10/22/2017

N. GREGORY MANKIW
Look for the answers to these questions:
PRINCIPLES OF
• What is an externality?
ECONOMICS • Why do externalities make market outcomes
Eight Edition
inefficient?
• What public policies aim to solve the
CHAPTER problem of externalities?
Externalities • How can people sometimes solve the
10 Why
problem of externalities on their own?
do such private solutions not
Premium PowerPoint Slides by: always work?
V. Andreea CHIRITESCU
Modified by Joseph Tao-yi Wang Eastern Illinois University
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Externalities Externalities
• ‘Markets are usually a good way to • Negative externality
organize economy activity’ – Impact on the bystander is adverse
– In absence of market failures, the • Positive externality
competitive market outcome is – Impact on the bystander is beneficial
efficient, maximizes total surplus
• Self-interested buyers and sellers
• Externality: one type of market failure
– Neglect the external costs or benefits of
– The uncompensated impact of one
their actions
person’s actions on the well-
– So the market outcome is not efficient
being of a bystander
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Externalities ASK THE EXPERTS

Vaccines
• ‘Government action can sometimes
“Declining to be vaccinated against contagious
improve upon market outcomes’ diseases such as measles imposes costs on
– Why markets sometimes fail to allocate other people, which is a negative externality.”
resources efficiently
– How government policies can potentially
improve the market’s allocation
– What kinds of policies are likely to work
best

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use © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
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Recap of Welfare Economics

Negative Externalities
P The market for gasoline The market equilibrium
• Examples of negative externalities $50 maximizes consumer
• Air pollution from a factory + producer surplus.
• The neighbor’s barking dog 40
Supply curve shows
• Late-night stereo blasting from the dorm room
private cost, the costs
next to yours 30
$25 directly incurred by
• Noise pollution from construction projects
sellers.
• Health risk to others from second-hand 20
Demand curve shows
smoke 10 private value, the value
• Talking on cell phone while driving makes the to buyers (the prices they
are willing to pay).
roads less safe for others 0
0 10 20 25 30 Q
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(liters)
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Analysis of a Negative Externality Analysis of a Negative Externality

P The market for gasoline P The market for gasoline

The socially
$ $50
Social cost Social optimal quantity
5 = private + external cost cost is 20 liters.
0 external 40
cost Supply (private cost) S At any Q < 20,
4 30 value of additional gas
External cost
0 exceeds social cost.
= value of the
negative impact 20 At any Q > 20,
3
on bystanders D social cost of the
0
= $10 per liter 10 last liter is
(value of harm greater than its value
2
from smog, 0 value
to to society.
society.
00 10 20 30 Q 0 10 20 25 30 Q
greenhouse gases)
(liters) (liters)
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as for
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classroom license distributed with a certain product or service or otherwise on a password-protected website or school-
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0

Analysis of a Negative Externality

Externalities
P The market for gasoline Market equilibrium
$ (Q = 25) • Internalizing the externality:
Social is greater than
5
cost – Altering incentives so that people take into
0 social
S optimum (Q =
account the external effects of their
20). actions
304
0 – In our example, the $10/liter tax on sellers
20 One solution: makes sellers’ costs = social costs.
tax sellers $10/liter,
D • If market participants pay social costs
10 would shift S curve
up $10. – Market equilibrium = social optimum
0
0 10 20 25 30 Q
(liters)
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Positive Externalities Positive Externalities

• Examples of positive externalities • With a positive externality
• Being vaccinated against contagious – The social value of a good includes
diseases protects not only you, but people • Private value – the direct value to buyers
who visit the salad bar or produce section • External benefit – the value of the positive
after you
impact on bystanders
• Research and development creates
knowledge others can use • The socially optimal Q maximizes
• People going to college raise the population’s welfare:
education level, which reduces crime and • At any lower Q, the social value of
improves government additional units exceeds their cost.
• At any higher Q, the cost of the last unit
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exceeds its social value.
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Active Learning 1 Analysis of a positive externality

Active Learning 1 Answers
P The market for flu shots P The market for flu shots
$500
• External benefit Socially optimal Q
$500 = 25 shots.
= $100/shot external
400 – Draw the social 400 benefit To internalize the
value curve. externality, use
S
300 – Find the socially S subsidy = $100/shot.
300
optimal Q.
200 Social value
– What policy would 200 = private value
internalize this + $100 external benefit
100
D externality? 100
D
0 Q
0 10 20 30 0 Q
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ASK THE EXPERTS

Effects of Externalities: Summary
Vaccines
• If negative externality “Considering the costs of restricting free choice, and
– Market quantity larger than socially desirable the share of people in the US who choose not to
vaccinate their children for measles, the social
• If positive externality
benefit of mandating measles vaccines for all
– Market quantity smaller than socially Americans (except those with compelling medical
desirable reasons) would exceed the social cost.”
• To remedy the problem, “internalize the
externality”
– Tax goods with negative externalities
– Subsidize goods with positive
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Public Policies Toward Externalities Public Policies Toward Externalities

• Command-and-control policies • Corrective taxes and subsidies
– Regulate behavior directly – Corrective taxes (Pigovian taxes)
• Limits on quantity of pollution emitted – Induce private decision makers to take
• Requirements that firms adopt a particular account of the social costs that arise
technology to reduce emissions from a negative externality
• Market-based policies – Places a price on the right to pollute
– Incentives so that private decision makers – Reduce pollution at a lower cost to society
will choose to solve the problem on their own
– Raise revenue for the government
• Corrective taxes and subsidies
• Tradable pollution permits
– Enhance economic efficiency
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Corrective Taxes vs. Regulations Corrective Taxes vs. Regulations

• Different firms • A pollution tax is efficient:
– Have different costs of pollution – Firms with low abatement costs will
abatement reduce pollution to reduce their
• Efficient outcome tax burden.
– Firms with the lowest abatement costs – Firms with high abatement costs have
reduce pollution the most greater willingness to pay tax.
• Regulation requiring all firms to reduce
pollution by a specific amount
– Is not efficient
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Example of a Corrective Tax: The Gas Tax

Corrective Taxes vs. Regulations
The gas tax targets three
• Corrective taxes are better for the negative externalities:
environment: – Congestion
– The corrective tax gives firms incentive to The more you drive, the more you contribute to
continue reducing pollution as long congestion.
as the cost of doing so is less – Accidents
than the tax Larger vehicles cause more damage in an
• If a cleaner technology becomes available, accident.
the tax gives firms an incentive to adopt it – Pollution
– In contrast, firms have no incentive for Burning fossil fuels produces greenhouse
further reduction beyond the gases.
level specified in a regulation © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
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ASK THE EXPERTS ASK THE EXPERTS

Carbon Taxes Carbon Taxes
“The Brookings Institution recently described a U.S. carbon tax of “A tax on the carbon content of fuels would be a
$20 per ton, increasing at 4 percent per year, which would raise less expensive way to reduce carbon-dioxide
an estimated $150 billion per year in federal revenues over the
emissions than would a collection of policies such
next decade. Given the negative externalities created by carbon
dioxide emissions, a federal carbon tax at this rate would involve as ‘corporate average fuel economy’ requirements
fewer harmful net distortions to the U.S. economy than a tax for automobiles.”
increase that generated the same revenue by raising marginal tax
rates on labor income across the board.”

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Active Learning 2 Reducing pollution Active Learning 2 A. Regulation

Acme and US Electric run coal-burning power • Policy option 1: Regulation
plants. Each emits 40 tons of sulfur dioxide Every firm must cut its emissions 25% (10
per month, total emissions = 80 tons/month. tons).
• Goal: Reduce SO2 emissions 25%, to 60 • Your task: Compute the cost to each firm
tons/month and total cost of achieving goal using
• Cost of reducing emissions: this policy.
– $1,000/ton for Acme
– $2,000/ton for US Electric

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Active Learning 2 A. Answers Active Learning 2 B. Tradeable pollution

permits
Each firm must reduce emissions by 10 tons.
• Policy option 2: Tradable pollution permits
Cost of reducing emissions: $1,000/ton for
– Issue 60 permits, each allows one ton SO2
Acme, $2,000/ton for US Electric.
emissions.
• Compute cost of achieving goal with this – Give 30 permits to each firm.
policy: – Establish market for trading permits.
– Cost to Acme: (10 tons) x ($1,000/ton) = – Each firm may use all its permits to emit 30 tons,
$10,000 may emit < 30 tons and sell leftover permits,
– Cost to USE: (10 tons) x ($200/ton) = or may purchase extra permits to emit > 30 tons.
$20,000 • Your task: Compute cost of achieving goal if
– Total cost of achieving goal = $30,000
Acme uses 20 permits and sells 10 to
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USE for $1,500 each.
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Active Learning 2 B. Answers Active Learning 2 B.

Goal: reduce emissions from 80 to 60 tons Answers
Cost of reducing emissions: $1,000/ton • Compute cost of achieving goal for USE:
for Acme, $2,000/ton for USE. – Buys 10 permits from Acme, spends $15,000
• Compute cost of achieving goal for – Uses these 10 plus original 30 permits, emits
Acme: 40 tons
– Spends nothing on abatement
– Sells 10 permits to USE for $1,500 each,
gets – Net cost to USE = $15,000
$15,000 Total cost of achieving goal
– Uses 20 permits, emits 20 tons SO2 =$5,000+$15,000=$20,000
– Spends $20,000 to reduce emissions by 20 • Using tradable permits, goal is achieved at
tons lower total cost and lower cost to each
as permitted in – Net cost to Acme: $20,000 − $15,000 =
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a certain product or service or otherwise on a password-protected website or school-approved learning 31 firm than using regulation.
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Public Policies Toward Externalities Public Policies Toward Externalities

• Tradable pollution permits system • Reducing pollution using pollution permits
– Reduces pollution at lower cost than or corrective taxes
regulation – Firms pay for their pollution
• Firms with low cost of reducing pollution • Corrective taxes: pay to the government
do so and sell their unused permits • Pollution permits: pay to buy permits
• Firms with high cost of reducing pollution
– Internalize the externality of pollution
buy permits
– Result: Pollution reduction is concentrated
among those firms with lowest costs

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Public Policies Toward Externalities Public Policies Toward Externalities

• Objections to the economic analysis of • Clean environment is a normal good
pollution – Positive income elasticity
– “We cannot give anyone the option of • Rich countries can afford a cleaner
polluting for a fee.” - by late environment
Senator Edmund Muskie • More rigorous environmental
• People face trade-offs protection
– Clean air and clean water - law of
– Eliminating all pollution is impossible
demand
– Clean water and clean air – opportunity • The lower the price of environmental
cost: lower standard of living protection
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Private Solutions to Externalities Private Solutions to Externalities

• The types of private solutions • The Coase theorem
– Moral codes and social sanctions – If private parties can bargain without cost
– Charities over the allocation of resources
– Self-interest of the relevant parties • They can solve the problem of externalities
on their own
• Integrating different types of businesses
• Whatever the initial distribution of rights
– Interested parties can enter into a contract
– Interested parties can reach a bargain:
• Everyone is better off
• Outcome is efficient

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Private Solutions to Externalities Private Solutions to Externalities

1.Dick has the legal right to 2.Dick has the legal right to
keep a barking dog (Spot). keep a barking dog (Spot).
– Dick gets a $5,000 benefit from the dog – Dick gets a $10,000 benefit from the dog
– Jane bears an $8,000 cost from the – Jane bears an $8,000 cost from the
barking barking
– Efficient outcome: – Efficient outcome:
• Jane can offer Dick $6,000 to get rid of the • Dick turns down any offer below $10,000
dog • Jane will not offer any amount above $8,000
• Dick will gladly accept • Dick keeps the dog
• Bye-bye Spot!
• Both are better off
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Private Solutions to Externalities Active Learning 3 Applying Coase

3.Jane can legally compel Dick to get rid Collectively, the 1000 residents of Chou Tribe
of the dog (Spot) value swimming in Sunny Moon Lake at
$1,000,000.
– Dick gets a $8,000 benefit from the dog
A nearby factory pollutes the lake water, and
– Jane bears an $5,000 cost from the barking
would have to pay $500,000 for non-polluting
– Efficient outcome equipment.
• Dick keeps Spot
A. Describe a Coase-like private solution.
• Private outcome: Dick pays Jane $6,000 to put
B. Can you think of any reasons why this
up with Spot’s barking
solution might not work in the real
The private market achieves the efficient outcome
world?
regardless of the initial distribution of rights
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Private Solutions to Externalities Summary

Why private solutions do not always work • When a transaction between a buyer and seller
– High transaction costs directly affects a third party, the effect is
• Costs that parties incur in the process of
called an externality.
– If an activity yields negative externalities, such
agreeing to and following through on a
bargain as pollution, the socially optimal quantity in a
market is less than the equilibrium quantity.
– Stubbornness: ( 最牛釘子戶 )
– If an activity yields positive externalities, such as
• bargaining simply breaks down
technology spillovers, the socially optimal
– Coordination problems quantity is greater than the equilibrium quantity.
• Large number of interested parties
• Coordinating everyone is costly
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Summary Summary
• Governments pursue various policies to remedy • According to the Coase theorem, if people can
the inefficiencies caused by externalities. bargain without cost, then they can always
– Regulating behavior reach an agreement in which resources are
– Internalizes an externality using corrective taxes allocated efficiently.
– Issue permits (similar results to imposing – In many cases, however, reaching a bargain
corrective taxes on polluters) among the many interested parties is difficult, so
the Coase theorem does not apply.

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Chapter 10: Externalities Chapter 10: Externalities

 Market Failure? Or, Lack of Market Failure!  Homework:
 Caused by lack of property rights!  Mankiw, Ch.10, Problem 1, 4, 5, 8, 9
 Challenge Questions (Past Midterms)
 Social Cost/Benefit≠Private Cost/Benefit  2007 - Essay Q6b
 2008 - Essay C5-9 (Multi-Choice Q12, Q13)
 Market-based Public Policy:  2009 - Essay C1-4 (Multi-Choice Q13)
 Corrective Taxes  2010 - Essay A (True/False Q10)
 Tradable Pollution Permits
 2014 - Essay B
 2015 - Essay A4-5, B3
 Private Solutions: Coase Theorem  2016 - Essay D

2017/10/22 Externalities Joseph Tao-yi Wang 2017/10/22 Externalities Joseph Tao-yi Wang