Externalities

When Markets(Invisible hand) fail

Markets fail on two occasions:

- When there are Externalities

- When there are Public Goods

What are externalities?

 When the actions of one consumer or producer affect

other consumers’ or producers’- third party- costs or
benefits in a way not reflected by market prices.

 Examples?
Examples

 Road Congestion: a cost…but you don’t pay ( unless

you have a time-based toll)

 Disease transmission: I don’t consider the benefits that

I am rendering to other children in the school when I
am inoculating my children. This positive externality is
not taken into consideration……and so is not reflected
in the price.
 Pollution: I don’t pay for polluting air…The cost only
includes fuel, wear and tear….but not the cost of
pollution.
Can we internalize the externality?

Coase Theory: complete property rights

Read up to page 4( including page 4 )of the
reading.
Other Methods:
- An emission Fee
- Standards
- Cap and Trade- reading
Cap and Trade system

Caps on how much of greenhouse gas can be

emitted from various Sources. For instance,
cap on power generating equipment, factories
, etc.
-The firm can emit subject to the cap over a
specific period of time.
-Firms are allowed to trade these prmits in the
market.
Cap and Trade system

 If a firm can emit less than the cap, it can

sell its allowance….to a firm for whom
pollution control would be more expensive.
 reductions in emissions of a given amount are
achieved as cheaply as possible.
Other approaches to internalize

 Little and Mirrlees approach and UNIDO:

considering Social Costs and Social benefits-
SCBA- in deciding whether a project is
feasible or not.
 New Economics Foundation (NEF) is an
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