PowerPoint Lecture Notes for Chapter 10:

Externalities
Principles of Economics 5th edition, by N. Gregory Mankiw
Premium PowerPoint Slides by Ron Cronovich

This chapter is slightly below average in length, and, for most

CHAPTER
10
students, in difficulty.
Externalities
For variety, this PowerPoint presentation uses different
Economics
PRINCI PLES OF

N. Gregory Mankiw
examples from the textbook in its analysis of externalities.

Premium PowerPoint Slides

by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved

In this chapter,
look for the answers to these questions:
§ What is an externality?
§ Why do externalities make market outcomes
inefficient?
§ What public policies aim to solve the problem of
externalities?
§ How can people sometimes solve the problem of
externalities on their own? Why do such private
solutions not always work?

Introduction
§ One of the principles from Chapter 1:
Markets are usually a good way
to organize economy activity.
In absence of market failures, the competitive
market outcome is efficient, maximizes total surplus.
§ One type of market failure:
externality, the uncompensated impact of one
person’s actions on the well-being of a bystander.
§ Externalities can be negative or positive,
depending on whether impact on bystander is
adverse or beneficial.
EXTERNALITIES 4

Introduction
§ Self-interested buyers and sellers neglect the
external costs or benefits of their actions,
so the market outcome is not efficient.
§ Another principle from Chapter 1:
Governments can sometimes
improve market outcomes.
In presence of externalities, public policy can
improve efficiency.

EXTERNALITIES 5
 Examples of Negative Externalities
§ Air pollution from a factory
§ The neighbor’s barking dog
§ Late-night stereo blasting from
the dorm room next to yours
§ Noise pollution from
construction projects
§ Health risk to others from
second-hand smoke
§ Talking on cell phone while driving makes the
roads less safe for others
EXTERNALITIES 6

Recap of Welfare Economics For many students, the concepts are easier to learn in the
P The market for gasoline
$5 The market eq’m context of a specific example with numerical values.
maximizes consumer
+ producer surplus.
4
Supply curve shows
3 private cost, the costs
directly incurred by sellers.
Note that maximizing consumer + producer surplus is NOT the
$2.50
2
Demand curve shows
same as maximizing TOTAL surplus when the trades impose
private value, the value
1
to buyers (the prices they external costs (or benefits) on bystanders.
are willing to pay).
0
0 10 20 25 30 Q
(gallons)
EXTERNALITIES 7

Analysis of a Negative Externality

P The market for gasoline
$5 Social cost
= private + external cost
4 external
Supply (private cost)
cost
3 External cost
= value of the
2 negative impact
on bystanders
1 = $1 per gallon
(value of harm
0 from smog,
0 10 20 30 Q
greenhouse gases)
(gallons)
EXTERNALITIES 8
 Analysis of a Negative Externality “At any Q < 20, value of additional gas exceeds social cost.”
P The market for gasoline
The
The socially
socially
$5
Social optimal
optimal quantity
quantity

4
cost is
is 20
20 gallons.
gallons.
For example, at Q = 10, the value to buyers of an additional
S
3 At
At any
any Q
Q << 20,
20, gallon equals $4, while the social cost is only $2. Therefore,
value
value of
of additional
additional gas
gas
2 exceeds
exceeds
At
At any
any Q
social
social cost.
20, cost.
Q >> 20, total surplus (society’s well-being) would increase with a
D social
social cost
cost ofof the
the
1 last
last gallon
gallon is
greater
is larger quantity of gas.
greater than
than its
its value
value
0 to
to society.
society.
0 10 20 25 30 Q
(gallons)
EXTERNALITIES 9
“At any Q > 20, social cost of the last gallon is greater than its
value.”

For example, at Q = 25 - the market equilibrium - the last

gallon cost $3.50 (including the external cost) but the value of
it to buyers was only $2.50. Hence, total surplus would be
higher if Q were lower.

Only at Q = 20 is society’s welfare maximized.

Analysis of a Negative Externality

P The market for gasoline
$5
Social Market eq’m
cost (Q = 25)
4
S is greater than
social optimum
3
(Q = 20).

2 One solution:
D tax sellers
1 $1/gallon,
would shift
0 S curve up $1.
0 10 20 25 30 Q
(gallons)
EXTERNALITIES 10

“Internalizing the Externality” The parenthetical remark at the bottom of the slide follows
§ Internalizing the externality: altering incentives from a lesson in Chapter 6: tax incidence and the allocation of
so that people take account of the external effects
of their actions resources is the same whether a tax is imposed on buyers or
§ In our example, the $1/gallon tax on sellers makes
sellers’ costs = social costs. sellers.
§ When market participants must pay social costs,
market eq’m = social optimum.
(Imposing the tax on buyers would achieve the
same outcome; market Q would equal optimal Q.)

EXTERNALITIES 11
 Examples of Positive Externalities The textbook explains that a better educated population makes
§ Being vaccinated against more informed voting decisions and elects higher quality
contagious diseases protects
not only you, but people who lawmakers and leaders.
visit the salad bar or produce
section after you.
§ R&D creates knowledge
others can use.
§ People going to college raise
Thank you for
the population’s education
not contaminating
level, which reduces crime the fruit supply!
and improves government.
EXTERNALITIES 12

Positive Externalities Since you have just walked students through the analysis of a
§ In the presence of a positive externality, negative externality, let’s see if they can do the analysis of a
the social value of a good includes
§ private value – the direct value to buyers positive externality.
§ external benefit – the value of the
positive impact on bystanders

§ The socially optimal Q maximizes welfare:

§ At any lower Q, the social value of This slide provides the introductory information they will need
additional units exceeds their cost.
§ At any higher Q, the cost of the last unit to do the analysis. The following slide provides the exercise.
exceeds its social value.

EXTERNALITIES 13

ACTIVE LEARNING 1
Analysis of a positive externality
P The market for flu shots
External benefit
$ 50 = $10/shot

40 § Draw the social

value curve.
S
30 § Find the socially
optimal Q.
20 § What policy would
internalize this
10 externality?
D

0 Q
0 10 20 30 14

ACTIVE LEARNING 1
Answers
P The market for flu shots
Socially optimal Q
= 25 shots.
$ 50
external To internalize the
40 benefit externality, use
subsidy = $10/shot.
S
30

Social value
20 = private value
+ $10 external benefit
10
D

0 Q
0 10 20 25 30 15
 Effects of Externalities: Summary
IfIf negative
negative externality
externality
§§ market
market quantity
quantity larger
larger than
than socially
socially desirable
desirable
IfIf positive
positive externality
externality
§§ market
market quantity
quantity smaller
smaller than
than socially
socially desirable
desirable
To
To remedy
remedy the
the problem,
problem,
“internalize
“internalize the
the externality”
externality”
§§ tax
tax goods
goods with
with negative
negative externalities
externalities
§§ subsidize
subsidize goods
goods with
with positive
positive externalities
externalities

EXTERNALITIES 16

Public Policies Toward Externalities

Two approaches:
§ Command-and-control policies regulate
behavior directly. Examples:
§ limits on quantity of pollution emitted
§ requirements that firms adopt a particular
technology to reduce emissions
§ Market-based policies provide incentives so that
private decision-makers will choose to solve the
problem on their own. Examples:
§ corrective taxes and subsidies
§ tradable pollution permits
EXTERNALITIES 17

Corrective Taxes & Subsidies Greg Mankiw’s blog (http://gregmankiw.blogspot.com) has

§ Corrective tax: a tax designed to induce private semi-regular posts on Pigou taxes, some of which are worth
decision-makers to take account of the social
costs that arise from a negative externality using in class (either as assigned or recommended reading or
§ Also called Pigouvian taxes after Arthur Pigou fodder for class discussion). On the main page, look under “A
(1877-1959).
§ The ideal corrective tax = external cost Few Timeless Posts” for “the Pigou Club Manifesto.”
§ For activities with positive externalities,
ideal corrective subsidy = external benefit

In the textbook, a new “In the News” box includes Mankiw’s

EXTERNALITIES 18
2007 New York Times piece arguing for carbon taxes to fight
global warming. The piece contrasts corrective taxes with
regulations and with cap-and-trade systems.

Corrective Taxes & Subsidies

§ Other taxes and subsidies distort incentives and
move economy away from the social optimum.
§ Corrective taxes & subsidies
§ align private incentives with society’s interests
§ make private decision-makers take into account
the external costs and benefits of their actions
§ move economy toward a more efficient
allocation of resources.

EXTERNALITIES 19
 Corrective Taxes vs. Regulations Some of your students may not know that pollution
§ Different firms have different costs of pollution “abatement” simply means taking measures to cut pollution.
abatement.
§ Efficient outcome: Firms with the lowest
abatement costs reduce pollution the most.
§ A pollution tax is efficient:
Regarding the last bullet point: If all firms must reduce
§ Firms with low abatement costs will reduce
pollution to reduce their tax burden.
emissions by a fixed amount (or fixed percentage), then
§ Firms with high abatement costs have greater abatement is NOT concentrated among firms with the lowest
willingness to pay tax.
§ In contrast, a regulation requiring all firms to abatement costs, and so the total cost of abatement will be
reduce pollution by a specific amount not efficient.
EXTERNALITIES 20
higher.

Corrective Taxes vs. Regulations

Corrective taxes are better for the environment:
§ The corrective tax gives firms incentive to
continue reducing pollution as long as the cost of
doing so is less than the tax.
§ If a cleaner technology becomes available,
the tax gives firms an incentive to adopt it.
§ In contrast, firms have no incentive for further
reduction beyond the level specified in a
regulation.

EXTERNALITIES 21

Example of a Corrective Tax: The Gas Tax Again, see Mankiw’s blog for more well-argued opinion
The gas tax targets three negative externalities: pieces by him and others in favor of gas or carbon taxes.
§ Congestion
The more you drive, the more you contribute to http://gregmankiw.blogspot.com.
congestion.
§ Accidents
Larger vehicles cause more damage in an
accident.
§ Pollution
Burning fossil fuels produces greenhouse gases.

EXTERNALITIES 22

ACTIVE LEARNING 2 This first exercise is simple.

A. Regulating lower SO2 emissions
§ Acme and US Electric run coal-burning power plants.
Each emits 40 tons of sulfur dioxide per month,
total emissions = 80 tons/month.
§ Goal: Reduce SO2 emissions 25%, to 60 tons/month
§ Cost of reducing emissions:
$100/ton for Acme, $200/ton for USE
Policy option 1: Regulation
Every firm must cut its emissions 25% (10 tons).
Your task: Compute the cost to each firm and
total cost of achieving goal using this policy.
23
ACTIVE LEARNING 2
A. Answers

§ Each firm must reduce emissions by 10 tons.

§ Cost of reducing emissions:
$100/ton for Acme, $200/ton for USE.
§ Compute cost of achieving goal with this policy:
Cost to Acme: (10 tons) x ($100/ton) = $1000
Cost to USE: (10 tons) x ($200/ton) = $2000
Total cost of achieving goal = $3000

24

ACTIVE LEARNING 2
B. Tradable pollution permits
§ Initially, Acme and USE each emit 40 tons SO2/month.
§ Goal: reduce SO2 emissions to 60 tons/month total.
Policy option 2: Tradable pollution permits
§ Issue 60 permits, each allows one ton SO 2 emissions.
Give 30 permits to each firm.
Establish market for trading permits.
§ Each firm may use all its permits to emit 30 tons,
may emit < 30 tons and sell leftover permits,
or may purchase extra permits to emit > 30 tons.
Your task: Compute cost of achieving goal if Acme
uses 20 permits and sells 10 to USE for $150 each.
25

ACTIVE LEARNING 2
B. Answers
§ Goal: reduce emissions from 80 to 60 tons
§ Cost of reducing emissions:
$100/ton for Acme, $200/ton for USE.
Compute cost of achieving goal:
Acme
§ sells 10 permits to USE for $150 each, gets $1500
§ uses 20 permits, emits 20 tons SO2
§ spends $2000 to reduce emissions by 20 tons
§ net cost to Acme: $2000 - $1500 = $500
continued…
26

ACTIVE LEARNING 2
B. Answers, continued
§ Goal: reduce emissions from 80 to 60 tons
§ Cost of reducing emissions:
$100/ton for Acme, $200/ton for USE.
USE
§ buys 10 permits from Acme, spends $1500
§ uses these 10 plus original 30 permits, emits 40 tons
§ spends nothing on abatement
§ net cost to USE = $1500
Total cost of achieving goal = $500 + $1500 = $2000
Using tradable permits, goal is achieved at lower total
cost and lower cost to each firm than using regulation. 27
 Tradable Pollution Permits
§ A tradable pollution permits system reduces
pollution at lower cost than regulation.
§ Firms with low cost of reducing pollution
do so and sell their unused permits.
§ Firms with high cost of reducing pollution
buy permits.
§ Result: Pollution reduction is concentrated
among those firms with lowest costs.

EXTERNALITIES 28

Tradable Pollution Permits Nitrogen oxides increase ground-level ozone, which has
in the Real World
adverse health effects.
§ SO2 permits traded in the U.S. since 1995.
§ Nitrogen oxide permits traded in the northeastern
U.S. since 1999.
§ Carbon emissions permits traded in Europe since
For more information, see
January 1, 2005. http://www.epa.gov/airmarkets/
§ As of June 2008, Barack Obama and John McCain
each propose “cap and trade” systems to reduce
greenhouse gas emissions.
For information about Europe’s new carbon emissions trading
EXTERNALITIES 29
program, see the Financial Times article featured in this
chapter’s new “In the News” box. You can also find lots of
good articles on this program at the website of the Financial
Times, www.ft.com.

Under Obama’s cap-and-trade proposal, permits will be

auctioned to polluters. As Mankiw notes in his New York
Times piece reprinted in the textbook, such a system is
equivalent to a tax. In contrast, under McCain’s proposed cap-
and-trade system, “permits will eventually be auctioned…”
(my emphasis).

Corrective Taxes vs.

Tradable Pollution Permits
§ Like most demand curves, firms’ demand for the
ability to pollute is a downward-sloping function of
the “price” of polluting.
§ A corrective tax raises this price and thus
reduces the quantity of pollution firms demand.
§ A tradable permits system restricts the supply of
pollution rights, has the same effect as the tax.
§ When policymakers do not know the position of
this demand curve, the permits system achieves
pollution reduction targets more precisely.

EXTERNALITIES 30
 Objections to the
Economic Analysis of Pollution
§ Some politicians, many environmentalists argue
that no one should be able to “buy” the right to
pollute, cannot put a price on the environment.
§ However, people face tradeoffs. The value of
clean air & water must be compared to their cost.
§ The market-based approach reduces the cost of
environmental protection, so it should increase the
public’s demand for a clean environment.

EXTERNALITIES 31

Private Solutions to Externalities The textbook gives a nice example of a contract in which a
Types of private solutions: beekeeper and apple orchard manager each agree to boost
§ Moral codes and social sanctions,
e.g., the “Golden Rule” production, as each producer’s activity confers an external
§ Charities, e.g., the Sierra Club benefit on the other.
§ Contracts between market participants and the
affected bystanders

EXTERNALITIES 32

Private Solutions to Externalities

§ The Coase theorem:
If private parties can costlessly bargain over the
allocation of resources, they can solve the
externalities problem on their own.

EXTERNALITIES 33

The Coase Theorem: An Example

Dick owns a dog named Spot.
Negative externality:
Spot’s barking disturbs Jane,
Dick’s neighbor.
The socially efficient outcome
maximizes Dick’s + Jane’s well-being.
§ If Dick values having Spot more See Spot bark.
than Jane values peace & quiet,
the dog should stay.
Coase theorem: The private market will reach the
efficient outcome on its own…

EXTERNALITIES 34
 The Coase Theorem: An Example Both Jane and Dick are better off. (What about Spot? Doesn’t
§ CASE 1: anyone care about Spot???)
Dick has the right to keep Spot.
Benefit to Dick of having Spot = $500
Cost to Jane of Spot’s barking = $800
§ Socially efficient outcome:
Spot goes bye-bye.
§ Private outcome:
Jane pays Dick $600 to get rid of Spot,
both Jane and Dick are better off.
§ Private outcome = efficient outcome.

EXTERNALITIES 35

The Coase Theorem: An Example

§ CASE 2:
Dick has the right to keep Spot.
Benefit to Dick of having Spot = $1000
Cost to Jane of Spot’s barking = $800
§ Socially efficient outcome:
See Spot stay.
§ Private outcome:
Jane not willing to pay more than $800,
Dick not willing to accept less than $1000,
so Spot stays.
§ Private outcome = efficient outcome.
EXTERNALITIES 36

The Coase Theorem: An Example

§ CASE 3:
Jane has the legal right to peace & quiet.
Benefit to Dick of having Spot = $800
Cost to Jane of Spot’s barking = $500
§ Socially efficient outcome: Dick keeps Spot.
§ Private outcome: Dick pays Jane $600 to put up
with Spot’s barking.
§ Private outcome = efficient outcome.
The
The private
private market
market achieves
achieves thethe efficient
efficient outcome
outcome
regardless
regardless of
of the
the initial
initial distribution
distribution of
of rights.
rights.
EXTERNALITIES 37
ACTIVE LEARNING 3 Have students work together – in small groups, or as a class
Applying Coase
(with you as moderator). If working in groups, allow 5
Collectively, the 1000 residents of Green Valley
value swimming in Blue Lake at $100,000. minutes, then solicit responses from the class.
A nearby factory pollutes the lake water, and
would have to pay $50,000 for non-polluting
equipment.
If you wish, insert a blank slide after this one and use it to type
A. Describe a Coase-like private solution.

B. Can you think of any reasons why this students’ responses as they share them.
solution might not work in the real world?

38
Most students should find part A very straight-forward. A
good Coasian solution would be for each of the 1000 residents
to chip in $75, so the town can offer $75,000 to the factory to
stop polluting.

The second part involves brainstorming: students try to come

up with a list of reasons why it might be difficult to implement
Coase-like solutions in the real world. Brainstorming engages
students and is shown to increase learning outcomes and
student satisfaction. And it provides a break from what
otherwise would be a long stretch of lecture.

I have not provided a slide with answers. Instead, the

following slide lists the reasons why private solutions don’t
always work, and the “notes” section (what you’re reading
right now) gives some examples of each in the context of this
scenario.
Why Private Solutions Do Not Always Work An example for each bullet point in the context of the
1. Transaction costs:
The costs parties incur in the process of
brainstorming activity on the previous slide:
agreeing to and following through on a bargain.
These costs may make it impossible to reach a
mutually beneficial agreement. 1. Transactions costs:
2. Stubbornness:
Even if a beneficial agreement is possible, Suppose lawyers charge $60,000 to represent the two parties
each party may hold out for a better deal.
3. Coordination problems:
and draw up a contract that is enforceable in a court. Then it
If # of parties is very large, coordinating them
may be costly, difficult, or impossible.
will be impossible for both parties to come to a mutually
EXTERNALITIES 39
beneficial agreement, and the factory will continue polluting
the lake.

2. Stubbornness:
Suppose the town offers $55,000 to the factory. The factory
would be better off taking this offer than nothing at all, but the
factory may counter with a $95,000 price. Both parties hold
out in hopes that the other will cede, but neither does. The
factory keeps polluting, and the residents of Green Valley
continue to be denied the joy of swimming in the lake.

3. Coordination problems:
Getting all 1000 residents to agree to a specific offer will be
difficult. Moreover, each resident has an incentive to free-ride
off his neighbors.
CHAPTER SUMMARY

§ An externality occurs when a market transaction

affects a third party. If the transaction yields
negative externalities (e.g., pollution), the market
quantity exceeds the socially optimal quantity.
If the externality is positive (e.g., technology
spillovers), the market quantity falls short of the
social optimum.

40

CHAPTER SUMMARY

§ Sometimes, people can solve externalities on

their own. The Coase theorem states that the
private market can reach the socially optimal
allocation of resources as long as people can
bargain without cost. In practice, bargaining is
often costly or difficult, and the Coase theorem
does not apply.

41

CHAPTER SUMMARY

§ The government can attempt to remedy the

problem. It can internalize the externality using
corrective taxes. It can issue permits to polluters
and establish a market where permits can be
traded. Such policies often protect the
environment at a lower cost to society than direct
regulation.

42