality.
• Costs that parties incur in the process of
agreeing to and following through on a – If an activity yields negative externalities, such
bargain as pollution, the socially optimal quantity in a
market is less than the equilibrium quantity.
– Stubbornness: bargaining simply breaks
– If an activity yields positive externalities, such as
down technology spillovers, the socially optimal
– Coordination problems quantity is greater than the equilibrium quantity.
• Large number of interested parties
• Coordinating everyone is costly
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Summary Summary
• Governments pursue various policies to remedy • According to the Coase theorem, if people can
the inefficiencies caused by externalities. bargain without cost, then they can always
– Regulating behavior reach an agreement in which resources are
– Internalizes an externality using corrective taxes allocated efficiently.
– Issue permits (similar results to imposing – In many cases, however, reaching a bargain
corrective taxes on polluters) among the many interested parties is difficult, so
the Coase theorem does not apply.
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10/16/21

Externalities Negative Externalities

Recap of Welfare Economics Analysis of a Negative Externality

Analysis of a Negative Externality Analysis of a Negative Externality

Externalities Positive Externalities

Positive Externalities Active Learning 1 Analysis of a positive externality

Active Learning 1 Answers

Public Policies Toward Externalities Public Policies Toward Externalities

Corrective Taxes vs. Regulations Corrective Taxes vs. Regulations

Example of a Corrective Tax: The Gas Tax

Active Learning 2 Reducing pollution Active Learning 2 A. Regulation

Active Learning 2 A. Answers Active Learning 2 B. Tradeable pollution permits

Active Learning 2 B. Answers Active Learning 2 B. Answers

Public Policies Toward Externalities Public Policies Toward Externalities

Public Policies Toward Externalities Public Policies Toward Externalities

Private Solutions to Externalities Private Solutions to Externalities

Private Solutions to Externalities Private Solutions to Externalities

Private Solutions to Externalities Active Learning 3 Applying Coase

Private Solutions to Externalities Summary

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