1

Chapter 17: Negative externalities (1.4)

Key concepts:
• Negative externalities
o In production
o In consumption
• Welfare loss
• Demerit goods
• Policies to deal with negative externalities in production – taxation,
tradable permits, bans
• Policies to deal with negative externalities in consumption –
government regulations, age limits, licenses, govt control of sales, bans

We have expounded on how markets succeed in both the production and distribution of goods – and how
the price function ultimately creates a market clearing. Recall that when quantity supplied equals quantity
demanded, the market is in equilibrium and there is optimal resource allocation – a Pareto-optimum.
Should – for some reason – the market not achieve this equilibrium then the market has failed.

• Negative externalities
Externalities arise whenever the market clearing price creates benefits for or inflicts costs on a third party –
i.e. a party other than the consumer or producer involved in the economic transaction. In the case of
negative externalities, the signalling function fails to correctly portray the real costs to firms and
consumers, resulting in over- production or over-consumption of goods. The market has failed to optimally
allocate resources.

An easy way to get an immediate grip on the concept of externalities is to just think for a minute or two
about the following question: Have you ever consumed a good which had a negative effect on others who
didn’t receive the good!? I warrant that your answer is ‘yes’; how about cigars and noisy motorcycles as an
example where other – non-consumers – bore the costs for goods they have not enjoyed? In this example,
your personal consumption has had negative effects on others – external effects which we call a negative
externality (or ‘negative spill-over’ effect).

o Negative externalities in production

Conversely, when the marginal private costs (MPC) are outweighed by marginal social costs (MSC) then
there is a negative externality. A good which renders higher marginal social costs than private costs is an
example of overproduction; the production of coal-powered electricity causes emissions of sulphur and
nitrogen dioxide which ultimately cause acid rain which kills forests and fish. Here, the market has
underestimated the true costs of the good to society and produced too much of it.
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Definition: Negative externalities in production

A negative externality in production is a burden/cost endured by third parties arising from the
production of the good. Negative externalities arise when the MSC > MPC.

Every year for over 25 years I have returned to my fishing paradise in Helsingland, middle Sweden, where
my friends Östen, Musen and I have fished since pre-teenagerdom. Every year when I return, I have the
same heart-in-throat experience of wondering whether the beautiful little brook-trout have finally
succumbed to increasing pollution – primarily acid rain. You see, the middle part of Sweden is along a
thermal weather path where a goodly proportion of emissions from Germany’s industrial centre
(Ruhrgebiet surrounding Köln) ultimately land. Sulphur and nitrogen oxides emitted in Germany ultimately
land as weak solutions of sulphuric and nitric acid in Swedish lakes and streams. This lowers the pH-values
of the water and can rapidly kill off entire populations of trout and the insects upon which they feed.1

Therefore, when I drive the 850 km north in my German VW Polo, listening to CDs manufactured by the
German firm TDK, and subsequently pitch my German VauDe tent by the river, I will not be paying the
full price of these goods since the real cost – the social costs – are considerably higher! Even the people
who have never had the thrill of stalking trout with a 9 foot fly-rod would seriously oppose measures to
keep a natural strain of trout alive. Why? Because the cost would be…well, incalculable. How does one
measure the loss of a sub-species?! Yes, one could measure the value of trout streams in purely monetary
terms such as tourism and fishing license revenues, but there are numerous intangible benefits which, while
impossible to calculate, are most evident; ‘a living natural environment’ sums it up. As Ronald Coase, one
of the world’s leading economists and Nobel Laureate in 1991 has put it; ‘The question to be decided is: is
the value of the fish lost greater than the value of the product which contamination of the stream makes
possible?’2

The negative effects of pollution are shown in figure 17.1. Using my fishing example, a tent-maker in
Germany using Teflon3 coatings does not include the costs of dying eco-systems in Sweden in the cost
picture when focusing on maximising profits. Any level of output will have external effects on third parties
– Swedish-American-Ecuadorian fly-fishing economics teachers on well deserved holidays for example.
Output will be set at Q0 (where MPC = MSB) rather than at the societal optimum of Qsocopt where MSC =
MSB. This over-production of goods causes external costs to society – which will not be reflected either in
the firms’ costs or the prices paid by consumers.

1) The extent of the negative externality: The external costs to society – dead fish and very sad fly-
fishermen – at Q0 are shown as the vertical distance between the marginal private costs and the
marginal social costs; MPC
MSC.

2) Welfare loss: The shaded triangle shows how the MSC is higher than the MSB for any unit of
output produced between Qsoc opt and Q0 – this is the welfare loss (burden) to society in producing
these units.

1
Local municipalities and fishing clubs combat this by dumping large amounts of limestone in source
lakes and feeder-streams in order to raise the ph-value.
2
Coase, Ronald; The Problem of Social Cost, Journal of Law and Economics, October 1960, page 3.
3
Teflon contains perfluorinated chemicals (PCOs) which accumulate in protein and can build up to high
levels in both humans and wildlife. Recent studies suggest PCOs are linked to birth defects, developmental
problems, liver damage and affect the neuroendocrine system. (I am way out of my depth here and had to
look this up…so you better ask your biology teacher.)
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Fig. 2.4.3 Negative externalities of plastic production

P($/unit) MSC
MPC
MPC
MSC; extent of the negative
externality in production
Psoc opt
P0 Welfare loss in producing Qsoc opt to Q0
more units of plastic – each unit has a
higher MSC than MSB
MSB (= MPB)
Qsoc opt Q0 Q/t (units/month)

(Marcia: I’m leaving the curves blue so I can shift them in red and green later.)

The MSB is assumed to be the same as the MPB, i.e. all benefits to society are accounted for by the private
benefits. Price and output is set where private costs equal private benefits. Since third parties suffer from
this, there are negative externalities arising from consumption. (Social costs = private costs + external
‘spill-over’ costs.)

Please note that the in examples used, acid rain, carcinogens and particulates, will naturally have numerous
negative externalities other than for us fishermen. I remember when one could walk around hundreds of
statues littering the grounds of the famous Acropolis in Athens. Returning some 30 years later, I found that
most of them have been moved indoors. While this might in part be due to the risks of theft and vandalism,
it is often simply to protect the invaluable antiquities from the highly damaging acid rain and air-born
particulates resulting from heavy traffic and industries – which have eroded this priceless cultural heritage
more in the past 40 years than the preceding 2,000 years!

WARNING! ‘EXTERNALITY’ AND ’WELFARE TRIANGLES’

Frequently students fail to differentiate sufficiently between ‘extent of the externality’ and the
‘welfare triangles’. The externality shows the net benefit/cost to society in the consumption of
the good. The triangles show how the external effects result in misallocation; a potential welfare
gain or welfare loss. I also urge you to “pull out the arrows and triangles” as I have done in the
illustrations in order to make it easier on your examiner.

The concept of externalities can be applied quite broadly. A new building which blocks your view confers a
loss of utility on you – and thus you, as a third party, will bear the cost of lost viewing pleasure. This is a
negative externality for society. A new building which enhances your viewing pleasure will of course bring
society positive externalities. It goes without saying that one ultimately stands on a pedestal of normative
judgement in assessing external costs and benefits; a free pop concert in the park will bring both depending
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on one’s preferences. It is obvious, however, that there are some costs which are more objectively
observable. An example is a World Bank study in 2000 which attempted to assess the social costs of air
pollution in developing countries.4 The study showed that air pollution could be linked to the premature
death of over 500,000 people each year, costing some 2% of GDP in health care and lost output.

o Negative externalities in consumption

Here’s the one you’ve all been waiting for; drugs. Nothing quite like quaffing a few pints whilst puffing on
a sizable Havana cigar.5 Oh, you were perhaps thinking of illegal types of mind-altering substances, say
cocaine and LSD. We’ll get to those, but for the time being I shall deal with the more conventional (and in
western countries, socially acceptable) substances alcohol and tobacco.

Author and victim – he’ll no doubt sue me in 20 years if I’m still alive.6

Demerit goods

Now, when I sit out on the balcony smoking my cigar and having my evening Cognac, my lady Bell
immediately closes the balcony door – forcing me press my nose against the window in order to catch the
news on TV.7 She still loves me…but not the smoke I exhale! She, the self-professed economics
ignoramus, is highly aware of the damage to others caused by second hand smoke – and just as aware of the
negative effects my consumption will have on me in the future. She rather wants me around for a while
longer.

4
http://www.worldbank.org/cleanair/global/topics/health_imp.htm

5
These are, of course, complement goods.
6
Before I start getting hate mail, the story goes something like this: Summer of 2008 I was back in Sweden for a
quick visit to Guy and his family – basically my adopted family. His (my) sister Monica had adopted two wonderful
Korean lads and standing on the lawn of Musen and Pernilla’s house it was time for a picture with Uncle Matt. I’m not
too comfortable with children and the discussion prior to the picture went something like this: “Matt! Picture time – get
in there with the kids!” “Em, I’m smoking a cigar.” “So put it down!” “I’m busy! It’s a good cigar…” Someone tossed
me an infant…and before I knew it, Toni the bendejo snapped a picture.
7
Yes. I’m getting a portable TV for the balcony cigar and Cognac sessions. Revise “complement goods”
right about here!
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It is often said by my more socially aware colleagues, that if cigarettes and alcohol were previously
unknown and then invented tomorrow, they would immediately be banned and severe sanctions for selling
and consumption would be imposed! They are quite right, to the extent that a lawsuit in Florida against
American tobacco companies in 2000 resulted in a ruling that $US145 billion (145,000,000,000) be
awarded to smokers (in Florida alone!) for health damage.8 While this might seem a trifle on the excessive
side, no-one can possibly deny over 50 years of research showing very high correlation between smoking
and various types of cancer, lung disease and premature death. Alcohol might well be even more costly for
society; not only do we have to contend with the severe health damage to individuals but also with the loss
of labour skills and output resulting from inebriation, hangover, alcohol related disease, and, again,
premature death.

It’s simple: don’t drink and drive.

Both tobacco and alcohol are demerit goods, since users either ignore or do not realise the full costs of
consumption – both to themselves and third parties. Both goods show the characteristics of the individual
consumer not being able to see how his/her consumption patterns negatively affects society. Indeed, when
it comes to alcohol and illegal drugs, a case can be made for judging many individual consumers as
seemingly incapable of making a correct decision even in terms of their own self interest!

Definition: Demerit good

A demerit good has negative externalities and users do not realise – or choose to ignore – the
costs to themselves in the long run. Common examples are tobacco and alcohol.

The negative effects of consuming tobacco are shown in figure 17.2. My consumption of tobacco will
create costs for non-users and me in the future – my health issues will of course inflict costs upon society

8
The Economist, July 20, 2000.
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such as hospital care and the loss of labour hours. Output will be set at Q0 (where MSC = MPB) rather than
at the societal optimum of Qsocopt where MSC = MSB. This over-consumption of a demerit good (tobacco)
causes external costs to society – which are not reflected either in the firms’ costs or the prices paid by
consumers.

1) The extent of the negative externality: The external costs to society – health issues and loss of
income due to increased sick days – at Q0 are shown as the vertical distance between the marginal
private benefits and the marginal social benefits; MPB
MSB.

2) Welfare loss: The shaded triangle shows how the MSC is higher than the MSB for any unit of
tobacco consumed between Qsoc opt and Q0 – this is the welfare loss (burden) to society in
consuming these units.

Fig. 17.2 Negative externalities of tobacco consumption

P($/unit)

MSC = MPC

MSB
MPB extent of the negative

P0 externality in consumption
Psoc opt
MPB Welfare loss in consuming Qsoc opt to Q0
more units of tobacco – each unit has a
higher MSC than MSB.
MSB
Q0 Q/t (units/month)
Qsoc opt

(Rory: I’m leaving the curves blue so I can shift them in red and green later.)

The MSC is assumed to be the same as the MPC, i.e. all costs in production are accounted for by the firms.
Price and output is set where private costs equal private benefits. At P0 there is an overconsumption of Qsoc
opt to Q0 since every one of these units of tobacco has a MSC greater than the MSB. This is the shaded
triangle representing the welfare loss to society. (I point out, again, that the double-edged arrow shows the
extent of the cost to society while the welfare triangle shows how resources are being mis-allocated.)

(Rory: again, all green text is just basically my notes to self.)

• Policies to deal with negative externalities in production (and evaluation) to

deal with neg externalities (taxation, tradable permits)
Figure 17.3 exemplifies a good which creates a negative externality in production; MSC > MPC and output
is Q0 rather than the allocatively efficient level of Qsoc opt. (Figure grossly exaggerated for clarity.) In order
to correct this market failure, the government imposes a (unit) tax of, shown by the double-sided black
arrow between the MPC0 curve and the MSC curve. (Note how we assume that the ‘money’ cost of
smoking or such can be estimated correctly. In fact, this would be virtually impossible in reality, as
assigning a money cost to loss of quality of life would be both highly subjective and arbitrary.) The tax
serves to shift the MPC0 curve left to MPC + tax, which lowers the quantity demanded to Q1. The results
are a) lower externalities, and b) lower welfare loss to society.
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Fig. 17.3 Taxing away negative externalities of production

P($)
Extent of negative externality with
expenditure tax added
MSC

MPC + tax

MPC0
Psoc opt
Expenditure tax per unit
P1

P0 Extent of negative
externality without tax
MSB (= MPB)
Q/t
Qsoc opt Q1 Q0

Welfare loss before tax

Welfare loss after tax

In taxing the production/consumption of the good, the real costs have been brought forward and now
burden those who are responsible for the externalities. Note that taxes can be imposed on either the
consumer or the producer, such as a tax per pack of cigarettes or a pollution tax on emissions by firms.
Both forms serve to internalise the externality. Smokers will bear more of the real cost of their habit while
in pollution cases it is an example of the ‘polluters pay principle’, which acts as a disincentive to producers
to continue to pollute. Additionally, in a best-cast scenario, the government might divert tax revenue to
those directly affected by the initial externalities, such as using road taxes to build sound barriers and plant
trees between major roads and housing areas. This would help to correct the inequity of third parties paying
a cost which rightly belongs to users/providers.
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Rory: did we find a nice figure for Evaluation? Let’s not actually use the word
evaluation but a figure. The kids will get used to it. I’m going to stick with this figure from now
on. Two main problems in taxing away externalities arise: the first is the difficulty in deciding how
large a tax to set on output. It is almost impossible in many cases to correctly estimate the extent
of the negative externality (e.g. “…what is the real value of an indigenous trout species in
Helsingland, Sweden) and thus impossible to estimate the ‘correct’ level of taxation. The next
problem arises in attributing the pollution to firms – and a third issue arises when offending firms
are on the other side of a national border where the domestic government has no control!

(Type 4 Smaller heading) Internalising externalities

One of the most common ways to bring external costs back into the fold of the market place is to levy costs
on firms producing goods which have negative externalities – the polluter pays principle. Commonly, such
goods are associated with external costs in production, such as circuit boards where ozone-depleting
chlorofluorocarbons (CFCs) are used in the manufacturing process.

A possible solution is to extend property rights by granting distinct ownership rights to those who are
affected. This is another way of internalising externalities; any damages to private property create a basis
for claims on the offending party. By doing so, the externality is brought into the fold of the market
mechanism since previously un-attributed costs have been made clear and responsibility is assigned. In the
case above, citizens suffering from prematurely rusting cars would have the right to claim from the
polluting firm and the firm would pay for property damages. In the case of air/river/noise pollution we will
get market failures and thus externalities since nobody owns any of these objects. One way to correct the
failure would be to establish firm private ownership of them and thus allow owners to collect damages.

Yet again, collecting damages in a situation where the offending firm is far away and
cannot be directly connected to the car owners’ loss of property is almost impossible. I didn’t choose this
example arbitrarily, as I simply wish to show that in many situations it is impossible to allocate and much
less enforce property rights. However, let us look at two simplified examples of how an extension of
property rights might be successfully implemented.

(Type 5 Smallest heading) The Beach – how to exert pressure on offending firms
Imagine a beautiful beach in the summer vacation paradise of your choice. Sand, cloudless 32 degrees and
nice breeze, crystalline azure blue water…no, wait, isn’t that raw sewage pouring out into the bay?! Yech!
And the sand resembles used kitty-litter upon closer examination. No wonder the tourists are at the beach
front restaurants and cafés instead. Or rather, ‘aren’t’ . It seems that the pollution has driven off a good
many tourists and the restaurants and cafés are not as full as they once were. This is a clear case where
other parties – manufacturing industries, households, hotels etc – have inflicted damage on others who have
a clear interest in clean beaches; the beach front businesses.
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A possible solution here is to grant property rights to all businesses

along the beach front. Give each business a granted right to a section of beach front and allow the
businesses to extend into sun-chair rentals, windsurfing schools, diving classes and the like. This creates an
incentive for the businesses to clean up the beach as they compete for tourists. It will also induce them to
put pressure on the offending polluters since the externality is damaging their property and thus in effect
harming their profits. One could expect the beach businesses to act towards either implementing new
legislation on sewage or demanding that existing suchlike is enforced. It is conceivable that the community
acts to charge households and industries for increased water purification and/or increase taxes in order to
build cleaning plants, since the costs of the externalities such as loss of tourism profits and tax revenues
will be made apparent by the new property owners.

(Type 5 Smallest heading) The River Runs Through It – how to get offending firms to exert
pressure on themselves

What if a factory upstream from where I fish trout were to release effluent into the river causing the trout
population to decline over time? This would be quite a blow to the thousands of fishermen who regularly
return to the stream. They would bear the external costs of the factory’s activity.

A possibility is to extend the property rights of the firm to encompass the entire river! Say that the
municipality were to grant the firm sole entrepreneurial rights along the river. River rafting, fishing,
camping – you name it. The decision the firm would face is whether the river is more valuable clean or
dirty; in other words, would the marginal revenue of all the river sports activities be greater than the
marginal costs involved in reducing pollution to acceptable levels? This solution would of course only be
considered if the answer were ‘yes’, and therefore the firm would be able to add to total earnings by
keeping the river clean. In creating a framework where the party responsible for a negative externality
(cost) must take them into account, the externality has been brought into a market framework, i.e.
internalised. However, it is quite possible that the original property right owners – say fishing clubs – might
simply have to pay the firm to limit pollution.

Definition: Extension of property rights

Extending property rights means there is an explicit right of use of an asset or resource.
Ownership – and thus responsibility – is granted, creating an incentive for owners to take into
consideration all costs, i.e. externalities. In this way private costs are brought closer to social
costs and firms are more inclined to limit total costs in line with a profit incentive. The
externality is in this way internalised by bringing external costs into a market-based
framework.

It should be noted that the concept of expanding property rights is quite wide. Many
examples involve granting sufferers the right to litigate (= take legal action, sue) against offenders. For
example, many cases of lung cancer have been brought within the legal jurisdiction (= responsibility) of
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firms which produced asbestos in the 1960s – firms will have to compensate these workers as the workers’
ownership of factors of production (= their own labour) has been harmed. The workers’ damaged property
will have to be paid for by the offender – the firm. A most notable case of late, is the class action suit
(where many people who have been injured get together and sue a company as one) against the
Swiss/Swedish multinational engineering company, ASEA Brown Boveri (ABB).9 When ABB bought the
American company Combustion Engineering in 1989, it also took over all of the American company’s
liabilities – even in terms of previous employees who claim damages from dealing with asbestos. ABB is
expected to pay over USD1.2 billion in settlements for claims and total costs together with legal fees could
run into the billions.10

While assigning property rights encounters any number of problems, such as who should pay whom and
how much, there is a market-based appeal to the system. There is no need for extensive regulatory bodies
which monitor and estimate the extent and cost of the externalities. This is instead done by the relevant
parties; the offending firms and the third party sufferers. In setting out well-defined property rights (which
is obviously the tricky part!) the offender and victim will be able to arrive at equitable compensation which
optimises resource allocation and minimises environmental damage.

(Type 3 Medium heading) Tradable permits

While this might sound like the medieval custom of sinners buying indulgences, a permit to pollute is
slightly different – but almost as controversial. This highly market-based solution to pollution is the
establishment of programs wherein a government regulatory agency sets a ceiling on total emissions and
then emits tradable ‘pollution permits’ to offending firms. A tradable permit scheme essentially means
that government decides the ‘acceptable’ level of pollution and then issues credits or allowances to firms
and fines firms which pollute more than their permits allow. The permits are allowed to be re-sold to other
firms, which in theory – and in practice in some cases – creates both an incentive to clean up production
and a disincentive to exceed the limits imposed.

(Type 4 Smaller heading) How tradable permits work

Consider a market comprised of ten firms, producing a market total of 100,000 Widgets and also emitting a
total of 1,000 tonnes of greenhouse gases (GHG, mainly carbon dioxide, ozone, methane,
chlorofluorocarbons and nitrous oxide). Let us for the sake of simplicity say that this comprises the sum of
externalities, which means that each Widget has an external cost to society of 10 kg of GHG per Widget
(1,000 tonnes of GHG / 100,000 Widgets). The government sets a ceiling of 500 tonnes of GHG and
initially simply allocates 50 one-tonne pollution permits to each firm. Assuming that this would also halve
market output, 50,000 Widgets would be produced. What happens next depends largely on how efficient
each individual firm is in producing Widgets, but here is a possible scenario:

1. Say that the three most polluting firms (= most inefficient firms) can only produce 1,000 Widgets
each when limited to 50 tonnes of GHG emissions and would have to invest so much in new
filtering technology in order to produce more that it simply wouldn’t be worth it. These high-
polluting firms leave the market but hold permits allowing for the emission of 150 tonnes of GHG
which they will not use. Total market output of Widgets is now 47,000.
2. The three exiting firms will sell the permits on the open market, the question being what will set the
market price? Simple; the foregone profits of firms not using the permits will set the floor while the
highest bidders, which will be the most efficient firms, will set the ceiling – since these firms will be
able to produce the most Widgets per tonne of GHG and thus be willing to pay the most for the
permits. (Keep in mind that the market price for Widgets will rise as three firms have left the
market.) Say that five of the remaining firms are producing half of their previous output and are

9
An attempt to sue McDonald’s for causing obesity was tossed out of court in the US in 2003.
10
http://www.forbes.com/2003/01/17/0117autonewsscan01.html and
http://www.corpwatch.org/news/PND.jsp?articleid=1888
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marginally efficient, i.e. they have no incentive to buy additional permits. They produce 25,000 of
the market total of 47,000.
3. Consider now that the final two firms, YellowFirm and GreenFirm, are also the most efficient firms
and are bidding for the extra 150 tonne allotment. YellowFirm is producing 10,000 Widgets with its
50 permits and estimates that it can produce an additional 20,000 Widgets with the additional 150
permits up for sale. (Note that the additional 150 permits does not mean that the firm can increase
output by 30,000 units! This is of course due to increasing marginal costs.) At the going market
price of €10 per Widget, YellowFirm’s additional revenue of €200,000 (€10 times 20,000 more
units) would cover all additional costs – both production costs and permit costs – if the price of the
permits were maximally €500 each.
4. GreenFirm is producing 12,000 Widgets and could produce an additional 30,000 Widgets with the
150 permits. The marginal revenue of €300,000 would cover all additional costs even if the cost of
the permits were as high as €510 each.
5. GreenFirm wins the bidding war, and after taking on Bell (153 centimetre ferocious Australian
female) as chief negotiator, pays €501 per permit.11 The final outcome is that the five non-bidding
firms produce 25,000 Widgets; YellowFirm produces 10,000; and GreenFirm 42,000. The sum
output total of 77,000 Widgets results in 500 tonnes of GHG, or unit external costs of 6.5 kg of
GHG per Widget.
6. The short run result is that pollutants contributing to the green house effect have decreased by 50%
while output has decreased by proportionately less, namely 23%.
7. It might appear that a polluting firm would have no real incentive to lower pollution levels once the
permits have been purchased. This is faulty economic reasoning, as the firm has resources (money)
tied up in the permits and thus incurs an opportunity cost. In the long run there will be an incentive
for firms to increase efficiency and lower emissions in order to free resources by selling the permits.
Put more bluntly; any new production method or technology which can save a polluting firm one
tonne of pollution at a lower cost than buying a permit on the pollution market will be attractive. It
will also enable firms to sell off unneeded permits and free up funds for other investment. (See
below; Case study; CO2 permits and the Clean Air Act (USA)).

The system does have a number of disadvantages, however. Many environmental

groups feel that the market based system sends the wrong signal to both producers and consumers, in that
there are ‘permissible or ‘non-harmful levels of pollution. The system might simply mislead society into
believing that pollution is decreasing when in fact it is not – only the pollution per unit. It is also feasible
that heavy polluters buying up ever-cheaper permits due to the diligence of firms cleaning up their act
might actually perpetuate the very pollution the permits attempt to reduce. A rather tricky issue is also that
pollution knows no boundaries – if the USA has strict controls via permits and Mexico does not then firms
might avoid the issue by establishing subsidiaries right across the border in Mexico. And finally, quite
frankly, most economists seem to favour the appealing simplicity and straightforwardness of emission taxes
rather than what often turns out to be rather complex systems of pollution permits.

• Policies to deal with negative externalities in consumption

However high the costs to society may be due to the production of goods, many negative externalities arise
from the consumption of goods such as alcohol, petrol and cigarettes. In such cases, taxing the good via

11
Woe betides the hotelier or restaurateur who tries to do a number on her!
 12

expenditure is the basis of an incentive-based solution to distortions arising due to market failure. The
cardinal rule of taxes on expenditure (see Chapter 13) is; ‘When you want less of a good, put a tax on it’.
The other rule deals with consumers’ preferences and marginal utility; if you want people to consume less,
adjust their demand by way of changing the way they think.

Fig. 17.4 Dealing with negative externalities of alcohol

P($/unit) MSC (= MPC)0

MSB
MPB extent of the negative
MSC (= MPC)0 externality in consumption

P+tax
Welfare loss in consuming Qsoc opt to Q0 more
P0 units of alcohol – each unit has a higher MSC
than MSB.
P1
Psoc opt
MSB
MPB1 extent of the negative
externality in consumption after government
policies reducing demand/supply
MPB0

MPB1 Welfare loss in consuming Qsoc opt to Q0

MSB more units of alcohol after government
policies reducing demand/supply
Qsoc opt Q0 Q0 Q/t (units/month)

Figure 17.4 shows the effects of government intervention in the market for a good which has negative
externalities in consumption; alcohol. Market equilibrium at P0 and Q0 render private benefits that are
clearly beyond the societal benefits (Qsoc opt), resulting in a negative externality of MSB
MPB. This is not
rocket science; street violence as drunken lads spew out of pubs at 01:00 in the morning…traffic fatalities
due to drunken drivers…loss of income and therefore tax revenue as workers stay home to nurse
hangovers…and the of human capital due to premature death resulting from the consumption of alcohol.
The over-consumption of Qsoc opt
Q0 is illustrated by the light blue triangle – every one of these units has
a higher social cost than social benefit and is thus a welfare loss.

By intervening on the market, a government can reduce the supply of alcohol (MSC0 to MSC1 in figure
17.4) or decrease demand (MPB0 to MPB1 in figure 17.4). In both cases the quantity consumed and market
price move closer to the societally optimum levels and the welfare loss is decreased. Governments use a
number of methods to limit the supply of alcohol (apart from the most obvious which is a ban):

• Decreasing supply: A tax on alcohol increases the costs for firms and decreases supply as do
government limits to the amount of licensed alcohol outlets allowed. (In many notable cases such
as Iceland, Sweden, Norway and Finland, all sales of alcohol are sold solely through a government
monopoly.) Limited opening hours, for example not selling alcohol after certain hours and
weekends (Sweden).

• Decreasing demand: For alcohol – and the highly non-complementary good driving – the issue is
to get consumption down by advertising negative aspects of consumption. Anti-drinking
campaigns hope to decrease demand (MSB0 to MSB1 in the top diagram) and move consumption
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levels towards the social optimum at Qsoc opt.12 Age limits for under-18s (UK) or under-20s
(Norway) also limit demand for alcohol as do warning labels and strict rules on the advertising of
alcohol.

The objective is to alter peoples’ behaviour. Making a good harder and/or more
expensive to obtain decreases consumption by decreasing supply. A major problem here is that the price
elasticity of demand for demerit goods is low – primarily due to the lack of substitutes. There is also the
black market effect; high taxes make it profitable for illegal sales of alcohol and tobacco – some studies put
forward that the resulting criminality actually imposes even greater costs on society than legal consumption
of the good would! (See for example the on-going debate in the US and Mexico as whether to legalise
drugs.)

Another issue is how to tax a harmful good without having numerous negative spin-off effects. One third of
US citizens are now clinically obese costing some USD147 billion in obesity related medical care and the
US has debated for years on the possibility of a ‘fat tax’ aimed at reducing the consumption of sugary and
fatty foods – ‘junk food’ in daily slang.13 The difficulty is that in aiming for, say, a decrease in the
consumption of sugar via a tax, firms producing ethanol or using sugar as a flavour enhancer in food
production will see costs rise. Also, which goods are healthy and which are unhealthy – a banana or grapes
might well wind up in the same tax bracket as a chocolate bar! A key issue with economists is also that a
tax on sugary/fatty foods becomes highly regressive – lower income groups will pay a larger proportion of
their income in tax.

As for government policies aimed at demand, educating and informing citizens of the real costs of use can
change market demand and thereby correct over-consumption of goods. Yet this is often a long term plan
over generations as evidence suggests that anti-drinking campaigns and ‘health awareness blitzes’ have
limited longevity in the hearts and minds of consumers. Societal mores and traditions take a long time to
change it would seem.

12
We were driving on the highway outside of Windhoek, Namibia when a most eye-catching sign appeared
by the side of the road. Apart from the less-than-subtle sign itself, which read ‘Drink kills’, there was an
additional extra to really drive the point home, so to speak. A smashed-up car had been wrapped around
one of the poles holding the billboard up. A most effective message. Another ad we saw frequently in
Namibia was an AIDS poster where a young lady says ‘My boyfriend said that using a condom takes all the
fun out of it. Boy did I have fun proving him wrong!’
13
Wall Street Journal; “Cost of Treating Obesity Soars”, July 28 2009. To date only Norway, Finland and
Hungary have introduced some form of ’fat taxes’ on pre-packaged foods with high salt or sugar content.
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Summary and revision (need a cool pic here….maybe a pic of someone doing push-ups!)

1. Negative externalities in production occur when firms do not see the costs to third
parties and thus over-produce the good in terms of societal welfare. Common examples
of negative externalities in production are air pollution, water pollution, noise pollution
and deforestation resulting in soil erosion and/or desertification.
a. The extent of the externality is the difference between the marginal social
costs and the marginal private costs (MPC > MSC)
b. The welfare loss is the allocative loss in overproducing a good. The sum of all
units produced where the marginal social cost is greater than the marginal social
benefit (MSC > MSB)shows the welfare loss to society.

2. Possible solutions to negative externalities in production are:

a. Expenditure taxes on the good
b. Polluter pays principle – property rights are assigned and offenders must pay
for the damage caused ‘
c. Extension/allocation of property rights giving firms a vested interest in
taking care of the property
d. Tradable permits – maximum levels of pollution are established and ‘pollution
permits’ can then be bought and sold on an open market. The aim is that the
most efficient firms (= least polluting) have an incentive to pay the most for
additional permits.

3. Negative externalities in consumption occur when consumers do not see the costs to
third parties and thus over-consume the good in terms of societal welfare. Common
examples of negative externalities in consumption are the health and social effects of
tobacco and alcohol (e.g. demerit goods).
a. The extent of the externality is the difference between the marginal social
benefit and the marginal private benefit (MSB < MPB)
b. The welfare loss is the allocative loss in over-consuming a good. The sum of
all units produced where the marginal social cost is greater than the marginal
social benefit (MSC > MSB)shows the welfare loss to society.

4. Possible solutions to negative externalities in consumption are:

a. Decreasing supply by way of expenditure taxes on the good
b. Decreasing supply via regulation of opening hours, access to the good by way
of age limits
c. Decreasing demand by using negative advertising and awareness campaigns