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EXTERNALITIES

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Learning Outcomes:

• 1. Identify and define the different types of

externality.
• 2. Illustrate and explain how externalities
make market outcomes inefficient.
• 3. Discuss the effectiveness of public
policies and private solutions used to
solve the problem of externalities.

2
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When the market works as it should…

• Recall: Adam Smith’s “invisible hand” of the

marketplace leads self-interested buyers and
sellers in a market to maximize the total
benefit that society can derive from a market.

But market failures can still happen.

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EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality refers to the uncompensated
impact of one person’s actions on the well-
being of a bystander.
• Externalities cause markets to be inefficient,
and thus fail to maximize total surplus.

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NEGATIVE AND POSITIVE
EXTERNALITIES
• When the impact on the bystander is adverse,
the externality is called a negative
externality.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.

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Negative Externalities

– Automobile exhaust
– Cigarette smoking
– Barking dogs (loud
pets)
– Loud stereos in an
apartment building

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Positive Externalities

– Immunizations
– Restored historic buildings
– Research into new technologies

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Production Externalities
• Positive Production Externalities
• Negative Production Externalities

• Negative production externalities lead markets

to produce a larger quantity than is socially
desirable. Or
• overproduction of what is socially undesirable.

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Production Externalities

• Positive production externalities lead markets

to produce a smaller quantity than is socially
desirable. or
• underproduction of what is socially desirable.

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Consumption Externalities
• Positive Consumption Externalities
• Negative Consumption Externalities
Negative consumption externalities lead
markets to consume a larger quantity than is
socially desirable. Or
Overconsumption of what is socially
undesirable.

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Consumption Externalities

• Positive consumption externalities lead

markets to consume a smaller quantity than is
socially desirable. Or
• Underconsumption of what is socially
desirable.

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EXTRA NOTES
• See extra notes.

• Exam will be based on these notes

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Example of Negative Production
Externality
• The Market for Aluminum
• The quantity produced and consumed in the market
equilibrium is efficient in the sense that it
maximizes the sum of producer and consumer
surplus.

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Figure 1 The Market for Aluminum

Price of
Aluminum Supply
(private cost)

Equilibrium

Demand
(private value)

0 QMARKET Quantity of
Aluminum

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Example of Negative Production
Externality
• If the aluminum factories emit pollution (a
negative externality), then the cost to society of
producing aluminum is larger than the cost to
aluminum producers. Social cost> private cost

• For each unit of aluminum produced, the social

cost includes the private costs of the producers
plus the cost to those bystanders adversely
affected by the pollution.

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 Figure 2 Pollution and the Social Optimum
Social cost
Price of
Aluminum
Cost of
Pollution
Supply
(private cost)

Optimum

Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
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Negative Production Externalities

• The intersection of the demand curve and the

social-cost curve determines the optimal output
level.
• The socially optimal output level is less than the
market equilibrium quantity.

• See definition of negative production externality

• And extra notes.

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Internalizing an externality

• Internalizing an externality involves altering

incentives so that people take account of the
external effects of their actions.
• Involves both positive and negative
externalities.

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Internalizing a negative production
externality
• Example
• To achieve the socially optimal output…
• the government can internalize an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable
quantity.

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Positive Externalities

• When an externality benefits the bystanders, a

positive externality exists.
• The social value of the good exceeds the private
value.
• Eg A technology spillover is a type of positive
externality that exists when a firm’s innovation
or design not only benefits the firm, but enters
society’s pool of technological knowledge and
benefits society as a whole.

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 Example of Positive Consumption Externality- Education
and the Social Optimum
Price of
Education
External Supply
benefit (private cost)

Optimum
Equilibrium
Social value

Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education

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Positive Externalities

• The intersection of the supply curve and the

social-value curve determines the optimal
output level.
• The optimal output level is more than the
equilibrium quantity.
• The market produces a smaller quantity than is
socially desirable.
• The social value of the good exceeds the private
value of the good.

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Positive Externalities

• Internalizing Externalities:
• Subsidies
• Used as the primary method for attempting to internalize
positive externalities.

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Positive Externalities

• Industrial Policy
• Government intervention in the economy that aims to
promote technology-enhancing industries
• Patent laws are a form of technology policy that give
the individual (or firm) with patent protection a
property right over its invention.
• The patent is then said to internalize the externality.

• Tax breaks

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PRIVATE SOLUTIONS TO
EXTERNALITIES
• Government action is not always needed to
solve the problem of externalities.
• Types of Private Solutions
– Moral codes and social sanctions
– Charitable organizations
– Integrating different types of businesses
– Contracting between parties

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The Coase Theorem

• The Coase theorem is a proposition that if

private parties can bargain without cost over the
allocation of resources, they can solve the
problem of externalities on their own.

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Why Private Solutions Do Not Always
Work
1 Transaction costs
• Transaction costs are the costs that parties incur in
the process of agreeing to and following through on
a bargain.

• Sometimes the private solution approach fails

because transaction costs can be so high that private
agreement is not possible.

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Why Private Solutions Do Not Always
Work
2 Bargaining simply breaks down
• Everyone holding out for a better deal for themselves

3 Large number of interested parties

• Coordinating everyone is costly

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PUBLIC POLICIES TOWARD
EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through . . .
– command-and-control policies.
– market-based policies.

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 Public Policies Toward Externalities

• Command-and-control policies
– Regulate behavior directly
– Regulation
• Market-based policies
– Provide incentives so that private decision makers
will choose to solve the problem on their own
– Corrective taxes and subsidies
– Tradable pollution permits

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Command-and-Control Policies:
Regulation

• Usually take the form of regulations:

• Forbid certain behaviors.
• Require certain behaviors.
• Examples:
• Requirements that all students be immunized.
• Department of Environment, Malaysia
Main role
Prevent, control and abate pollution through the enforcement of the
Environmental Quality Act (ECA), 1974 and its 34 subsidiary legislation

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Market-Based Policy 1: Corrective Taxes
and Subsidies

• Government uses taxes and subsidies to align

private incentives with social efficiency.

• What is a Corrective Tax?

• Corrective/ Pigovian taxes are taxes enacted to
correct the effects of a negative externality.

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 Public Policies Toward
Externalities
• Corrective taxes and subsidies
• Corrective tax
• Induce private decision makers to take account of the
social costs that arise from a negative externality
• Places a price on the right to pollute
• Reduce pollution at a lower cost to society
• Raise revenue for the government
• Enhance economic efficiency

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certain product or service or otherwise on a password-protected website for classroom use. © 2008 Cengage Learning
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Corrective tax

• How it works in solving pollution?

• Firms that can correct pollution with low costs

will do so and thus pay less tax.

• Firms that can only correct pollution with high

costs will not do so and thus pay more tax.

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Market-Based Policy 1: Pigovian Taxes
and Subsidies
• Examples of Regulation versus Pigovian Tax
• If the EPA decides it wants to reduce the amount of
pollution coming from a specific plant. The EPA
could…
• tell the firm to reduce its pollution by a specific amount
(i.e. regulation).
• levy a tax of a given amount for each unit of pollution the
firm emits (i.e. Pigovian tax).

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Market-Based Policy 2: Tradable Pollution
Permits

What is a Tradable pollution permit ?

• Tradable pollution permits allow the voluntary

transfer of the right to pollute from one firm to
another.

• Firms buy these permits from the government .

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Market-Based Policy 2: Tradable Pollution
Permits
• How it works?
• A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.

• A firm that can reduce pollution only at a high cost

may prefer to buy its permit to a firm that can
reduce pollution at a low cost.

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 Market-Based Policy 2: Tradable
Pollution Permits
• Tradable pollution permits
• Advantage of free market for pollution permits
• Initial allocation of pollution permits doesn't matter

• Efficient final allocation

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certain product or service or otherwise on a password-protected website for classroom use. © 2008 Cengage Learning
38
 Market-Based Policies:

• Reducing pollution using pollution permits or

corrective taxes

• Firms pay for their pollution

• Corrective taxes – pay to the government
• Pollution permits – pay to buy permits

• Internalize the externality of pollution

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39
COMPARE REGULATIONS AND MARKET
BASED
• If the EPA decides it wants to reduce the amount of
pollution coming from a specific plant. The EPA
could…
• tell the firm to reduce its pollution by a specific amount
(i.e. regulation).
• levy a tax of a given amount for each unit of pollution the
firm emits (i.e. Pigovian tax).

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COMPARE REGULATIONS AND MARKET
BASED
• 1. REGULATIONS
• RIGID - MUST FOLOW

• MARKET BASED
• FLEXIBLE- CHOICE DEPENDING
ON COSTS

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COMPARE REGULATIONS AND MARKET
BASED
2. REGULATIONS
INEFFICIENT
• MUST FOLLOW

• MARKET BASED
• EFFICIENT
• CHOOSE METHOD BASED ON COSTS

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COMPARE REGULATIONS AND MARKET
BASED
3. REGULATIONS
NO INCENTIVE TO DO MORE

MARKET BASED
• INCENTIVE
• PAY LESS TAXES
• SELL PERMITS

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