INTRODUCTION

• In economics, an externality is the cost or benefit that affects a third party who
did not choose to incur that cost or benefit.
• If a laundry is located next to a steel mill, the act of making steel increases costs
for the laundry because of all the dirt and smoke generated in making steel.
• There can be positive externalities as well. In the classical example of
externalities, the owner of an apple orchard provides a positive externality for a
neighboring apiary (in terms of the quantity and sweetness of honey). And the
apiary provides a positive externality to the orchard in terms of the bees
pollinating the apple blossoms.
DIFFERENT TYPES OF EXTERNALITIES
a)NEGATIVE PRODUCTION EXTERNALITY: When a firm’s production reduces the well-being of
others who are not compensated by the firm.
A steel mill dumps its pollutants into a nearby river. Thereby, the fish population declines and a
fisher further down the river experiences a decline in production. Nevertheless, since the fisher is no
monopolist, the market price for fish remains the same.
• Private marginal cost (PMC): The direct cost to producers of producing an additional unit of a
good
• Marginal Damage (MD): Any additional costs associated with the production of the good that are
imposed on others but that producers do not pay.
• Social marginal cost (SMC = PMC + MD): The private marginal cost to producers plus marginal
damage.
b) Negative consumption externality: When an individual’s consumption reduces the well-being
of others who are not compensated by the individual.
Tenant A and tenant B live in the same building. Tenant A listens extensively to very loud music,
which is not enjoyed by tenant B, i.e., tenant B cannot consume silence. The rent, however,
remains unchanged.
Private marginal benefit (PMB): The direct benefit to consumers of consuming an additional unit of
a good by the consumer.
Social marginal benefit (SMB): The private marginal benefit to consumers plus any costs associated
with the consumption of the good that are imposed on others.
c) Positive production externality: When a firm’s production increases the well-being of others but
the firm is not compensated by those others.
Beehives of honey producers have a positive impact on pollination and agricultural output.
d) Positive consumption externality: When an individual’s consumption increases the well-being of
others but the individual is not compensated by those others.
Example: Beautiful private garden that passers-by enjoy seeing
MARKET OUTCOME IS INEFFICIENT
• With a free market, quantity and price are such that PMB = PMC
• Social optimum is such that SMB = SMC
• Private market leads to an inefficient outcome (1st welfare theorem does not
work)
• Negative production externalities lead to over production
• Positive production externalities lead to under production
• Negative consumption externalities lead to over consumption
• Positive consumption externalities lead to under consumption
EXTERNALITY THEORY: GRAPHICAL ANALYSIS
• One aspect of the graphical analysis of externalities is knowing which curve to shift, and
in which direction. There are four possibilities:

• Negative production externality: SMC curve lies above PMC curve

• Positive production externality: SMC curve lies below PMC curve
• Negative consumption externality: SMB curve lies below PMB curve
• Positive consumption externality: SMB curve lies above PMB curve

The key is to assess which category a particular example fits into. First, you must assess
whether the externality is associated with producing a good or with consuming a good.
Then, you must assess whether the externality is positive or negative.
PRODUCTION POSSIBILITIES WITH AN
EXTERNALITY
• In the figure the production possibilities for steel and laundry are
shown, showing the maximum of the two that can be produced.
• With no externality (line3), both can produce maximum amount and

Laundry production
the two firms are essentially independent.
• With a modest externality (line 2) increased steel production will
diminish laundry output.
• If the externality is strong enough (line 3) the reduction in laundry
output will be even larger.

Steel production

A production externality exists when one firm’s profits

The steel mill produces steel (S) and smoke emissions (e) using
inputs
are affected by another’s. Suppose output of
laundry( L) is given by
And are different inputs into laundry
production and e is smoke emission from steel
manufacturing.
Note that e is chosen by steel mill but enters into the
production function of the laundry.
INDIFFERENCE CURVES WITH CONSUMPTION EXTERNALITY
• A consumption externality is very analogous. The difference is that
we deal with utility functions. Consider the utility function U(x,e),
where x is just a basket of goods chosen for consumption and e is
levels of pollution, which enters the utility function through no
choice of consumer.
• This is illustrated in the figure. To the left of P, swimming and
pollution are inversely related. More pollution means the
swimming experience is degraded. Thus additional quantities of
other goods are needed to keep utility constant. After point P, the
swimming is just no fun anymore, the river has become so polluted
that swimming ceases. After this point increased pollution has no
effect on utility.
PARETO RELEVANCE OF
EXTERNALITY
• The figure illustrates the case of steel mill and the laundry mill
with a modest externality in the form of smoke from the steel
mill.
• Figure shows the possible output combinations of laundry and
steel given a fixed amount of inputs. The maximum amount of
steel that can be produced with these resources is S0.
• If steel mil, produces S0, the laundry mill will produce as much
as it can at L0.
• Now eliminate externality by merging the laundry and steel into
one firm. Steel production will adjust, taking into account the
negative effects of the smoke, finding a point at which the
value of both S and L is maximum( S1, L1)
• Thus the externality is corrected at (S1,L1).
PRIVATE-SECTOR SOLUTIONS TO NEGATIVE
EXTERNALITIES
• Key question raised by Ronald Coase (famous Nobel Prize winner Chicago libertarian economist):
Are externalities really outside the market mechanism?
• Internalizing the externality: When either private negotiations or government action lead the price to the
party to fully reflect the external costs or benefits of that party’s actions.

PRIVATE-SECTOR SOLUTIONS TO NEGATIVE EXTERNALITIES:

COASE THEOREM
• Coase Theorem (Part I): When there are well-defined property rights and costless bargaining, then
negotiations between the party creating the externality and the party affected by the externality can bring
about the socially optimal market quantity.

• Coase Theorem (Part II): The efficient quantity for a good producing an externality does not depend on
which party is assigned the property rights, as long as someone is assigned those rights.
EXAMPLE 1:
A cattle-farmer and a crop-farmer share a piece of soil for their respective production. However, the
economic activity of the cattle-farmer limits the possibilities of production for the crop-farmer
(since the cattle tramples down the crop), without this restriction being mirrored in market prices.

There are two ways to internalize the damage:

1) polluter-pays principle: The property rights are allocated to the crop-farmer; the cattle-farmer
compensates the crop-farmer for his loss in income. If the cattle-farmer anticipates his liability, he
will possibly take precautions (such as building a fence) to prevent any damages to the crop-farmer.
In that case the costs of those precautionary measures would internalize the externality.

2) affected-party-pays principle:
The property rights are allocated to the cattle-farmer; the crop-farmer has to build a fence or
compensate the cattle-farmer for holding less cattle. In this scenario the internalization of
externalities prevents any effective damage, too.
• EXAMPLE 2:
Firms pollute a river enjoyed by individuals. If firms ignore individuals, there is too much pollution

1) Individuals own river: If river is owned by individuals then individuals can charge firms for polluting
the river. They will charge firms the marginal damage (MD) per unit of pollution.

Why price pollution at MD? If price is above MD, individuals would want to sell an extra unit of
pollution, so price must fall. MD is the equilibrium efficient price in the newly created pollution market.

2) Firms own river: If river is owned by firms then firm can charge individuals for polluting less. They will
also charge individuals the MD per unit of pollution reduction.

Final level of pollution will be the same in 1) and 2)

PROBLEMS WITH COASIAN SOLUTION: BOTTOM LINE
• Ronald Coase’s insight that externalities can sometimes be internalized was useful.
• It provides the competitive market model with a defense against the onslaught of market failures.
• It is also an excellent reason to suspect that the market may be able to internalize some small-
scale, localized externalities.
• It won’t help with large-scale, global externalities, where only a “government” can successfully
aggregate the interests of all individuals suffering from externality. In cases where externalities affect
many agents (e.g. global warming), assigning property rights is difficult( also it would be difficult to
negotiate when there are larger number of individuals). Coasian solutions are likely to be more effective for
small, localized externalities than for larger, more global externalities involving large number of people and
firms.
PUBLIC SECTOR REMEDIES FOR
EXTERNALITIES

Public policy makers employ two types of remedies to resolve the problems
associated with negative externalities:
1) price policy: corrective tax or subsidy equal to marginal damage per unit

2) quantity regulation: government forces firms to produce the socially

efficient quantity
The concept of the Pigou tax was introduced by Arthur Cecil Pigou in his book “Economics of Welfare” (1920)
and states that, in the case of complete information concerning the marginal benefits and – damages of firms
and society, respectively, the socially optimal production of Q can be reached by imposing a tax on Q with a
tax rate t which equals the difference between MC Society and MC Firm for any amount of Q produced. Thus:
P2 = MC Firm(Q2) + tax rate t(Q2) = MC Society (Q1)
PUBLIC SECTOR REMEDIES FOR
EXTERNALITIES: REGULATION
• In an ideal world, Pigouvian taxation and quantity regulation would be
identical.
• Quantity regulation seems more straightforward, hence, it has been the
traditional choice for addressing environmental externalities.
• In practice, there are complications that may make taxes a more effective
means of addressing externalities.
• The only way to reduce an externality, e.g., pollution, is not to cut down on
production. Think of a “pollution reduction” technology (many examples).