Chapter 10: Externalities

 Markets do many things well but they do not do everything well.

 Government actions can sometimes improve market outcomes.

 One category of market failure are externalities.

 Externality: The uncompensated impact of one person’s actions on the

well-being of a bystander.
o Negative externality: An adverse impact on a bystander.

o Positive externality: A positive impact on a bystander.

 Society’s interest in market outcomes go beyond just the buyer and

seller. Society must consider the positive and negative effects of market
transactions on society as a whole as well.

 Buyers and sellers neglect the external effects of their actions.

 Market equilibrium does not maximize the well-being of society at large.

Market equilibrium only maximizes the outcome narrowly for the buyer and
seller.

 Examples of externalities:
o Pollution from automobiles (negative externality). Consumers
generally ignore this externality when purchasing a vehicle. The
government addresses this problem by setting emissions standards and
taxing the consumption of gasoline.

o Restored historic buildings (positive externality). Neighbors,

tourists and urban dwellers get to enjoy the beauty and sense of history
of these buildings. Building owners do not get the full benefit of
restoration (and often prefer to tear buildings down). Local governments
regulate the destruction of historic buildings and can provide tax breaks
(incentives) for landlords who maintain these buildings.

o Barking dogs (negative externality). Dog owners do not bear the

full cost of the noise that disturb and upsets their neighbors. Local
governments can implement local noise ordinances to minimize this
phenomenon.
 o Research on new technologies (positive externality). Universities
and individuals will not pour energy into novel research without sufficient
incentives. The government addresses this problem, in part, through the
patent system which affords exclusive use of new innovations for a
period of time.

10-1 Externalities and Market Inefficiency

 Externalities can impact economic well-being.

 Negative externality example: An aluminum factory:

o Background:
 Aluminum factories emit pollution (a negative externality).

 For each unit of aluminum produced, a certain amount of

smoke enters the atmosphere.

 The smoke poses a health risk for innocent bystanders who

breath the air.

o How does a negative externality affect the efficiency of the market

outcome?
 The cost to society producing aluminum is larger than the
cost to the aluminum producers.

 The social cost includes the private costs of the aluminum

producers plus the costs of the bystanders impacted by the pollution.

 The social-cost curve is above the supply curve (because it

adds the external costs of aluminum production).

o Chart illustrating social cost curve and impact on market

outcomes:
(Image from Wikipedia.org)

 The socially optimal equilibrium (intersection of social-cost curve and

demand curve) is different from the actual equilibrium (where externalities
are not considered).

 One solution: policymakers can tax aluminum producers for each ton of
aluminum sold.
o The tax shifts the supply curve upward by the size of the tax.

o Tax should reflect the external cost of pollutants released into the
atmosphere (in order to match the social-cost curve).

o New market equilibrium would result in socially optimal quantity of

aluminum.

o Internalizing the externality: Altering incentives so that people

account for the external effects of their actions.
 Positive externality example: Education
o Background:
 Some activities yield benefits to 3rd parties.
 Education results in numerous positive externalities:
 More informed voters which leads to better
government.

 More educated populations yields lower crime rates.

 More educated population results in improved

technology adoption and higher worker productivity and wages.

 A person should prefer neighbors who are well educated.

o How does a positive externality affect the efficiency of the market
outcome?
 A standard demand curve does not reflect the value to
society for a good.

 Social value is greater than private value so the social-value

curve lies above the demand curve.

 The optimal quantity is found where the social-value curve

and the supply curve intersect.

 The socially optimal quantity is greater than the quantity that

the private market would achieve on its own (normal market
equilibrium).

 Chart illustrating social value (social demand) curve and impact on

market outcomes:
(Image from Wikipedia.org)

 Government can correct market failure by internalizing the externality:

o Positive externalities require subsidies.

o This will move the market equilibrium closer to the social

optimum.

 Summary of the impacts of positive and negative externalities:

o Negative externalities result in production of larger quantities than
desired by society.

o Positive externalities result in production of smaller quantities than

desired by society.

o Government guide policies to “internalize the externalities” to

adjust incentives to either increase production (subsidies) or reduce
production (taxes) to achieve the socially optimal quantity.
 Technology spillover is a type of positive externality where one firm’s
research and production of a technology benefits other firms. Patent
protections are one way to provide incentives for innovation while still
making long-term benefits available to competing firms.

10-2 Public Policies toward Externalities

 Governments can manage externalities in two ways:

1. Comand-and-control policies which regulate behavior directly.
 Regulations that require or forbid certain behaviors.

 Example: Making it a crime to dump hazardous chemicals

into the water supply.

2. Market-based policies which provide incentives so that firms can

determine the best way to solve a problem.
 Corrective tax: A tax designed to induce private decisions
makers to take into account the social costs that arise from a negative
externality.

 Tradable Permits (aka “Cap and Trade”): Example:

Voluntary transfer of the right to pollute from one firm to another. The
government, in effect, creates a scarce resource (“pollution permits”).
The result is creation of a market governed by supply and demand.
Permits end up in the hands of firms that value them most highly.

 Economists prefer market-based policies to command-and-control

policies. For instance, corrective taxes raise revenue for the government
but they also create incentives for market participants.

 Case study: Why is gasoline taxed so heavily?

 Gasoline is one of the most taxed goods in many countries.
 Gas tax is a corrective tax that addresses the externalities of driving:
o Congestion: Gas taxes manage congestion by creating an
incentive to take public transportation, carpool, eliminate unnecessary
tips and walk. Result is reduced traffic.

o Accidents: Larger vehicles make the driver safer but are less safe
for everyone else. The gas tax creates an incentive to purchase smaller,
more fuel efficient vehicles. Result is safer roads.
 o Pollution: Gas tax discourages driving and the resultant pollution it
causes. Result is a cleaner environment.

 A 2007 study suggested that the optimal corrective tax in the U.S. would
be $2.78/gallon in 2015 dollars. Actual gas tax was only $0.50/gallon in
actual dollars.
 Tax revenue from a gasoline tax could be used to lower income taxes
(which distort incentives and result in deadweight losses).
 Gasoline tax could also result in fewer government regulations.
 Unfortunately a higher gasoline tax is not politically popular.

 Objections to the economic analysis of pollution:

o Environmentalists are opposed to putting a price on pollution.

o Economists respond with the axiom that trade-offs are part of

decision-making and that a value must be assigned in order to make an
intelligent comparison.

o Economists view a clean environment as another good.

10-3 Private Solutions to Externalities

 In some cases, government intervention is not needed to address

externalities.

 Types of private solutions:

o Moral codes and social sanctions.

o Charitable organizations (example: the Sierra Club).

o The self-interest of the relevant parties.

 Coase theorem: The proposition that if private parties can bargain

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

 The Coase theorem only works when the relevant parties come to an
agreement and are able to enforce the agreement.

 Transaction costs: The costs that parties incur during the process of
agreeing to and following through on a bargain.
 Efficient bargaining becomes increasingly difficult when the number of
interested parties is large. This is because coordinating more people is
costly.

10-4 Conclusion

 “The invisible hand is powerful but not omnipotent.”

 Market equilibrium optimizes the sum of producer and consumer

surplus.

 The costs born by 3rd parties, as byproducts of market transactions,

need to be considered as well (externalities).

 The invisible hand is not always effective when it comes to allocating

resources efficiently to address externalities.

Chapter 11: Public Goods and Common Resources

 There are many goods that have no market price.

 These goods include things like nature (e.g. rivers, mountains, beaches,
lakes, etc.) or government amenities and events (playgrounds, parks,
parades).

 These goods face a different set of economic problems since the normal
market forces that provide efficient allocation are absent.

11-1 The Different Kinds of Goods

 Economic goods can be grouped according to the following

characteristics:
o Is the good excludable? Excludability: The property of a good
whereby a person can be prevented from using it.

o Is the good rival in consumption? Rivalry in consumption: The

property of a good whereby one person’s use diminishes other people’s
use.

 Using the above characteristics, it is possible to group goods into four

categories:
 o Private goods: Goods that are both excludable and rival in
consumption. Example: An ice cream cone. It is excludable because you
can prevent someone from eating one. It is rival in consumption because
if someone eat an ice-cream cone, another person cannot eat the same
cone.

o Public goods: Goods that are neither excludable nor rival in

consumption. Example: A tornado siren in a small town. It is not
excludable because it is impossible to prevent any single person from
hearing it when the siren sounds. It is not rival in consumption because
when one person benefits from the warning it does not reduce the benefit
to others.

o Common resources: Goods that are rival in consumption but not

excludable. Example: fish in the ocean. It is rival in consumption because
when one person catches a fish there are fewer fish for the next person
to catch. It is not excludable because it is difficult to stop fishermen from
catching fish from a large ocean.

o Club goods: Goods that are excludable but not rival in

consumption. Example: fire protection in a small town. It is excludable
because the fire department can decide not to save a building from a fire.
It is not rival in consumption because once paid for the additional cost of
protecting one more house is small.

 Matrix of economic goods with examples:

(Image from Wikipedia.org)

 The boundaries between goods is not always clear.

 The characteristics of being excludable and rival in consumption can be
a matter of degree.
o Example: fish in an ocean may not be excludable because of
practical challenges of managing ocean stocks. However, government
restrictions and a large coast guard can make fish partially excludable.

 Public goods and common resources are closely related to externalities:

both these goods and externalities are the result of something of value
having no associated price.
o Example: If an individual builds and operates a tornado siren in a
town, the neighbors will benefit from the siren without paying for it
(positive externality).

o Example: If an individual uses a common resource such as fish in

the ocean, others are worse off because there are fewer fish to catch
(negative externality).

 “Private decisions about consumption and production can lead to an

inefficient allocation of resources, and government intervention can
potentially raise economic well-being.”

11-2 Public Goods

 The Free-Rider Problem

o Example: A fireworks display. This good is not excludable (you
cannot prevent someone from seeing fireworks) and it is not rival in
consumption (because on person’s enjoyment does not reduce another’s
enjoyment).

o Free rider: A person who receives the benefit of a good but

avoids paying for it.

o The free-rider problem prevents the private market from supplying

public goods.

o Government is one solution to this problem. If the total benefit

exceeds costs, a government can finance a public good with tax
revenue.

 Important public goods:

o National defense.
 o Basic research.

o Fighting poverty.

 Some goods switch between public goods and private goods

(depending on circumstances).
o Example: A fireworks display performed in a town can be a public
good. A fireworks display at a private amusement park (e.g. Disneyland)
is a private good.

o Example: A lighthouse operated by the government is a public

good. A privately owned lighthouse that charges adjacent ports for
operation is a private good.

 Cost-benefit analysis: A study that compares the costs and benefits to

society of providing a public good.

11-3 Common Resources

 Common resources are not excludable (like public goods). Unlike public
goods, common resources are rival in consumption: one person’s use
degrades the resource for others.

 Tragedy of the Commons: A parable that illustrates why common

resources are used more than is desirable from the standpoint of society as
a whole.
o Social and private incentives differ.

o Government can solve the problem through regulation or taxes to

reduce consumption.

o Government can also solve the problem by turning the common

resource into a private good.

 Some important common resources:

o Clean air and water.

o Congested roads.

o Fish, whales and other wildlife.

 Case Study: Why the cow is not extinct:

 o Cows live on ranches that are privately owned and are private
goods. Ranchers have strong economic incentives to maintain cattle
populations because of market demand for beef.

o Contrast with elephants which are commercially valuable (ivory)

but are a common resource. Poachers have strong incentives to kill the
elephants.

o Some countries have experimented with treating elephants as

private goods. Landowners with elephants on their land may allow
individuals to hunt some of their elephants but the landowners also have
a strong incentive to maintain their stock of elephants because of this
profit motive.

11-4 Conclusion: The Importance of Property Rights

 There are some goods that the market does not adequately address or
provide for (clean air, for example).

 Governments are relied on to provide necessary common goods.

 Markets cannot allocate resources efficiently without property rights.

 Goods that do not have well established “owners” lack similar incentives
for firms and individual actors.

 Policies that are well planned and necessary can make the allocation of
resources more efficient and raise economic well-being.