CHAPTER 5

Externalities

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Externalities
 Externality – An activity on one entity that
affects the welfare of another entity in a way
that is outside the market mechanism
 Not an Externality – suburban-urban
migration example vs pollution example

5-2
The Nature of Externalities
 Privately-owned versus commonly-owned
resources
 Externalities can be produced by consumers
as well as firms
 Externalities are reciprocal in nature
 Externalities can be positive
 Public goods can be viewed as a special kind
of externality
5-3
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 5-4
Actual output
Bargaining and the Coase Theorem
MSC = MPC + MD
$

MPC

h
d
g

c
MD

MB
0
Q* Q1 Q per year
5-5
The Coase Theorem
 Coase Theorem – Provided that transaction casts are
negligible, an efficient solution to an externality
problem is achieved as long as someone is assigned
property rights, independent of who is assigned
those rights
 Assumptions necessary for Coase Theorem to work
 The costs to the parties of bargaining are low
 The owners of resources can identify the source of
damages to their property and legally prevent damages

5-6
Other Private Solutions
 Mergers
 Social conventions

5-7
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
5-8
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
5-9
Emissions Fee

$ MC

f*

MSB
0
e* Pollution reduction
5-10
 Uniform Pollution Reductions
MCH

Bart’s Tax
Payment Homer’s Tax
MCB Payment

f= f=
$50 $50

50 75 90 Bart’s 25 50 75 90 Homer’s
pollution pollution
reduction reduction
5-11
 Cap-and-Trade
MCH

MCB

f= f=
$50 $50
a

10 50 75 90 Bart’s 25 50 75 90 Homer’s
pollution pollution
reduction reduction
5-12
Cap-and-Trade v Emissions Fee
MC’
$ MC*

f*

MSB
0 ef e’ e* Pollution reduction
5-13
Too little pollution reduction Too much pollution reduction
Cap-and-Trade v Emissions Fee
MC’
$ MC*

f*

MSB

0 ef e’ e* Pollution reduction
5-14
Too little pollution reduction Too much pollution reduction
Emissions Fee v Cap-and-Trade
 Responsiveness to Inflation
 Responsiveness to Cost Changes
 Responsiveness to Uncertainty

5-15
Distributional Effects
 Emissions fee
 Cap-and-Trade

5-16
Command-and-Control Regulation
 Incentive-based regulations
 Command-and-control regulations
 technology standard
 performance standard
 Is command-and-control ever better?
 hot spots

5-17
The U.S. Response
 Clean Air Act
 1970 amendments
 Command-and-control in the 70s
 How well did it work?

5-18
Progress with Incentive-based Approaches
 Policy Perspective: Cap-and-Trade for Sulfur
Dioxide
 Policy Perspective: Cap-and-Trade to Protect
Fisheries and Wildlife
 individual transferable quotas

5-19
Implications for Income Distribution
 Who Benefits?
 Who Bears the Cost?

5-20
Positive Externalities
$

MC

MSB = MPB + MEB

MPB
MEB
R1 R* Research
per year 5-21
A Cautionary Note
 Requests for subsidies
 Resource extracted from taxpayers
 Market does not always fail
 Policy Perspective: Owner-Occupied Housing

5-22