Public Finance

Externalities
 After This Session You Would
Know
• Understanding Externalities (4-7)
• Nature of Externalities(8-11)
• Graphical presentation of the implication (12-20)
• Private response to externalities—Coase theorem (21-28)
• Private response to externalities—other workarounds (29)
• Public response to externalities—Pigouvian approach (30-35)
• Public response to externalities—market creation (36-38)
• Public response to externalities—regulation (39-41)
• Implication for income distribution (42-43)
• Subsidy and positive externalities (44-45)
• Subsidy for owner occupied housing (46)
• Subsidy for higher education (47-50)
 DEFINITION
• Externality – An activity on one entity that affects the
welfare of another entity in a way that is outside the market
mechanism
• Externalities are side effects of private production and
consumption. True externalities are external to the
voluntary exchange process-- they effect third parties.
• Externalities generally lead to an inefficient allocation of
resources, or , what is referred to as a market failure, just
as do public goods.
• Though externalities are two types, positive and negative,
most of our externality related problems are associated
with negative externalities.
 AN EXAMPLE: -VE EXTERNALITY

• Tanneries on the bank of Buriganga river expels all its

toxic waste directly into the river which saves them huge
sums of money in waste disposal. However, such toxic
waste are causing serious health problems for those
living on the bank of the river.
• In other words, such hazardous practice saves the
tannery owner money, at the same time, causes
sufferings for others. Thus the tannery owners shifting
their cost to the society effectively.
• This is what we know as negative externalities to the
society.
 AN EXAMPLE: +VE EXTERNALITY

• Primary education is considered as one of the fundamental

rights of all citizens of a country. When an individual
receives primary education, he is benefited. Since, social
progress has a direct relationship with the percentage of
literate adult, the society gets benefited too.
• That is, though a primary school is generating benefits for
the individual who receives/buys education from there and
for rest of the society, the market mechanism only allows it
to charge for the benefit that is rendered to the individual.
That is, the benefits generated by the school to the society
remains unpaid by the market.
• This is positive externality from societal perspective.
 AN EXAMPLE: NO EXTERNALITY

• Because of improved communication and many other

factors house rent at Uttara has increased many fold in
last 10 years whereas the same in Dhanmondi has
experienced a notable decrease.
• One might think that this is a case of negative externality
for the house owners in Dhanmondi.
• However, since the change is relative demand is
reflected by the relative change in house rent, we can
safely conclude that, in this case the market is working
by adjusting the price.
• Hence, this can not be an example of externality.
 BASIC ISSUE
• When there are public consequences of
private decisions, the usual competitive
market process has no mechanism for
incorporating the cost or benefits of those
public consequences.
• The producer of a negative externality is
imposing external costs on others, while the
producer of a positive externality is producing
external benefits ( e.g., a public good ).
 NATURE OF EXTERNALITIES

1. Externalities can be produced by

consumers as well as by companies: In
our previous examples, we have seen
how companies can produce externalities.
By smoking in a public place one can
decrease the supply of fresh air for the
rest of those who are present their and
can cause negative externality for them.
 NATURE OF EXTERNALITIES (CONT)
2. Externalities are reciprocal in nature: In our
tannery example, we have seen that, the cost
of the waste disposal for the factories would go
up if they can’t use the river for the purpose.
So, we can say that, by living on the bank of
river, other people is causing negative
externality to the tannery firms.
3. Externalities can be positive or negative:
We have already explained this point in our
first two examples.
 NATURE OF EXTERNALITIES (CONT)
4. Public goods can be viewed as a
special kind of externality: Sometimes,
the boundary between externality and
pure public goods are a bit fuzzy. For
example, if a new departmental store in a
residential area installs insect
electrocution device which kills all the
mosquito in a neighborhood then it
becomes a pure public goods, but if only
a few adjacent households get this
benefit, then it is externality.
 NATURE OF EXTERNALITIES (CONT)

5 True externalities are not reflected in

market prices: Finally, as we have seen
in our ‘No Externality’ example, if the
impact of any external/third party is
reflected in the price, then there is no
externalities.
 The Nature of Externalities-Graphical
Analysis
MSC = MPC + MD
$

MPC

h
d
g

c
MD

b f MB
a e
0
Q* Q1 Q per year
Socially efficient output
Actual output
 GRAPHICAL ANALYSIS OF -VE
EXTERNALITIES
Suppose, these are the MC and
MR curves for a tannery.
Currently the tannery produces Q1
A MC quantity of goods at a marginal
cost of P1, which meets the
MC=MR criterion.
P1 x
At this level of production, the
total revenue for Q1 quantity will
M be AxQ1O and total cost will be
MR
OMxQ1 and total profit would be
O
Q1
=>total revenue-total cost=MAx
 GRAPHICAL ANALYSIS OF -VE
EXTERNALITIES (CONT)
Now, if we include the marginal
MSC (MC+MSD)
social disutility from the
hazardous wastage disposal
A MC (represented by MSD curve)
c into the picture, then the MC
P2
y curve will be replaced by
P1 x marginal social cost (MSC)
d
curve.
MSD
In this new equilibrium, the
M MR tannery should produce only Q2
O quantity instead of Q1 quantity.
Q 2 Q1

At this level, the total profit for

the tannery would be MdyA.
 GRAPHICAL ANALYSIS OF -VE
EXTERNALITIES (CONT)
Implications:
MSC 1. Market may not produce
A MC
socially desirable
c
quantity of goods. In
P2
y case of negative
P1 x externalities, market
d produces too much of a
MSD
commodity than socially
M MR desirable.
O 2. Some degree of
Q 2 Q1
pollution is socially
desirable.
 GRAPHICAL ANALYSIS OF -VE
EXTERNALITIES (CONT)
Implications:
3. We can calculate the following from
MSC the graph.
a) Total profit for the tannery is
A MC reduced by dxy.
c b) Total cost/disutility for the society
y would reduce from McQ1 to
P2
P1 x MyQ2, i.e., the total reduction is
d ycxd.
MSD c) If gain to the society and gain for
the tannery is measured in same
M MR scale, the net benefit from
reducing production is ycx.
O 4. Finally, MSD is the main determinant
Q 2 Q1
of socially desirable level of output.
However, it is extremely difficult to
objectively measure MSD for any
society.
 GRAPHICAL ANALYSIS OF +VE
EXTERNALITIES
Suppose, these are the MC and MR
curves for a primary school. Other
thing remaining the same, the school
A would produce Q1 quantity of
MC
services, which meets the MC=MR
criterion.
P1
P2 However, if the school generate +ve
d externalities as shown in MSU curve,
the total benefit generated by the
M school would become MSR. Hence, it
MSU MR MSR is socially desirable that the school
O produce Q2 quantity of services.
Q1 Q2

Hence, we see +ve externality

induces a firm to produce less than
socially desirable level of output.
 DETERMINING MSD

• As we have just said, it is extremely difficult to

measure the marginal social disutility for any
negative externality. Lets try to put this
difficulties in the context of our pollution
example. In this particular situation, it is very
difficult to determine
– What activities produce pollution; and how much of it
can be attributed to a particular tannery
– What harm does this pollution cause; and
– What is the value/cost of the pollution
 Class Exercise
• The manufacturer of trucks produce pollution of various
kinds. Imagine that producing a truck creates one unit of
pollution and a unit of pollution has a cost of Tk.3,000.
Also, imagine that the supply of trucks is competitive.
The market supply and demand for trucks is shown in
below.
Price Quantity Quantity Social Marginal
($000) Supplied Demanded Costs
19 480 660
20 540 630
21 600 600
22 660 570
23 720 540
24 780 510
25 840 480
 Class Exercise
• Plot the supply and demand curve for the truck market
and find the private market equilibrium price and
quantity.
Price Quantity Quantity Social Marginal
(000) Supplied Demanded Costs
19 480 660
20 540 630
21 600 600
22 660 570
23 720 540
24 780 510
25 840 480
 Class Exercise
• Now adding the social marginal cost of Tk. 3,000 per truck the
figures are rewritten as below.

Price Quantity Quantity Social Marginal

($000) Supplied Demanded Costs
19 480 660 22
20 540 630 23
21 600 600 24
22 660 570 25
23 720 540 26
24 780 510 27
25 840 480 28
 If the social costs of pollution are taken into account, what
is the equilibrium price and quantity?
PRIVATE RESPONSE TO EXTERNALITIES—
COASE THEOREM
• ASSIGNING PROPERTY RIGHTS
– Nobel laureate Ronal Coase, in his 1960 article titled
“The Problem of Social Cost” in Journal of Law and
Economics showed that the problem of externalities can
be avoided if property rights can be established to either
of the parties involved.
– To demonstrate his argument we will first see the output
level if the tannery owns the river; then will see impact
when the people on the river bank gets the ownership of
the river.
– Two important assumption of this model is
• The negotiation cost for the parties would be negligible
• The owner(s) can take legal action to compensate damages
 COASE THEOREM (cont)
THE TANNERY OWNS THE
MSC
RIVER

A MC We can see that usual MC=MR

c logic would influence the tannery
P2
y to produce at Q1.
P1 x
d But, the people on the river bank
MSD would immediately notice that if
they collectively give the tannery
M MR a fee in exchange for a promise
O from the tannery to reduce their
Q 2 Q1
production level, they might get
better-off.
 COASE THEOREM (cont)
The tannery should also find it
lucrative to reduce their output if
MSC loss of profit from such reduction
A MC is less than or equal to the
c
potential fee that it could collect
P2
y from the people on the river bank.
P1 x That is, the tannery would like to
reduce output so far as
d
MSD
Marginal Fees>(MR-MC)
M MR
And the people on the river bank
O
Q 2 Q1 would like to pay fees so far as

Marginal Fees<MSD
 COASE THEOREM (cont)
To maximize benefits for both the
parties, we know that the
MSC negotiation of fees for less
A MC production would continue till
c
P2
y
MR-MC
Marginal Fees=(MR-MC); and
P1 x
Marginal Fees=MSD;
or MSD=(MR-MC).
d
MSD
In the graph, we can see that, these
M MSD MR conditions are met only at point Q2.
O
Q 2 Q1 So we see that, if river is owned by
the tannery, it produces socially
desirable level of output without any
government intervention.
 COASE THEOREM (cont)
THE PEOPLE OWN THE RIVER
If people own the river, they would
MSC immediately impose a fee on the
A MC tannery to compensate for the
c
damage that the tannery is causing to
P2
y them.
P1 x
Now the people would be ready to
d
MSD accept some pollution as long as the
payment is more than their marginal
M MR disutility or MSD.
O
Q 2 Q1 The tannery would also find it
beneficial if such fees is less than the
benefit that it derives from producing
more.
 COASE THEOREM (cont)
That is the respective bargaining
goal would be Marginal Fee>MSD
MSC for the people and Marginal
A MC Fee<Marginal Profit for the tannery.
c
P2
y And, the negotiation would
P1 x continue till MSD=Marginal Profit.
That is, the production level would
d
MSD once again be fixed at Q2.

M MR Thus we see, even when the

O
people on the river bank gets the
Q 2 Q1 property rights, the market
produces socially desirable level of
output.
 COASE THEOREM (cont)

• So, we can conclude that the problem associated with

externalities can be avoided, without public intervention, if
the property rights can be established. However, we
should keep the following in mind when applying this
theorem.
– First, the outcome of the negotiation would actually depend on the
relative bargaining power of the involved parties. If the tannery in
question is a major employer in the area, the people may find it very
difficult to negotiate their rights.
– Second, because of the fact that there are many people residing on the
river bank, it would be very expensive for them to collectively negotiate.
– Finally, we should not forget about the problem of finding out MSD for
any given situation.
 APPLICATION OF COASE THEOREM

• Despite these issues, Coase theorem is easily applicable to

situations where the number of involved parties are limited.
• In Bangladesh, the “Social Forestation Project” of the GOB
is a great example of how assigning ownership can solve
externality problem.
– Generally speaking, people living near a forest or plantation area has
no incentive to preserve the forest. The MC for deforestation is zero
where the MR is positive. Hence, they cut more trees than socially
desirable. Now, under this project, the people were assigned the
property rights of the forest, and they are paid for each tree chopped.
– This has reduced the deforestation to a socially desirable level.
• There are a few such examples sited in your book (page
88)
 PRIVATE RESPONSE TO EXTERNALITIES—OTHER
WORKAROUNDS

• MERGERS/INTERNALIZATION
– If the people on the bank of the river buys the tannery, in other
word, take over/internalized the externalities, then for its own
benefit, they would produce socially desirable level of output. In
this respect, we may recall that, by producing at Q2, the total
gain was more than the total cost. (slide 15)
• SOCIAL CONVENTIONS
– Our ethical standard, as governed by socially acceptable norms,
also help eliminate some externalities.
– For example, it is socially desirable norm that we should not spill
banana skin everywhere. Though the cost for spilling banana
skin is almost zero for us, the social cost is high.
– Like wise, we are taught to behave such that anything that we do
for our own good does not negatively affect other’s wellbeing.
 PUBLIC RESPONSE TO EXTERNALITIES—
PIGOUVIAN APPROACH

• Government may tax or subsidize the party causing the

externality to remove the misallocation problem
– The MC curve of the party, who is responsible for generating
negative externalities, only include the cost of the inputs and not
the social cost of the externality. As a result, such party tends to
produce more than socially desirable level of output.
– In 30s, noted economist A. C. Pigou suggested that if the
government impose tax on the responsible party such that the
imposed marginal tax is equal to the marginal social disutility,
then the overproduction problem would disappear. Similarly, the
government can provide subsidy to the party who generates
such negative externality and by providing incentives for not to
overproduce, the over production problem can be solved.
Public Responses to Externalities -
Taxes
MSC = MPC + MD
$ (MPC + cd)
Pigouvian MPC
tax revenues

d
i

j c
MD

MB
0
Q* Q1 Q per year
 PIGOUVIAN TAXES
Suppose, these are the MC and MR
curves for a tannery. Currently the
MSC
tannery produces Q1 quantity of
A
goods at a marginal cost of P1, which
MC1=MC+MT
MC
meets the MC=MR criterion.

y Now if the government introduce a

P2
P1 x per unit tax represented by MT on
g
each unit produced by the tannery,
d
MSD the marginal cost curve would shift to
MC1.
M
MT
MR As a result the tannery would find the
O
Q2 Q1 new profit maximizing level of output
at Q2, which, as per our previous
discussions, is the socially desirable
level of output.
 PIGOUVIAN TAXES (cont)
Note, at this level of output and taxes, the
total tax revenue would be the shaded
MSC
region (P2ydg) in our graph.
A MC1=MC+MT
MC
It may be tempting at the first glance to
say that since the people in the river bank
y still faces some degree of pollution, the
P2
P1 x government should use the tax revenue to
g
compensate the people. However, we
d
MSD must bear in mind the following points
• Some degree of pollution is still socially
M
MT desirable
MR • Paying compensation to the people of
O
Q2 Q1 the river bank would encourage more
people to migrate to the area who
wouldn’t otherwise reside there.
 PIGOUVIAN SUBSIDY
Once again, given the MC and MR
curves for a tannery in the graph, the
MSC tannery produces Q1 quantity of
A MC1=MC+MS goods at a marginal cost of P1, which
MC meets the MC=MR criterion.
c
y
P2 Now if the government introduce a
P1 x
per unit subsidy represented by MS
d
MSD
on each unit not produced by the
tannery, the marginal cost curve
M
MS
would shift to MC1.
MR
O
Q2 Q1
As a result the tannery would find the
new profit maximizing level of output
at Q2, which, as we know, is the
socially desirable level of output.
 PIGOUVIAN SUBSIDY (cont)
Note that, in this level of
production and subsidy, the
MSC total subsidy to be provided to
A MC1=MC+MS the tannery would is
MC represented by the shaded area
y
(ycxd).
P2 c
P1 e
g Also note that, the distributional
x
d
MSD impact of tax and subsidy
differs dramatically. While in
M
MS case of tax, the tannery
MR required to pay P2ydg amount
O
Q2 Q1 of tax, in this situation the
government would require to
pay ycxd amount of subsidy.
Public Responses to Externalities -
Subsidies
MSC = MPC + MD
$ (MPC + cd)
MPC
Pigouvian
subsidy

d k
i f
g
j c h
MD

MB
e
0
Q* Q1 Q per year
 ISSUES WITH PIGOUVIAN
TAX/SUBSIDY
• First of all, we already know that it is difficult to efficiently estimate
the marginal social disutility.
• Imposition of marginal tax may be prohibitively expensive. For
example, following the Pigouvian approach, the government may
charge mileage tax on vehicles to eliminate the overproduction of
pollution. However, tracking mileage for each vehicle would be very
expensive. On the other hand, a fixed charge on all vehicle,
irrespective of their mileage, is inefficient form distributional
perspective.
• Subsidy on the other hand lead to higher profits for the firm. Hence,
providing subsidy may encourage new firms to establish their
factories on the river bank and thereby cause increase in pollution.
• Also, as Mishan notes, pollution free water is socially desirable
objectives, hence the polluters must be held accountable and
should pay the price.
 PUBLIC RESPONSE TO EXTERNALITIES—
MARKET CREATION

• Similar to the Coase theorem, the government can

create a market for pollution and thereby eliminate the
problem of overproduction.
• Under this scheme, the government would limit the
maximum limit of pollution permissible to the river and
charge a per unit price for each unit of waste disposal.
• Then the government can either
– Auction/sale the right to pollute among different tanneries who
are interested to do so; or
– Assign another company the property right of the pollution permit
and the company in turn can sale the permit to the interested
polluters.
 MARKET CREATION (cont)

• When pollution permits are available in the market for

purchase, the companies can then use the right just like
any other factors of production and decide between
reduced output using conventional technology and more
output with cleaner technology based on its own
production preferences.
• One possible limitation of this scheme is that a firm may
want to pay more price than the firm’s cost-minimizing
requirement to deter other firms from entering the
market. However, whether such strategic behavior would
actually occur is hard to predict.
 MARKET CREATION (cont)

• However, there are some advantages to this approach.

The three distinct advantages of this approach are
– Government can set the maximum level of pollution without
leaving it to the market mechanism and uncertainty.
– This approach establish direct links between the amount of
pollution and cost rather than a indirect link between the quantity
of production and cost. Hence, the producers would feel more
encouraged to invest in cleaner technology.
– Moreover, in a inflationary situation, market price would
automatically adjust to reflect true value of the pollution.
Changing tax rates to achieve such reflection is time consuming
and often expensive.
PUBLIC RESPONSE TO EXTERNALITIES—
REGULATION
• Government may introduce new law requiring the
polluters to reduce pollution by a certain amount or
else face legal sanctions.
• In our example, the government can ask the tannery
reduce the pollution and produce at Q2 and monitor
the production of the firm to ensure compliance.
• Regulation is likely to be inefficient when there is more
than one polluting firm.
 REGULATION (cont)
• Let us assume there are two
tanneries X and Y, each of
which pollutes the river with
waste disposal.
• Lets also assume, though the
MR curves are different they
MSCx=MSCy
have the same MC curve and
produces the same quantity to
MCx=MCy
maximize their profits.
• If MSD is the social disutility
then the marginal social cost
MRy for both X and Y would be
MSCx=MSCy.
MRx MSD
• We can see here that, for
these firms the socially
desirable production quantity
is Qx and Qy respectively.
Qy Qx Q1
 REGULATION (cont)
• Implications: if the
government restrict each
firm’s pollution to a limit than
some firms would produce
more pollution than the
others.
MSCx=MSCy • To example intuitively, lets
consider the governments
MCx=MCy
recent initiative to install
catalytic converter to all
vehicles. We know, the taxi
MRy
cabs runs more than most of
the privately owned cars.
Now, what sense does it
MRx MSD make to force owners of both
the type of vehicle to pay for a
converter? This graph shows
Qy Qx Q1
it does not make any.
 IMPLICATION FOR INCOME
DISTRIBUTION
• Who benefits
– The answer depends on type of externalities. Generally air
pollution in Uttara is not as bad as in Kamalapur. Hence, taking
steps to improve air quality of Dhaka would benefit the residents
of Kamalapur more and improve equality.
– On the other hand, improving the parks and gardens of Dhaka city
by cleaning up the waste and evicting the floating population form
there would benefit the comparatively rich middle class more.
After all, they are the major users of these facilities.
– Again, we should bear in mind one fine detail here. Though
Kamalapur residence are more benefited from a ‘clean air’
program, in taka term, the rich families of Uttara may be willing to
pay more for clean air and hence get more utility than the poor of
Kamalapur.
 IMPLICATION FOR INCOME
DISTRIBUTION
• Who bear the costs
– Again, there is no straight forward answer to this question. When
environmental concern force the tannery to produce less, it also
means that the tannery would reduce its workforce which are mostly
poor. In the short run these poor worker would become unemployed
and in the long run they have to accept lower wage rates.
– The increased cost would drive the price of the commodity up. In
our example, the tannery would increase the prices to P 2 from its
previous price level of P1. Now, the relative impact of such price
change depends whether the rich or the poor consume the
commodity in question most.
– Assuming that both the poor and the rich consumes the product, the
nominal change in price has different relative impact on the
wellbeing of the two different classes which means the rich bears
relatively less cost.
 SUBSIDY AND POSITIVE
EXTERNALITIES
From our discussion on positive
externalities (slide 16) we have seen
that market tends to produce less than
Subsidy socially desirable quantity of goods
A MC which has positive externalities.
It is popular among the policy maker to
P1 resort to subsidy to effectively shift the
P2 MR curve to the right and correct the
d under production problem.
MR1
MR
However, we must also remember that
M MSU MSR every subsidy comes from some form
O of taxation. Each Taka taxed reduces
Q1 Q2
the social benefit of the population and
net impact of such transfer is not
certain and may not be socially
desirable.
 SUBSIDY AND POSITIVE
EXTERNALITIES (cont)
• We would like to site two specific
examples to illustrate the point that the
use of subsidy to correct output level
problem in cases of positive externalities
are not always desirable.
• We would use the example of owner
occupied housing and higher education.
 SUBSIDY FOR OWNER OCCUPIED
HOUSING
• Both our income tax system and our municipality tax system
provide incentives to those who reside in their own house.
The logic here is, home owner creates positive externality
by being stable member of a society, having a stake at the
country, taking more interest in community development,
caring more about the environment and so on.
• However, we should not forget that those who own homes,
especially those urbane who pay income taxes, are
relatively rich. And being rich itself could assert the
presence of all the above externalities.
• Moreover, it is unjust to have a system to subsidize a
person who is relatively rich from equality perspective.
 SUBSIDY FOR HIGHER EDUCATION

• The case for primary education as a case of positive

externality is well conceivable. We all know how illiterate
citizens of a country might negatively impact the overall
wellbeing of the people. However, the case for higher
education is not clear at all.
• The following are the major arguments of those who
support subsidy for higher education
– Higher education increases the income potential of a individual and
his family
– Higher education improves the human-capital of a nation and
contribute in national development, thus has positive externalities.
– People belonging to lower income group needs the subsidy to
overcome the cost barrier to send their off spring to universities
which improve equality
SUBSIDY FOR HIGHER EDUCATION (cont)

• Argument 1:Higher education increases the income

potential of a individual and hence, contribute in national
development
• Those who oppose this argument put these counter
argument:
– Since the additional spending on higher education is reflected in
the future income of graduates, there exists no externalities.
– Even if, for the shake of argument we accept the plea that the
future high income of a graduate is less than the cost of higher
education as a whole now, one can argue that, if left alone, in the
long run the cost for higher education would decrease and the
potential income advantage would increase in the long run
following usual market mechanism.
SUBSIDY FOR HIGHER EDUCATION (cont)

• Argument 2: Higher education improves the human-

capital of a nation and contribute in national
development, thus has positive externalities.
• Those who oppose this argument put these counter
arguments:
– It is true that development of any nation has a perceived direct
relationship with the stock of human-capital.
– However, do all subject taught in public university contribute the
same way in the national development? Isn’t it true that in
different phase of a country’s development it needs different
skills? If so, then a system to subsidized all types of higher
education is not justified.
SUBSIDY FOR HIGHER EDUCATION (cont)

• Argument 3: People belonging to lower income group needs the

subsidy to overcome the cost barrier to send their off spring to
universities which improve equality
• Those who oppose this argument put these counter arguments:
– If a young from a poor family who wants to open a auto-repair
shop does not get subsidy why should he be given subsidy to
go to the university?
– The assumption that “young individuals from poor families are
less likely to attend higher education only because of cost” is
also challenged by some economists. It is more often the
intellectual knack that determines the actual decision to
attend to a university. Hence, they argue, an education loan
program by the government would be more appropriate than
an outright subsidy to help those who has the knack.
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