Chapter Two

Externality and Government policy

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 Introduction
• Usually, market is considered as a means of efficient allocation
of good and services.
• But there may be market failure in efficient allocation. In such a
case:
• All relevant costs of production are not accounted for.
• All relevant benefits of consumption are not accounted for.
• When a transaction between a buyer and a seller directly affects a
third party, the effect is called an externality.
• 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
• Externalities are a type of market failure. There are two forms of
externality:
• Positive externality
• Negative externality
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 Cont.
• Externalities are a type of market failure
-prices in a market do not reflect the true marginal costs and/or
marginal benefits associated with the goods and services
traded in the market.
• 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.

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 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.

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 Negative externality
• Negative externalities are always oversupplied in the market. In
other words, there is more production of goods that have negative
externalities than is considered socially efficient.
• Here, MPC stands for marginal private cost, MSC is marginal
social cost, and MB is marginal benefit.
• In Figure 2.1, the superscript E on the quantity indicates the
socially efficient level of production of the good with the negative
externality
• The intersection of the demand curve and the social-supply curve
determines the optimal output level
• The optimal output level is less than the market equilibrium
quantity.
• The optimal price charged is greater than the market equilibrium
price 5
 Figure 2.1: Negative externality

MSC

MPC
P

MB

Qe Q

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 Positive externalities
• Positive externality refers to positive benefit received by a third part
who is not the part of market transaction.
• If positive externalities is present, 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 are always undersupplied by the market.
• This is because the marginal private benefit is lower than the
marginal social benefit.
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 Cont.
• As shown in Figure 2.2, 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.
• Take education as an example. If someone was trying to
decide whether they wanted to go on to college, they would
weigh the cost of doing so against their personal benefit.
– People will attend college as long as their marginal private
benefit is greater than or equal to marginal cost.
– But if the market were working efficiently, they would decide to
attend as long as marginal social benefit was at greater than or
equal to marginal cost.

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 Figure 2.2: Positive Externality

MC

Pe

P MSB

MPB

Q Qe

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 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.

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 Dealing With Externalities
• There are a variety of ways to deal with externalities. These include:
– Assigning property rights
– 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.
• The above methods of dealing with externality enable to:
– Regulate behavior and
– Internalize the externality
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 Pigovian tax to internalize externality
• Dead weight loss is associated with the negative production
externality
• Pigovian taxes:
– The government can internalize the externality by imposing a
tax on the producer. The tax shifts private cost up to social
cost and eliminates the deadweight loss.
– Internalize an externality means to alter incentives so that
people take account of the external effects of their actions
– Pigovian taxes are enacted to correct the effects of the
negative externalities

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 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 2.3 below)
• For internalization, the tax (T) to be imposed must be equal to
the MEC:
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 Fig. 2.3, where S’ reflects the full marginal social cost
(MSC) of producing paper while S is MPC.
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Fig. 2.3. Effects of a Corrective Tax (Pigouvian Tax)

MSC
P
MPC

Pe tax

Qe Q Q

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 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 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

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 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.

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Fig. 2.4 Effects of a Corrective Subsidy (Pigouvian Tax)

MSC
P

Pe
P Subsidy of $20

MSB

MPB

Qe Q Q

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 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 the stream of for 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.

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 Property right and externality
• Property right refers to bundle of entitlements defining owner’s
rights, privileges, limitations for using the resource
• Eefficient 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)

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 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).

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 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 payment (say $10) 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

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 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.

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 The problems with the Coasian Solution

• The following are the major problems of Coasian solution:

– The assignment problem
– The holdout problem
– The free rider problem
– Transaction costs and negotiating problems

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