Externalities and

Public Goods

16

Chapter Outline

(Insert image of text cover)

16.1

Externalities

16.2

Fixing Externalities

16.3
Further Topics in
Externalities and Their Remedies
16.4

Public Goods

16.5 Conclusion

16-1
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Introduction

16

Pollution is a major fact of life around the world

In the United States, there are areas (notably urban) struggling

with air quality issues, with the resulting health costs estimated at
over $100 billion per year
Much pollution is due to coal-fired power plants operating both
domestically and abroad

Other forms of pollution are also common

The noise of your neighbors party

The person smoking a cigar next to you
The mess in your neighbors lawn

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Introduction

16

These outcomes are evidence of a market failure

Markets are efficient when all transactions that positively benefit

society take place
An efficient market takes all costs and benefits, both private and
social, into account
Similarly, the smoker in the park is only concerned with his
enjoyment, and not the costs imposed on other people in the park
An efficient market takes these additional costs into account

Asymmetric information is a source of market failure that we

considered in the last chapter. Here, we discuss two further
sources

Externalities
Public goods
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16-3

16.1Externalities

16

Externalities A cost or benefit that affects a third party not

directly involved in an economic transaction

Negative externality A cost imposed on a third party not

directly involved in an economic transaction
Example: Air pollution from coal-fired power plants

Positive externality A benefit conferred on a third party not

directly involved in an economic transaction
Example: A beekeepers bees not only produce honey, but can help
neighboring farmers by pollinating crops

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16.1Externalities

16

Economic Inefficiencies from Externalities

In the presence of externalities, societys benefit or cost from
an economic transaction is different from the private benefit or
cost to those who are party to the transaction
For example, a smokers private costs of smoking are (in part):

The cost of purchasing cigarettes

Smelly clothing, yellow teeth, etc.
Private health costs

Societal costs are (in part):

Second-hand smoke health effects
Any smoker health costs that are borne by society
The noxious smell imposed on nonsmokers
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16.1Externalities

16

Economic Inefficiencies from Externalities

External marginal cost The cost imposed on a third party
when an additional unit of a good is produced or consumed

External marginal benefit The benefit conferred on a third

party when an additional unit of a good is produced or consumed

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16.1Externalities

16

Economic Inefficiencies from Externalities

When there are no externalities, societys costs and benefits
align with the costs and benefits of the private parties to a
transaction
When there are externalities, the social costs and social
benefits will differ from the private costs and private benefits

Social cost: The cost of an economic transaction to society, equal

to the private cost plus the external marginal cost
Social benefit: The benefit of an economic transaction to society,
equal to the private benefit plus the external marginal benefit

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16.1Externalities

16

Negative Externalities: Too Much of a Bad Thing

Negative externalities occur when a market transaction
imposes an external cost on society
Consider the example of a coal-fired power plant

The power plant produces electricity, which is good, but in the

process, pollutants are released into the air: particulate matter,
nitrogen oxides (NOx), and sulfur dioxide (SO2)

These pollutants both directly and indirectly impact human and

environmental health, leading to welfare losses

The costs of operating the plant are borne by the plant, but the
health effects are external costs, borne by society
Consider a competitive market for electricity
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16.1Externalities

16

Figure 16.1 Negative Externalities in a Competitive

Electricity Market
Price
($/MW
h)

P*
PMKT

A perfectly competitive
Social marginal cost,Because
themarket
marketproduces
does not
electricity
SMC = MCI + EMC take
marginal
cost
QMKTexternal
at market
price PMKT
,
Deadweight loss
into account
where Swhen
= MCIsetting
= D. its
from externality
At
this
quantity,
the
of output, itindustry
ends up
Supply, S = MCI quantity
imposes
external
marginal
producing more electricity
cost
EMC.
A
QMKTequals
than
is
the
socially
SMC
the
sum
of MCI
optimal
quantity
B
and
EMC. Q*,
Total
surplus
is
maximized at
resulting in a deadweight
Q*< from
QMKT ,overproduction
where price P*
loss
EMC
SMC.triangle.
equal to equals
the shaded
External marginal
cost, EMC
Demand, D
Q*

QMKT

Quantity of
electricity (MWh)

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16.1Externalities

16

Negative Externalities: Too Much of a Bad Thing

The deadweight loss on the previous slide represents the social
cost associated with the competitive outcome in the presence
of an externality

The magnitude of the deadweight loss depends on the size of the

externality
People buy electricity who otherwise wouldnt if the price reflected
the true social cost

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Leather Tanning

figure it out

Suppose leather is sold in a perfectly competitive industry. The

industry short-run supply curve (marginal cost curve) is P =
MC = 3Q, where Q is measured in millions of hides per year.
The inverse demand for leather hides is given by P = 60 7Q.
Answer the following questions:
1.

Find the equilibrium market price and quantity sold.

2.

Suppose that leather tanning is a polluting activity that releases chromium and other pollutants into local waterways. The external marginal cost is estimated to be $4 for each hide produced. Calculate the socially optimal level of output and price for the leather tanning industry.

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figure it out

Leather Tanning
1.

To find the competitive outcome, set the inverse demand

and supply curves equal to one another

3Q 60 7Q

10Q 60
Q 6 million hides
Using the supply curve to solve for the equilibrium price yields

2.

The social marginal cost is equal to the industry marginal cost plus

the external marginal cost:

P 3Q $18

To find the social optimum, equate SMC with the inverse demand

And the socially optimal price is:

SMC MC EMC 3Q 4

3Q 4 60 7Q
10Q 56
Q 5.6
P 3Q 4.00 16.8 4 $20.8
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16.1Externalities

16

Positive Externalities: Not Enough of a Good Thing

Positive externalities exist when an economic activity has a
spillover benefit enjoyed by third parties

Marginal social benefit of an economic activity is higher than the

private marginal benefit (i.e., the demand curve)

The classic example of a positive externality is education

Education is associated with private benefits (as seen in Chapter

15), including higher lifetime earnings and many others
Education is also associated with broader social benefits, such as
an increase in overall entrepreneurial activity, higher incomes, and
a faster pace of technological growth

We can examine positive externalities with a figure

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16.1Externalities

16

Figure 16.2 Positive Externalities in the Market for College

Degrees

The social demand for college

degrees (SD) equals the private
marginal benefit curve D plus the
Price Deadweight loss
Because the market does not take
external marginal benefit EMB.
($/degree) from externality
into
account
external
marginal
The
sociallythe
optimal
number
of
benefit
it ends
collegeEMB,
degrees,
Q*,up
is producing
found at
S = MCI
fewer
degrees QMKT
point college
A, the intersection
ofthan
the
marginal
cost
curve quantity
S = MCI and
the
socially
optimal
Q*,
EMB
A
In
an
unregulated
market
for
resulting in a SD.
deadweight loss
P*
college
degrees,
production
occurs
equal
to
the
shaded
triangle.
B
at point B (QMKT , PMKT ), where D =
PMKT
S = MCI .
Social demand,
SD = D + EMB
D
QMKT Q*

External marginal
benefit, EMB
Quantity of
college degrees

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Fixing
16.2Externalities

16

Competitive markets with externalities produce more or less

than that which is socially efficient. There are a number of
market interventions available to governments and regulators
that can help fix externalities

Some work through their effect on prices (e.g., taxes)

Some target the quantity produced and consumed

First, determine the size of the externality, and thus the

amount by which production must be changed to reach the
socially efficient outcome

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Fixing
16.2Externalities

16

Example: The Efficient Level of Pollution

The goal is to determine the socially efficient level of
pollution

The level of emissions necessary to produce the efficient quantity

of the good tied to the externality
The resulting level of production occurs where the marginal benefit
of production of a good (willingness to pay) is equal to the marginal
cost (private + external)
This also implies that the marginal costs of pollution (health costs,
etc.) are equivalent to the marginal benefits of pollution (increased
production of goods and/or services)

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Fixing
16.2Externalities

16

Figure 16.4 The Efficient Level of Pollution

Price
($/unit)

*
PPOLL

The efficient level of

Marginal cost
pollution (POLL*, PPOLL * )
of pollution, MCP
occurs where the
marginal cost of pollution
(MCP ) equals the
marginal benefit or
marginal abatement cost
of pollution (MBP = MAC).
Marginal benefit of
pollution, MBP = marginal
abatement cost, MAC
POLL*

Quantity of
pollution

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Fixing
16.2Externalities

16

The Efficient Level of Pollution

Why does the marginal cost of pollution curve (MCP)
slope upward?

At low levels of pollution, the damage associated with an additional

unit of pollution is relatively low
At higher levels of pollution, health effects become more severe,
and additional units of pollution are more costly to society

Why does the marginal benefit of pollution curve

(MBP) slope downward?

High levels of pollution are associated with high levels of

production, and therefore lower market prices. As pollution is
reduced, so is production, and the forgone consumer and producer
surplus is an opportunity cost
As pollution is reduced, the cost of reducing pollution even further
increases
because
easy All
pollution-reduction
methods are
exhausted
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Fixing
16.2Externalities

16

The Efficient Level of Pollution

Marginal abatement cost The cost of reducing emissions
by one unit, including technological costs and forgone
production
The previous figure is very similar to the supply and demand
figures we have been using throughout this class

MBP is demand for pollution; MCP is the marginal societal cost, or

supply
This represents a hypothetical market for pollution, with a resulting
optimal price and quantity placed on pollution
Since this market doesnt exist in the real world, what can be done
to induce private parties to produce/consume at the socially
efficient level?
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Fixing
16.2Externalities

16

Using Prices to Fix Externalities

Consider changing the price of goods that are produced in the
presence of externalities, so that the social and private
benefits/costs align

For a negative externality, tax production or consumption

For a positive externality, subsidize production or consumption

In the presence of negative externalities, economists often

advocate for the use of a Pigouvian tax

A tax that equals the external marginal cost imposed by an

externality
Pigouvian taxes are designed to fix market failures and, therefore,
improve societal welfare (rather than distorting markets like other
taxes)

Consider the power plant example

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Fixing
16.2Externalities

16

Figure 16.5 A Pigouvian Tax Corrects for a Negative

Externality
Price
($/MWh)

P*
PMKT

SMC = MCI + T
S = MCI
A
B

EMC = T

Q* QMKT

In an unregulated market, a
power company
Now, the power
company
overproduces
quantity
QMKT
produces
at
point
A,
where
at price PMKT (point B).
SMC intersects demand D,
A Pigouvian tax T equal to
and supplies the socially
the external marginal cost
efficient quantity Q* MWh at
EMC shifts up the supply
price P*.
curve S from marginal cost
= MCI to the social marginal
EMC = Tax,
T curve SMC.
cost
D
Quantity of
electricity (MWh)

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Fixing
16.2Externalities

16

Using Prices to Fix Externalities

Similarly, in the presence of positive externalities, economists
often advocate for the use of a Pigouvian subsidy

A subsidy that equals the external marginal benefit imposed by an

externality

Consider the education example

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Fixing
16.2Externalities

16

Figure 16.6 A Pigouvian Subsidy Corrects for a

Positive Externality
Price EMB = Sub
($/degree)
A

P*
PMKT

S = MCI

In an unregulated market,
colleges
Now,
the under
collegeproduce
market
quantity
Q
,
college
MKT
produces where
supply S
degrees,
atSD,
price
PMKT
(point
intersects
and
supplies
A Pigouvian subsidy Sub
B).
the socially efficient
quantity
equal to external marginal
Q*, college degrees, at price
benefit EMB shifts demand D
P* (point A).
out to social demand SD.

SD = D + EMB = D + Sub
EMB = Subsidy, Sub
D
QMKT Q*

Quantity of
college degrees

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Leather Tanning

figure it out

Returning to our example of leather tanning, suppose the

government imposes a tax of $4.00 on every hide of leather
sold. The industry short-run supply curve (marginal cost curve)
is P = MC = 3Q, where Q is measured in millions of hides per
year. The inverse demand for leather hides is given by P = 60
7Q (remember, the externality was equal to $4 per hide)
Answer the following question:

How many leather hides would be sold, what price would buyers pay, and what price would sellers receive (net of the tax)?

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figure it out

Leather Tanning

To solve this problem, we use the method from Chapter 3,

where the price paid by buyers, PB, is equal to the price
received by sellers, PS, plus the tax, T. Therefore, PB = PB + 4.
The inverse demand and supply
P Scurves
3Q are given by

P B 60 7Q
To equate the two inverse demand curves, however, requires us to rewrite the supply curve in terms of PB

Solving for the equilibrium quantity,

P B P S 4 3Q 4
And the prices paid by buyers and sellers are:

3Q 4 60 7Q
10Q 56
Q 5 .6
P B 3Q 4 $20.8
P S 3Q $16.8
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Fixing
16.2Externalities

16

Quantity Mechanisms to Fix Externalities

Quantity-based interventions have the same goal as taxes or
subsidies: to move a market with externalities toward the
efficient outcome
Quota A regulation mandating that the production or
consumption of a certain quantity of a good or externality be
limited (negative externality) or required (positive externality)

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Fixing
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16

Figure 16.7 The Effects of a Quota on a Market with a

Negative Externality
Price MC (with quota)
I
($/MWh)

SMC
S = MCI

A
P*
PMKT

Quota = Q*QMKT

In an unregulated market, a
power company overproduces
quantity QMKT at price PMKT
(point B).
When the government enacts a
quota limiting production to
Q*, the private marginal cost
curve MCI becomes vertical at
Q*, intersecting the social
marginal cost SMC at the
socially optimal quantity Q*
EMC
and price P* (point A).
D
Quantity of
electricity (MWh)

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Application

16

Rationalization in Fisheries
Historically, fishing effort was managed using tools such as
total allowable catch (TAC) limits and limited entry (LE)
In the British Columbia, Canada, (B.C.) halibut fishery,
these two regulations effectively limited catch but had
other consequences
In response to the LE (limited to 435 vessels), in the
1980s vessel owners invested in alternative forms of
capital (e.g., better electronics, larger crews)
In response to the TAC, fishermen fished as fast as they
could, as soon as the season opened (in 1982, 60-day
season; in 1990, a 6-day season)
This derby fishing was very dangerous. Fishermen
would go out in horrible weather, and sinkings and
deaths increased
Further, the short seasons made it difficult to enforce
Citation: Casey, K, C. Dewees, J. Wilen, and B. Turris, 1995. The Effects of Individual Transferable Harvest Quotas
the
TAC; TAC was exceeded by 10% in 1990
in the British Columbia Halibut Fishery, Marine Resource Economics 10(5).

Photos courtesy of NOAA Fisheries

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Application

16

Rationalization in Fisheries
In response, the B.C. government decided to implement an
individual vessel quota system (IVQ)
Vessels given a yearly share of the TAC and the right to
fish at any point in an 8-month season (until the TAC is
reached)
At first, IVQs were not tradable, but they were leasable;
trading was allowed after two-year trial period
Enforcement self-funded (tax of C$0.09/pound)
Many benefits:
Firms focus on lowering costs rather than racing to fish
Longer season made fishing safer, reduced idle capital
Longer season also increased fish prices, as more fish
were able to be sold to fresh markets, rather than
frozen
Citation: Casey, K., C. Dewees, J. Wilen, and B.Turris, 1995. The Effects of Individual Transferable Harvest Quotas
Fishermen
felt more secure in their investments; profits
in the British Columbia Halibut Fishery, Marine Resource Economics 10(5).
grew
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Photos courtesy of NOAA Fisheries

Application

16

Rationalization in Fisheries
Also some problems
Vessel owners were primary beneficiaries. Reported
crew shares declined (crew are often paid a percentage
of revenue; now, quota was viewed as a valuable asset
and worthy of its own share)
Focus on cost savings reduced fishing employment in
communities with few outside options
Is it fair to permanently bequest access rights to a
public asset to private citizens?
Photos courtesy of NOAA Fisheries

Citation: Casey, K., C. Dewees, J. Wilen, and B. Turris, 1995. The Effects of Individual Transferable Harvest Quotas
in the British Columbia Halibut Fishery, Marine Resource Economics 10(5).

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Fixing
16.2Externalities

16

Price-Based versus Quantity-Based Interventions with

Uncertainty
With perfect information, price and quantity instruments are
equally effective in controlling externalities
Without perfect information, there are significant informational
problems facing regulators

The costs of controlling externalities (marginal abatement costs)

are often difficult to ascertain ex ante
The benefits of controlling externalities (marginal pollution costs)
are similarly difficult to estimate (in the case of pollution, valuing
changes to human health, ecosystems, etc.)

When there is uncertainty in marginal abatement costs, price

and quantity mechanisms are not equivalent
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Fixing
16.2Externalities

16

Price-Based versus Quantity-Based Interventions with

Uncertainty
The equivalence between price and quantity instruments
breaks down under uncertainty because of a simple difference
between the two

Price instruments fix the price of pollution (e.g., a pollution tax

imposes a fixed cost on polluters for each unit emitted)
Quantity instruments fix the quantity of pollution

Consider the case when marginal abatement costs turn out to

be larger than expected

Under a pollution permit system, firms are forced to abate a fixed

amount of pollution
Under a pollution tax system, firms will abate less pollution (they
will limit pollution until the additional cost of reducing one more
unit of pollution
is equal
to
the
tax,
and then
they will16-32
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pay
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Publishers, All
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Reserved
Microeconomics
Goolsbee/Levitt/Syverson
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Fixing
16.2Externalities

16

Price-Based versus Quantity-Based Interventions with

Uncertainty
What happens to the outcomes under taxes and
permits when the marginal benefits of reducing
pollution (MCP) are greater than expected?

Nothing! Polluting firms operating under a pollution tax system will

only change their pollution control efforts in response to a change
in the private costs of pollution control (marginal abatement costs)
The benefits of reducing pollution are in the form of reduced
external costs. As these costs are not borne by polluting firms, the
choice of how much pollution to emit is not affected
Benefit uncertainty does not alter the equivalence between price
and quantity interventions
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Fixing
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16

Price-Based versus Quantity-Based Interventions with

Uncertainty
When are price-based interventions preferable to
quantity-based interventions, and vice-versa?
When the marginal abatement cost (MAC) and marginal
pollution cost (MCP) curves are linear, two factors determine
the relative superiority of on intervention of the other
The slope of the MAC curve
The slope of the MCP curve

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Fixing
16.2Externalities

16

Figure 16.8 When Quantity Mechanisms Are

Preferable to Price Mechanisms
Price
($/unit)

T*
T

Government officials initially

believe abatement costs to be
Deadweight loss from
MACe .
Deadweight loss
quantity mandatefrom Pigouvian tax
MCP

A
X
B

If government regulators
Because MAC is flat relative to
incorrectly estimate farmers
MCP, the quantity-based
marginal abatement costs (MACe
intervention is preferable to the
Y
< MAC),
the quantity-based
price
mechanism,
as seen by
intervention
would
reduce
comparing the resulting
C
pollution
to POLL
POLL*,
B <from
deadweight
losses
thewhile
two
Pigouvian
tax would
increase
MBP =the
MAC
interventions
(X < Y).
pollution to POLLC > POLL*.
MBPe = MACe

POLLB POLL* POLLC Quantity of fertilizer

runoff (ppm)
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Fixing
16.2Externalities

16

Figure 16.9 When Price Mechanisms Are Preferable

to Quantity Mechanisms
Price
($/unit)

Deadweight loss from

quantity mandate
MCP

T*
T

X
B

Y
C

Government officials initially

believe abatement costs to be
MACe .

Deadweight loss
from Pigouvian tax

If government
regulators
Because
MAC is steep
relative to
incorrectly
estimate
farmers
the marginal cost of pollution
marginal
abatement
costs (MAC
MCP, the
price mechanism
is e
<preferable
MAC), theto
quantity-based
the quantity
MBP = MAC
intervention
reduce
mechanism,would
as seen
by
pollution
to POLL
while
comparing
the
B <POLL*,
resulting
MBPe = MACe
the
Pigouvianlosses
tax would
deadweight
from increase
the two
Quantity
of
fertilizer
pollution
to POLL(X
POLLB POLL* POLLC
interventions
Y).
C ><POLL*.
runoff (ppm)
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Fixing
16.2Externalities

16

A Market-Oriented Approach to Reducing Externalities:

Tradable Permits Markets
Using price or quantity interventions involves a lot of effort

Firms may differ dramatically in their abatement costs

Often, pollution control regulations require a fixed aggregate
emissions reduction; taxes have difficulty with this

In response to these challenges, many regulatory agencies

issue tradable permits to control pollution

A government-issued permit that allows a firm to emit a certain

amount of pollution during production and that can be traded to
other firms
In theory, they are effective in achieving allocative efficiency:
marginal abatement costs equalized across firms
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Fixing
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16

Firms Costs of Reducing Emissions

Suppose there are two firms producing electricity, Acme and
Best

Without regulation, each firm would emit 40 tons of pollutant, for a

total of 80
The regulator has come to the conclusion that 50 tons is the
socially optimal aggregate level of emissions
Any scheme of emissions reduction across the two firms that adds
to 30 tons will work to achieve this reduction
However, all schemes are not equal, particularly if costs differ

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Fixing
16.2Externalities

16

Firms Costs of Reducing Emissions

Consider the following

Acme is older and less efficient at reducing pollution. Marginal

abatement costs are (cost per ton cut)

MACA 2eA

Best is newer and more efficient at reducing pollution. Marginal

abatement costs are (cost per ton cut)

MACB eB

Notice that each firms MAC increases as they cut more; each
additional unit of pollution reduction costs more than the last

Why does it cost more to reduce additional pollution?

At first, firms are able to take advantage of relatively low cost

technologies
As those low-cost methods are exhausted, removing additional
pollution
becomes
moreAllexpensive
16-39
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Fixing
16.2Externalities

16

Firms Costs of Reducing Emissions

The lowest-cost way for society to achieve the 30-ton
emissions cut is to split the cut across the two firms in a way
that equalizes the two firms marginal abatement costs

If, at any allocation of pollution cuts, Best has a lower MAC than
Acme, the standard could be met at a lower cost by shifting cuts to
Best from Acme

16-40
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Fixing
16.2Externalities

16

Firms Costs of Reducing Emissions

The efficient allocation of cuts occurs where

MACA MACB 2eA eB

How do we solve for the efficient allocation? We know that the total
pollution reduction must be equal to 30

eA eB 30

Using this equation and the one above, solve the first for eB, and then
substitute into the second

eB 2eA eA 2eA 30 eA 10

And solving for Bests emission

e reductions
20
B

The cost-minimizing allocation of reduction is for Acme to cut 10 tons

and Best toCopyright
cut 20.
This
makes
Best isaGoolsbee/Levitt/Syverson
more efficient
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Fixing
16.2Externalities

16

Firms Costs of Reducing Emissions

Why do we need tradable permits? Cant the
regulator assign emissions reductions to firms
efficiently?

In reality it is difficult for regulators to ascertain firms costs of

reducing pollution
Often, firms do not have a perfect understanding of the costs
involved with reducing pollution
There is the problem of moral hazard: firms have an incentive to
overstate costs to regulators, hoping to reduce their financial
liability

Tradable permits solve this problem

High-cost firms purchase permits from low-cost firms until there are
no mutually beneficial trades remaining
The market
price
permits
will
be equal to
MAC
for
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Noise Pollution

figure it out

Global Package Service (GPS) and Mail & Parcel Service (MAPS)
are cargo airlines using a small regional airport. Their jets inflict
noise pollution on a nearby town. At current production levels,
GPS creates 600 decibel-hours (dbh) of noise each day, while
MAPS creates 750 dbh. Government regulators would like to lower
the total noise pollution to 1,000 dbh. GPS faces a total
abatement cost of TACG = 20dG + 2dG2 and a marginal abatement
cost of MACG = 20 + 4dG, where dG is the number of dbh abated
by GPS. MAPS planes are older, so its TAC and MAC are greater:
TACM = 40dM + 3dM2 and MACM = 40 + 6dM.
Answer the following questions:

1. Suppose regulators implement a quantity regulation and divide the

1,000 dbh limit equally. How many dbh will each firm have to cut?
2. How much will this cut in jet noise cost each firm? What is the total cost
of reducing the noise pollution to its optimal level?
3. Suppose regulators create 1,000 1-dbh permits and divide them
equally, allowing trading. How many dbh will each firm cut? What is the
price of a permit?
4. What is the total cost of reducing the noise pollution to 1,000 dbh with
tradable permits?
How
does this
compare
with question
2? 16-43
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Noise Pollution

figure it out

1. If regulators require each firm to cut its noise pollution to 500

dbh, GPS will have to cut 100 dbh (= 600 500) and MAPS will
have to cut 250 dbh (= 750 500)
2.

The cost of this plan is equal to the sum of each firms total abatement cost

TACG 20dG 2dG2 20(100) 2(100)2 $22, 000

TAC M 40d M 3d M2 40(250) 3(250) 2 $197,500
Total Cost TACG TACM $22, 000 $197, 500 $219, 500

16-44
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figure it out

Noise Pollution

3. Under a system of tradable permits, GPS and MAPS will split

the reduction in noise pollution in the most efficient way. This
occurs when their marginal abatement costs are equalized

Remembering that

MACG MACM 20 4dG 40 6dM

for the efficient allocation of emission reductions
dG ,wedcanMsolve
350
dG dM 350 dG 350 dM
20 4dG 40 6dM

The price of a permit is equal to each firms MAC. Using GPS:

20 4 350 dM 40 6dM
10dM 1, 380 dM 138dbh
dG 350 dM 350 138 212dbh

Price MACG 20 4dG 20 4 212 $868

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Noise Pollution

figure it out

4. The total cost of abatement is equal to the sum of the

abatement costs of the two firms

TACG 20dG 2dG2 20(212) 2(212)2 $94,128

TACM 40dM 3dM2 40(138) 3(138)2 $62, 652
This is significantly less than the $219,500 cost of the uniform standard

Total Cost TACG TACM $156, 780

16-46
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Further Topics in
Externalities and Their
Remedies

16.3

16

The Tragedy of the Commons a common resource is used

more intensively than it would be if it were privately owned
Another pervasive form of a negative externality
A common resource is an economic good that all individuals can
access freely and whose value to the individual consumer
decreases as others use it

Many lake, river, coastal, and ocean fisheries, public forests,

reservoirs, aquifers, and other sources of water, the atmosphere
Public airways, public bathrooms
Key characteristic: nonexcludability consumers cannot be
prevented from consuming the good once it is available

16-47
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Further Topics in
Externalities and Their
Remedies

16.3

16

The Tragedy of the Commons

Nonexcludability means that users have little private incentive
to protect the resource for others, since they do not realize the
full cost of overuse
Consider the case of a lake fishery owned by a single person

Subject to a few assumptions about the price of fish, the cost of

fishing, and the biological growth of fish, the owner will treat the
fishery like an asset
He will recognize that removing a fish to sell today comes with
three costs: the cost of catching the fish, the opportunity cost of
not being able to catch the fish in the future, and any lost
reproduction or natural growth that would have occurred
Since the resource is treated like an asset, it will earn a resource
rent, just as labor and capital each earn a rent (wage and interest,
respectively)
16-48
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Further Topics in
Externalities and Their
Remedies

16.3

16

The Tragedy of the Commons

Now, consider the case of a lake fishery with no exclusions on
who can go fishing there

Individual fishermen will only consider their private cost of fishing

when determining how much to fish
They cannot capture the benefits of leaving a fish in the lake (the
option to catch it, or its offspring, in the future)
Fisheries with open access will experience rent dissipation,
whereby any positive economic profit experienced in the fishery is
driven to zero by new entrants and/or greater fishing pressure
Open-access fisheries have also experienced severe biological overexploitation, with some historically important fisheries collapsing
So, private property rights have been used in fisheries to help
manage the problem of nonexcludability
16-49
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Further Topics in
Externalities and Their
Remedies

16.3

16

The Coase Theorem: Free Markets Fixing Externalities

on Their Own
Under certain circumstances, it may be possible to reach the
efficient market outcome through private negotiation.
The Coase Theorem: costless negotiation among market
participants will lead to the efficient market outcome,
regardless of who holds legal property rights

It does not matter who has a property right

If outcomes can be monitored and individuals can costlessly
coordinate and negotiate, parties should be able to reach the
efficient outcome
Coordination is often very difficult, particularly when there are
many participants and information problems exist
16-50
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Coasian Solutions to Externalities

figure it out

Green Acres Fertilizer Company is located near Barneys Dry

Cleaning Service. Green Acres production process emits noxious
odors that are absorbed by the clothing that Barney is cleaning.
The result is that Barney has lost many customers over time.
Barney estimates that the odors cost his business $10,000 per
year. Green Acres can eliminate its odors by altering its
production process at a cost of $12,000 per year.
Answer the following questions:

1.

If Green Acres has the right to emit the odors, what will the socially optimal outcome be? How will it be reached? Will any money change hands?

2.

If Barney has the right to odor-free air, what will the socially optimal outcome be? How will it be reached? Will any money change hands?

16-51
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Coasian Solutions to Externalities

Figure it out

1. The socially optimal outcome will occur when Green Acres

emits the odor. The cost of eliminating the emissions ($12,000
per year) is greater than the external cost of the odor ($10,000
per year). If Green Acres has the right to emit the odors, it will
continue to do so. Barney does not value clean air enough to
purchase that right from Green Acres, so no money will change
hands.
2. The socially optimal outcome will still be for Green Acres to
emit the odor. The optimal outcome is determined by the
relative values that Green Acres and Barney place on the
resource (air). Because Green Acres values the air more than
Barney does, it should use the resource and emit the odor.
However, because Barney has a right to odor-free air, Green
Acres will have to purchase the right to emit odors from him.
Assuming that this can be done costlessly, Green Acres will
have pay Barney between $10,000 and $12,000 for that right.

16-52
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Further Topics in
Externalities and Their
Remedies

16.3

16

The Coase Theorem and Tradable Permits Markets

The Coase theorem has been used to help inform the design of
government regulations for controlling externalities

Consider the concept of tradable permits for pollution control

discussed previously
How should a regulatory agency distribute the rights to
pollute? Should they be given away for free? Allocated by
sector? Auctioned to the highest bidder?
The Coase theorem suggests it does not matter who is endowed
with the rights, or how they are distributed
So long as there is monitoring and the ability to coordinate
participants in a way that facilitates negotiation, the outcomes
should be the same no matter the initial allocation
This is one reason why markets for tradable permits receive
attention in the literature; markets act to make coordination easier
16-53
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Application

16

Fishing Quota Markets

While tradable permits and other market-based
solutions sound good in theory, will they work in
the real world?
The benefit of tradable permits is that they allow
efficiency gains by allocating production to the most
efficient firms
In the case of fisheries, this means that more efficient
fishing operations should be purchasing quota from less
efficient operations, thereby lowering the cost of
catching a given amount of fish

Photo courtesy of:

www.munz.org.nz

Newell et al. (2005) examined the rationalization

experience (privatization of fishing rights) in New Zealand
In 1986, N.Z. established an individually transferrable
quota (ITQ) system for its previously open-access
fisheries
Citation:
R.G., J. N. Sanchirico, and S. Kerr, 2005. Fishing Quota Markets. Journal of Environmental Economics and Management 49(3) 437
It Newell,
covered
28 species, expanding to 45 in 2000, with
462.
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1/e
quota being traded in over 275 markets; as of mid-

Application

16

Fishing Quota Markets

The authors found that at the onset of the ITQ system,
there was significant price dispersion and few quota
transactions
Characteristic of thin markets: low volume, high price
variability
As time went on, however, price dispersion declined
While the amount of quota permanently transferred
between parties actually fell over time, leasing activity
increased dramatically, with almost half of total quota
being leased to third parties by 2000
Implies quota owners view their quota as a valuable
asset that may grow in value over time

Photo courtesy of:

www.munz.org.nz

Newell et al. contend that this is a sign that ITQ systems

can be effective in both controlling fishing effort and
improving the economic performance (efficiency) of
Citation: Newell, R.G., J. N. Sanchirico, and S. Kerr, S. Fishing Quota Markets. Journal of Environmental Economics and Management 49(3) 437462.
fisheries
16-55
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16.4Public Goods

16

There is another type of good for which markets can fail to

deliver the socially optimal level of output: public goods

A good that benefits the individual consumer even as others

consume it
These goods (e.g., national defense, a fireworks display, or clean
air) remain just as valuable to the consumer, even as other people
consume them

Similar to positive externalities

Provide positive external benefits to everyone, regardless of who

purchases them; public goods, however, differ in a fundamental
way
Public goods are nonrival: Defining property of a public good that
describes how one individuals consumption of the good does not
diminish another consumers enjoyment of the same good

Using theCopyright
definitions
of excludability and rivalry, we
can
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16.4Public Goods

16

16-57
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16.4Public Goods

16

The Optimal Level of Public Goods

Market efficiency requires that a good is produced until the
marginal benefits of production are equal to the marginal costs

Since public goods are nonrival, the marginal benefit of a given

level of provision is the vertical sum of all individuals marginal
benefit curves
Total marginal benefit is defined as

MBT MBi

where the i subscript indicates each individual

The cost side is the same as with any other good

16-58
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16.4Public Goods

16

Figure 16.10 Efficiency in the Market for a Public

Good

Marginal benefit,
marginal cost
Total marginal benefit,
MBT = MB1 + MB2

MB2

MB1
Q1

*
Q2 QPub

MC

The two consumers of a

public good have marginal
If the
two consumers
benefit
curves,
MB1 and MB2
privately bought the good,
, respectively.
each
would
consume
At the
efficient
point,below
both
the optimal
levelQ*
atPub of
consumers
consume
quantities
Q1 good,
and Qwhere
the public
2 , where
MB
MB
their
total
marginal
benefit
1 and
2 each intersect
curve MBT MC.
intersects the
marginal cost curve MC.
Quantity of
public good

16-59
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16.4Public Goods

16

The Optimal Level of Public Goods

There are two reasons why markets will underprovide public
goods
The first is illustrated by the figure on the previous slide

If individuals are able to purchase the goods themselves, they will

purchase only up until the point at which private marginal benefit
equals marginal cost
The efficient level occurs when the total marginal benefits equal
marginal cost

A second problem results from the nonexcludability of public

goods

This is called the free-rider problem: A source of inefficiency

resulting from individuals consuming a public good or service
without paying for it
16-60
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Why take
on any private costs, when you can simply benefit
from

Public Goods

figure it out

Dale and Casey are neighbors in a rural area. They are

considering the joint installation of a large fountain near their joint
property line so that each can enjoy its beauty and also improve
the value of his property. Dales marginal benefit from the
fountain is MBD = 70 Q, where Q measures the diameter of the
fountain (in feet). Caseys marginal benefit from the fountain can
be represented as MBC = 40 2Q. Assume that the marginal cost
of producing the fountain is constant and equal to $80 per foot (in
diameter).
Answer the following questions:

1.

Find an equation to represent the total marginal benefit of the fountain.

2.

What is the socially optimal size of the fountain?

3.

Would you expect Dale and Casey to build the optimally sized fountain? Explain.

16-61
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figure it out

Public Goods

1. The total marginal benefit is the vertical summation of Dales and

Caseys individual marginal benefit curves:

MBT MBD MBC 70 Q 40 2Q 110 3Q

2. The socially optimal size of the fountain occurs where MBT equals the
marginal cost of producing the fountain:

MBT MC 110 3Q 80
30 3Q Q 10
The socially optimal diameter for the fountain is 10 feet.
3. Dale will not be willing to build a fountain that is 10 feet in diameter
because his private marginal benefit is less than the marginal cost

MBD 70 Q 70 10 60 MC (80)

Casey also will be unwilling to build a 10-foot fountain because his private
marginal benefit from a 10-foot fountain is lower than the marginal cost:

MBC 40 2Q 40 20 20 MC (80)

Therefore, the optimally sized fountain will not be built.

16-62
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16.4Public Goods

16

Solving the Free-Rider Problem

The most common way that the free-rider problem is dealt with
is through government action

Governments have the ability to tax citizens, and those powers are
often used to provide public goods such as national defense, air
traffic control, weather forecasting services, etc.

There are other potential solutions

Groups of private citizens can form to provide public goods (e.g.,

homeowners associations for condo buildings)
It is not always the case that people will succumb to the free-rider
problem. Private motivations are often more complicated than
assumed by the economic theory of rational agents

16-63
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Application

16

The Al Gore Effect: Voluntary Provision of

Public Goods
The global climate regulatory system is a public good
Nonexcludable
Nonrival
However, by contributing to the greenhouse effect, our
carbon-based global economy is degrading the ability of
our atmosphere to regulate global temperatures
Without a global climate agreement in place, some
advocates have called for more effective outreach to the
public
Induce people to make more climate-friendly
consumption decisions
Encourage the purchase of carbon offsets to reduce
individual carbon footprints

Citation: Jacobsen, G.D. 2011. The Al Gore Effect: An Inconvenient Truth and Voluntary Carbon Offsets. Journal of Environmental Economics and
Management 61(1):
6778.

16-64
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Application

16

The Al Gore Effect: Voluntary Provision of

Public Goods
Jacobsen (2011) investigated whether the release of Al
Gores film An Inconvenient Truth in 2006 corresponded
with an increase in the purchase of carbon offsets
Examined households in zip codes within a 10-mile
radius of theaters
The main finding: households near theaters that screened
An Inconvenient Truth were more likely to purchase offsets
In the two months following the films release,
households within the radius experienced a 50%
relative increase in carbon offset purchases, compared
to households outside the radius
During other times, purchasing patterns did not differ
However, purchases were one time; there was no
discernible
difference
theAnfollowing
year
Citation:
Jacobsen, G.D. 2011.
The Al Gore Effect:
Inconvenient Truth
and Voluntary Carbon Offsets Journal of Environmental Economics and
Management 61(1):

6778.

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16.5Conclusion

16

In this chapter, we delved into the issues that develop when

markets are missing or otherwise incomplete

Externalities occur when costs and/or benefits are not completely

captured by those making production and consumption decisions
Nonexcludable, common-pool goods suffer from overuse and/or
underinvestment
Public goods are underprovided by private agents due to free riding
and the misalignment of private and total marginal benefits

In the final chapter, we examine situations in which economic

actors (consumers and producers) may not appear to be the
rational, utility- and profit-maximizing agents we have modeled
throughout this text

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