Externality and Government

policy
 Definition
• Externalities are cost or benefits of market transaction not
reflected in prices. When externalities prevails, a third party
other than the buyers or sellers of an item is affected by its
production or consumption.

• i.e. When a transaction between a buyer and a seller directly

affects a third party, the effect is called an externality. This is a
type of market failure. There are two forms of externality:
• Positive externality
• Negative externality
 Cont.
• Externalities may be related to production activities,
consumption activities, or both.

Production externalities: production activities of one

individual imposes costs/benefits on other individuals that
are not transmitted accurately through a market.
Consumption externalities: consumption of an
individual imposes costs or benefits on other
individuals that are not accurately transmitted
through a market.
 Negative externality
• Negative externalities exist if the price of good or services
does not reflect the full marginal social cost of resources
allocated to its production
• The Marginal External Cost (MEC) is the extra cost to third
party resulting from production of another unit of a good or
service.
– The Marginal Private Cost (MPC) is the marginal cost
that producers base their decisions
– The Marginal Social Cost (MSC) = MPC + MEC ; when
the negative externalities exist.
 Cont…
• Negative externalities are always oversupplied in the
market..

• Here, MPC stands for marginal private cost, MSC is

marginal social cost, and MB is marginal benefit. The
superscript E on the quantity indicates the socially
efficient level of production of the good with the
MSC

negative externality P1 MPC

E
Pe

MB

Qe Q1
 Negative externality
• The intersection of the demand curve and the social-supply curve determines the
optimal output level
• In negative externality the optimal output level is less than the market
equilibrium quantity
• The optimal price charged is greater than the market equilibrium price

MSC

P1 MPC
E
Pe
G

MB

Qe Q1

Pe = Equilibrium price

Qe = Equilibrium Quantity
 Positive externalities
• Positive externality refers to positive benefit received by a third part
who is not the part of market transaction.
• Positive externalities present, when prices do not fully equal the
marginal social benefit of a good or service.
– Marginal external benefit (MEB) is the benefit of additional
output accruing to parties other than buyers or sellers of the good
or services
– Marginal private benefit (MPB) is the marginal benefit that
consumers base their decision on.
– The Marginal Social Benefit (MSB) = MPB +MEB ; when the
positive externalities exist.
• Positive externalities, on the other hand, are always
undersupplied by the market. This is because the marginal
private benefit is lower than the marginal social benefit.
 Cont.
• The intersection of the social demand curve and the supply curve
determines the optimal output level.
• The optimal output level is greater than the market equilibrium
quantity.
• The optimal price is less than the market equilibrium price.es

MC

PSocial
Subsidy

PMarket
PSubsidy
E

G } D=MSB

D= MPB

Qe Q Optimum

Positive Externality
 Externalities and market inefficiency
• Externalities cause markets to be inefficient, and thus fail.
• Demand curve reflects the value to the buyers and supply
curve reflects the cost to the seller.
• At market equilibrium, total surplus is maximized.
• In the absence of externalities, market equilibrium is
efficient .
• Both decision-makers fail to take account of the external
effects of their behavior.
• We need to design appropriate policy measure to control
externality.
 Dealing With Externalities
• There are a variety of ways to deal with externalities. These include:
– Assigning property rights – Suppose there is a firm that pollutes a nearby
river as a result of production, and that same river is used for recreational
swimming.
– Command/Control – The government might place a limit on the amount
of pollution firms are allowed to produce in an attempt to solve the market
inefficiency.
– Taxation/Subsidies – The government can tax things that create negative
externalities, and subsidize those things that create positive externalities.
– Permits – Firms can buy and sell permits from each other for the right to
pollute. This creates incentive to find efficient ways of production so you
can sell unneeded permits.
 Internalization of externality
• The above method of dealing on externality categorized
into to parts.
– Regulate behavior and
– Internalize the externality

Regulate behavior : Government can discourage

negative externalities by taxing goods and services that
generate spillover costs. Government can encourage
positive externalities by subsidizing goods and
services that generate spillover benefits.

P.T.O.
 Pigovian tax to internalize externality
• The dead weight loss (a cost to society created by market
inefficiency ) is associated with the negative production
externality
• Pigovian taxes: A British economist Arthur C. Pigou introduce
Pigovian taxes to correct the effects of the negative externalities.
i.e taxes that are designed primarily to change behaviour rather
than to raise revenue (tobacco tax, carbon tax).
– The government can internalize the externality by imposing a
tax on the producer. The tax shifts private cost supply up to
social cost supply and eliminates the deadweight loss.
– Internalize an externality means to alter incentives so that
people take account of the external effects of their actions
 Cont.
• Let us assume we have paper production firm/industry.
• Suppose corrective taxes were levied by the government on
producers of paper to internalize the negative externality they
cause during production.
• The MEC = $10 (see fig)
• For internalization, the tax to be imposed must be equal to the
MEC .
i.e. T=MEC = $10 per ton of paper production.
• Paper producers will include this tax in their cost functions and
it increases their MPC of production.
Consequently, the supply (MPC) curve shifts up to the left from S to S’ in
the following figue, where S’ reflects the full marginal social cost (MSC)
of producing paper.

Effects of a Corrective Tax (Pigouvian Tax)

MSC
P
MPC
S’
Pe tax
S
P

MSB

Qe Q Q
 Cont.
• In summary, the corrective tax causes the following results.

– An increase in the price of paper reduces quantity demanded for paper

until the point where MSC=MSB.

– If the revenue collected is used for improving recreational services

along with the stream of the provision of other public services, there
will be a welfare transfer from producers to consumers.

– A reduction (but not elimination) of use of streams as waste disposal

sites and the consequent reduction in damage to alternative users of the
stream.
 Pigovian subsidy to internalize externality
• A corrective subsidy is a payment made by government to either buyers or
sellers of a good so that the price paid by consumers is reduced. The
payment must equal to the amount of MEB so that MSB=MSC.
• Suppose a corrective subsidy (S) of $20 per person is given by the
government for vaccination to internalize the positive externality.
• The Subsidy (S) = MEB = $20.
• The subsidy will be added to the MPB of each person
• Consequently, the demand (MPB) curve shifts from D=MSB where D’
reflects the full marginal social benefit (MSB) of society.
MSC
P
D’
Pe
D
P Subsidy of $20

MSB

MPB

Qe Q Q
 Property right and externality
• Property right refers to bundle of entitlements defining owner’s rights,
privileges, limitations for using the resource.
• Efficient property right structures :
• Exclusivity : all benefits and costs accrue to owner
• Transferability: voluntary exchange
• enforceability :secure from involuntary seizure
• Types of property right
• private property right
• state property (govt owned)
• common property (joint ownership)
• open-access (no ownership)
 The Coase Theorem
• In this approach the question is Why won’t the market simply
compensate the affected parties for externalities?
• Coase theorem if, at no cost, people can negotiate the
purchase and sale of the right to perform activities that cause
externalities, they can always arrive at efficient solutions to the
problems caused by externalities
• The solution:
– To see how a market might compensate those affected by
the externality, look at what would happen if the fishermen
or farmers owned the river polluted by the paper plant (i.e.,
if they have the property right over the river).
 Cont.
– They would demand the paper plant to stop polluting the
river as the river now belongs to them.
– The paper plant has two options:
• One is to reduce the pollution by closing down the
plant.
• The other option is to bargain with them and pay a
compensation (say $100 per ton of paper produced)
– As long as the paper plant makes profit even after paying
the $100 payment per unit, this is a better deal for the plant
than shutting down.
– The payment to the fishermen or farmers becomes part of
the input costs.
 Cont.
• Part I of the Coase Theorem:
– When there are well defined property rights and costless
bargaining, then negotiations between the party creating the
externality and the party affected by the externality can bring
about the socially optimal market quantity.
• Part II of the Coase Theorem:
– The efficient solution to an externality does not depend on which
party is assigned the property right., as long as someone is
assigned those rights.
 The problems with the Coasian Solution
• The following are the major problems of Coasian Solution

– The assignment problem. (allocation problem)

– The holdout problem (The holdout problem arises when sellers of

land (or other valuable resources) strategically choose not to sell,
even though the buyer would-be offers a price that the seller would
accept.)

– The free rider problem (Ex : allowing others to pay for the show, and
then watch for free from his or her backyard. Externalities occur when
one person's actions affect another person's well-being and the
relevant costs and benefits are not reflected in market prices.)

– Transaction costs and negotiating problems

Thank You