CH 9 Externalities

9
MARKET FAILURE AND EXTERNALITIES
FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 5TH EDITION
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I. Market Failure
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Market Failure
◦ Market models lose their value….
◦ … when making predictions if we have imperfect information
and irrational behaviour.
◦ …because individuals and firms have different levels of power
and influence in markets.
◦ …in the presence of externalities.
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II. Externalities
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Belief Systems
The intellectual basis for the market system…
◦ … individuals being left to their own devices without
government interference motivated by self-interest, lead the
market to maximize total benefit that society can derive from a
market.
◦ This occurred as economic agents were led by Adam Smith’s
“invisible hand” of the marketplace
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Belief Systems
Critics of this belief system argue that…
◦ … individuals make decisions without fully understanding the
costs and benefits and lead to inefficiencies which the market
system on its own does not solve.
As a result, externalities may still occur...
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Externalities
An externality is an uncompensated impact of one person’s
actions on the well-being of a bystander.
o Externalities cause markets to be inefficient, and so fail to
maximize total surplus.
o An externality arises...
. . . when a person engages in an activity that affects the well-being
of a bystander and yet neither pays nor receives any compensation
for that effect.
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Externalities
When the impact on the bystander is adverse, the externality is
called a negative externality:
◦ Car exhaust fumes
◦ Cigarette smoking
◦ Barking dogs (loud pets)
◦ Loud stereos in an apartment building
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Externalities
When the impact on the bystander is beneficial, the externality is
called a positive externality.
◦ Immunizations
◦ Restored historic buildings
◦ Research into new technologies
◦ In either situation, decision makers fail to take account of the

external effects of their behaviour.
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The Social Costs and Social Benefits of
Decision Making
Market decisions are based on weighing up private costs and
private benefits.
When there are social costs and social benefits lost or gained by
those not party to the initial decision, then:
◦ Decision makers in the market may not take account of the social
costs and benefits of their actions
◦ The market equilibrium is not efficient when there are externalities.
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III. Externalities And Market
Inefficiency
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Welfare Economics: A Recap
Negative externalities lead markets to produce a larger quantity
than is socially desirable.
Positive externalities lead markets to produce a larger quantity

than is socially desirable.
◦ Look at the market for aluminium (figure 1)
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Welfare Economics: A Recap
Figure 1. The Market for Aluminium
Price of
Aluminum Supply
(private cost)
Equilibrium
Demand
(private value)
0 QMARKET Quantity of
Aluminum
9781473725331 © CENGAGE EMEA 2017
Negative Externalities
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.
◦ If, however, the aluminum factories emit pollution (a negative
externality), then the cost to society of producing aluminum is larger
than the cost to aluminum producers.
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The Market for aluminum
◦ 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
Price of
Social
Aluminum
cost
Welfare loss in
Cost of
market equilibrium
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0 QOPTIMUM QMARKET Quantity of

Aluminum
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.
• Unless output is brought down from QMARKET to QOPTIMUM there
will be a welfare loss:
• The cost of the last units produced is less than the benefits
experienced by consumers from it.
Internalizing an externality involves altering incentives so

that people take account of the external effects of their
actions.
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Achieving 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.
◦ The shaded triangle represents the welfare loss from the market
equilibrium when the externality is not internalized.
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Positive Externalities
A positive externality exists when an externality
benefits the bystanders.
◦ The social value of the good exceeds the private value.
◦ Example: Education yields positive externalities.
◦ A better-educated population leads to improved productivity
and economic growth. The economic growth is the positive
externality as it benefits everyone.
The marginal social benefit (MSB) is the private value

plus the external benefit to society at each price.
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Figure 3. Education and the Social Optimum
Price of
Education
Supply
(private cost)
MSB
or
Social
value
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of

Education
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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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Figure 3 Education and the Social Optimum
Figure 3. Education and the Social Optimum
Price of
Education
Welfare loss in Supply
market equilibrium (private cost)
MSB
or
Social
value
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of

Education
Copyright©2014 Cengage
Internalizing Externalities:
◦ Subsidies can be used to attempt to internalize positive externalities.
Industrial Policy:
◦ Government intervention to promote technology-enhancing industries.
◦ Patent laws give the individual (or firm) with patent protection a
property right over its invention.
◦ Without property rights there would be less research.
◦ Property rights provide the exclusive right of an individual, group or
organization to determine how a resource is used.
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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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Positional Externalities
Positional goods have the characteristic that the utility from
consumption of those goods is dependent on how it
compares with others in the same class
◦ Purchases or decisions that alter the context of the evaluation
of the positional good by an individual can generate a positional
externality
Which option would you prefer:

◦ A: Your income = CHF 60’000, other’s income = CHF 150’000
◦ B: Your income = CHF 50’000, other’s income = CHF 40’000
◦ A is more “rational” but most people prefer B
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Positional Externalities
A positional externality is a situation which exists when the payoff
to one individual is dependent on their relative performance to
others.
◦This occurs, for example, in professional sports when players’
rankings depend on the percentage of matches they win.
A positional arms race is a situation where individuals invest in a

series of measures designed to gain them an advantage, but
which simply offset each other.
◦In professional sports, for example, they would hire a new coaching team
to give them the extra edge.
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IV. Private Solutions To
Externalities
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Types of Private Solutions
Government action is not always needed to solve the
problem of externalities.
Social norms and Moral Behaviour

◦ Do unto others as you would have them do unto you.
Charities that deal with externalities.

◦ E.g. Greenpeace.
Self-interest
◦ Where two firms gain from each other’s presence (apple grower, bee
keeper)
Social Contracts
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Integrating different types of businesses (Self-interest)
◦ Suppose a beekeeper and an apple grower have adjacent
property
◦ The bees pollinate the flowers on the apple trees and help the
orchard produce apples
◦ They get the nectar in return which they use to produce honey
◦ Without internalization, the orchard owner plants too few trees
and the beekeeper keeps too few bees
◦ These positive externalities could be internalized if the orchard
owner bought the beehives (or vice-versa)
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Contracting between parties (Social Contracts)
◦ An alternative would be for the two parties to sign a contract regulating
the numbers of bees, trees and side payments
◦ The contract can solve the inefficiencies associated with the externality
and make both parties better off
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The Coase Theorem
Suppose that I like to play music LOUD and my neighbors do not
like my selection…
◦ My next door neighbor might come banging on my door requesting that I
lower the volume…
◦ What the Coase theorem says is that, absent bargaining costs, my

neighbor and I will reach an efficient outcome
◦ Say that my private value to listening to the music is €40 and that the cost
to the neighbor is €30
◦ Then, the efficient outcome is that I listen to music as the benefit to me

exceeds the cost to the neighbor
◦ Thought this might be the efficient outcome, it is not the end of the story…
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The Coase Theorem
With these payoffs, if necessary, I would be prepared to pay
him any amount in excess of €30 but less than €40 in order
to continue listening to the music
◦ He would accept my payment and the solution would be
efficient:
◦ The prevailing outcome maximizes welfare of both parties
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The Coase Theorem
Does it matter whether the law sets limits on how loud the
music can be?
◦ Not as far as the efficiency of the outcome is concerned!!
◦ Even if I were not legally allowed to play music so loud, if I were willing
to compensate the neighbor as described, we would reach the efficient
outcome:
◦ The compensation would make it worthwhile for the neighbor to listen
to the music and he would not invoke legal action against me
◦ If the law said nothing about music volume, then I would invoke it and
continue to play loud music
◦ The neighbor would not find it worth his while to buy me out
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The Coase Theorem
Though the efficient outcome was reached in both cases,
the law impacted which transfers took place (if at all)
◦ If the law protects silence, it will favor the neighbour and I have
to compensate him
◦ If is does not protect silence, it will favor me and I have to do
nothing
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The Coase Theorem
Of course it could be the case that the value of silence to
the neighbor exceeded my value to loud music
◦ In this case, the efficient outcome is that I do not play loud
music
◦ If the law protects the neighbor, then he will invoke it and I will
have to stop playing loud music
◦ No money will change hands in this case because he dislikes
loud music more than I like it
◦ If the law protects me, I would invoke it and the neighbor would
find it worth his while to buy me out
◦ Though the law did not affect efficiency, it affected transfers
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Why Private Solutions Do Not Always Work
Sometimes the private solution approach fails because

transaction costs can be so high that private agreement is
not possible
◦ Need to hire lawyers, translators, …
Bargaining Problems
◦ Each party tries to hold out for a better deal.
Difficult to Coordinate the interested parties

◦ This can easily be the case when there are many negotiating
parties
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Why Private Solutions Do Not Always Work
Asymmetric Information:
◦ Parties might not know each others’ costs/benefits, difficult to
negotiate (might overstate cost, understate benefits)
There may be free-riders:

◦ People who would benefit from a solution but who do not want
to pay…
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V. Public Policies Toward
Externalities
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Command and Control: Regulation
Command-and-Control Policies
◦ Usually take the form of regulations:
◦ Forbid certain behaviours.
◦ Require certain behaviours.
◦ Examples:
◦ Requirements that all students be immunized.
◦ Stipulations on pollution emission levels set by the
government.
◦ Needs good information
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Market based policies: Corrective Taxes
and Subsidies
Market-Based Policies: e.g. taxes/subsidies to align private
incentives with efficienty
Pigovian taxes are taxes enacted to correct the effects of a
negative externality.
• Gives factories an incentive to reduce pollution up to a point
where the marginal abatement cost is equal to the tax rate
imposed.
• Firms that can reduce pollution with the least cost are likely
to do so (to avoid the tax) while firms that encounter high
costs when reducing pollution will pay the tax.
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Market based policies: Corrective
Taxes and Subsidies
Regulation Versus PigovianTax.
If the government decides it wants to reduce the
amount of pollution coming from a specific plant, the
government 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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Taxes and Subsidies
Economists generally prefer Pigovian taxes over regulations
because taxes can reduce pollution at a lower cost for
society.
To see this, consider an example:
Suppose two factories – a steel mill and a paper mill – are
each dumping 500 tons of effluent in a river
Regulation: The government could tell each factory to bring it
down to 300 tons
Pigovian tax: levy a tax on each factory of €50000 per ton
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Taxes and Subsidies
The tax and the regulation can be equally effective in
reducing pollution:
• By setting the tax high enough, the government can achieve any
desired reduction in pollution
• However, taxes might do so more efficiently than regulations
• Suppose that the paper mill can reduce the emissions very easily
compared to the steel mill
• With the tax, the company that could reduce it more easily would do
so whereas the other one would reduce a bit and accept that it had
to pay the tax
• If there is a regulatory decline in production identical across the
board, it will not take into consideration the different needs of
individual firms
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Taxes and Subsidies
In addition, with regulation, firms will work to achieve the set
limit and stop there.
• With a tax, companies have an incentive to look for ways to
produce more pollution free as this would reduce the amount of
tax
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Tradable Pollution Permits
Suppose a regulation (in quantities) is indeed issued by the
government:
◦ Would it be beneficial to allow companies to trade pollutions
permits?
Tradable pollution permits allow the voluntary transfer of the

right to pollute from one firm to another.
◦ 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.
If a market to trade pollution permits is allowed to develop,

regulations and Pigovian taxes have the same outcome
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Figure 4a. The Equivalence of Pigovian Taxes and Pollution Permits: Pigovian tax
Price of
Pollution
P Pigovian
tax
1. A Pigovian
tax sets the
price of Demand for
pollution . . . pollution rights
0 Q Quantity of
Pollution
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
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Figure 4b. The Equivalence of Pigovian Taxes and Pollution Permits: Pollution Permits
Price of Supply of
Pollution pollution permits
Demand for
pollution rights
0 Q Quantity of
Pollution
2. . . . which, together 1. Pollution
with the demand curve, permits set
determines the price the quantity
of pollution. of pollution . . .
When setting a Pigovian tax, the demand curve for pollution
rights determines the quantity
◦ When setting the quantity, the demand curve determines the
price
If the government does not know the demand curve for
pollution rights but does not want pollution to exceed 600
tons of effluent
◦ Then it can auction 600 pollution permits
◦ Such an auction will generate the same amount of revenue as
the Pigovian tax would have
◦ In this case, the auction is a better procedure than the tax
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VI. Public/Private Policy Toward
Externalities
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Property Rights
o In some cases, private solutions to externalities can
occur but need some form of legal back-up, such as the
establishment of property rights
o Property rights is the exclusive right of an individual,
group or organization to determine how a resource is
used.
◦ When property rights are not defined (for example over some
category of natural resources), it may be difficult to achieve
efficient solutions regarding their use.
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Property Rights
If I have ownership rights over the air 1 km above my house then
no one can legally pollute it.
◦ I can negotiate with a firm that wishes to pollute that air and agree a
price for the right to do so.
◦ This moves outcomes closer to efficiency in terms of how the air above
my house is used.
◦ However, it is a complex task to establish a system of such property
rights and they may be expensive to enforce.
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Property Rights
o Extending property rights is therefore one area
where externalities can be internalized.
o Arrives at efficient solutions.
o Can be extended to include intellectual property rights.
o However, it is a complex task to establish a system of such
property rights and they may be expensive to enforce.
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Control of Positional Arms Races
o An incentive must exist to prevent the investment in
attempts to gain some benefit which is ultimately
mutually offsetting.
◦ Laws against performance enhancing drugs in sport.
◦ External body overseeing any dispute over the social
norms.
◦ Limiting advertisement expenditures during electoral
campaigns.
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Objections to the Economic Analysis of
Pollution
o Some individuals dislike the idea of allowing
companies to purchase the right to pollute.
• These people fail to understand that an economy has limited
ability to eliminate pollution and such elimination would come
at a high opportunity cost.
• “People face trade-offs” and we must decide how much we
would be willing to give up to have no pollution.
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VII. Government Failure
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The Importance of Power
o Government decision-making is often flawed and not
based on perfect information or rational, positive
analysis.
o The benefits accrue to a small number of people, but the
costs are spread across large sections of the population.
o Government failure a situation where political power and
incentives distort decision making so that decisions are
made which conflict with economic efficiency.
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Public Choice Theory
Governments might intervene in markets as a reaction to
public pressure or moral panic spread by news
organizations.
◦ Public choice theory is the analysis of governmental behaviour,
and the behaviour of individuals who interact with government.
◦ Public interest: making decisions based on a principle where the
maximum benefit is gained by the largest number of people at
minimum cost.
◦ Example of road congestion: Government wants people to pay

for roads, but pressure groups against road pricing win the day.
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The Invisible Hand versus Public Interest
Public choice theory looks at are cases where individual self
interest of voters, politicians, lobbyists or civil servants leads to
decisions and the allocation of resources which may not be the
most efficient allocation.
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Voter, Politician and Bureaucrat Incentives
Rational ignorance
◦ A voter tends not to not seek out information to make an informed
choice in elections since they do not see their individual vote as
making any difference.
Politicians will reflect the interests of the local

communities they are seeking to serve.
◦ They want to be re-elected.
Bureaucrat
◦ Civil servants providing advice have power.
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Other Distorting Behaviour
The special-interest effect may lead to minorities gaining
significant benefits, but the cost is borne by the population as a
whole.
Logrolling is a term used to describe vote trading in government.
Rent seeking is where individuals or groups take actions to

redirect resources to generate income (rents) for themselves or
the group.
Public sector inefficiency – without a profit motive, no motivation

to be more productive, reduce costs, ...
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Other distorting behaviour
Cronyism (returning favours).
Inefficiency in the Tax System

◦ Individuals and companies using of loopholes in the tax
system to avoid paying tax.
◦ Tax avoidance is legal. Tax evasion is illegal and includes the
informal economy.
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Summary
① When one party’s activity affects another party, the effect
is called an externality.
② Negative externalities cause the socially optimal quantity

in a market to be less than the equilibrium quantity.
③ Positive externalities cause the socially optimal quantity

in a market to be greater than the equilibrium quantity.
④ Those affected by externalities can sometimes solve the

problem privately.
9781473768543 © CENGAGE EMEA 2020
Summary
⑤ Coase theorem states that if people can bargain without
a cost, they can always reach an agreement in which
resources are allocated efficiently.
⑥ When private parties cannot adequately deal with

externalities, then the government steps in.
⑦ The government can either regulate behaviour or

internalize the externality by:
◦ Using Pigovian taxes or by issuing pollution permits,
◦ It might create property rights so that the private parties may be
able to bargain and reach a satisfactory outcome.
9781473768543 © CENGAGE EMEA 2020
Summary
⑧ Government intervention to correct market failure might be
subject to its own failures.
◦ Minority groups are able to exercise political power to influence
decision making of politicians and bureaucrats to gain benefits which
might be outweighed by the costs imposed on the majority.
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9

MARKET FAILURE AND EXTERNALITIES

As a result, externalities may still occur...

◦ In either situation, decision makers fail to take account of the

Positive externalities lead markets to produce a larger quantity

0 QOPTIMUM QMARKET Quantity of

Internalizing an externality involves altering incentives so

The marginal social benefit (MSB) is the private value

0 QMARKET QOPTIMUM Quantity of

0 QMARKET QOPTIMUM Quantity of

Which option would you prefer:

A positional arms race is a situation where individuals invest in a

Social norms and Moral Behaviour

Charities that deal with externalities.

◦ What the Coase theorem says is that, absent bargaining costs, my

◦ Then, the efficient outcome is that I listen to music as the benefit to me

Sometimes the private solution approach fails because

Difficult to Coordinate the interested parties

There may be free-riders:

◦ Needs good information

Tradable pollution permits allow the voluntary transfer of the

If a market to trade pollution permits is allowed to develop,

◦ Example of road congestion: Government wants people to pay

Politicians will reflect the interests of the local

Logrolling is a term used to describe vote trading in government.

Rent seeking is where individuals or groups take actions to

Public sector inefficiency – without a profit motive, no motivation

Inefficiency in the Tax System

② Negative externalities cause the socially optimal quantity

③ Positive externalities cause the socially optimal quantity

④ Those affected by externalities can sometimes solve the

⑥ When private parties cannot adequately deal with

⑦ The government can either regulate behaviour or

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