CHAPTER 3

EXTERNALITIES AND GOVERNMENT

POLICY

INSTRUCTIONAL OBJECTIVES
Chapter 3 introduces the student to the important concept of an externality. Externalities are defined
simply as costs or benefits of market transactions not reflected in prices. This definition concentrates the
student's attention on market failure to achieve efficiency when externalities are present. The chapter
seeks to provide students with an understanding of why markets fail to achieve efficiency when
externalities exist. A few extended examples are developed to show students how prices fail to reflect
marginal social benefit or marginal social cost when positive or negative externalities exist in competitive
markets.

Another objective of the chapter is to discuss alternative means of internalizing externalities to achieve
efficiency. Externalities are internalized when marginal private cost (or marginal private benefit) is
adjusted so that resource users consider the actual marginal social cost (or marginal social benefit) of their
actions when making decisions. The text considers corrective taxes (or subsidies), emissions standards,
and property rights assignment (the Coase theorem) as alternative means of internalizing externalities.
The advantage and disadvantage of each approach are highlighted for the student. The discussion is often
very pragmatic and it considers the transactions costs and data requirements for implementing each
scheme.

CHANGES IN THIS EDITION

The discussion of pollution rights and sulfur dioxide allowances has been updated. There is a lot more
information on the trading of emissions rights and the prices of the allowances under the acid rain
program. The discussion in the International View has been updated with a discussion of Kyoto Protocol.
References and Internet Resources have been updated.

CHAPTER OUTLINE
Externalities: A Classification and Some Examples

Externalities and Efficiency

Negative Externalities
Positive Externalities

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Internalization of Externalities
Corrective Taxes: A Method of Internalizing Negative Externalities
Internalizing Negative Externalities Associated with Goods Sold in Imperfectly
Competitive Markets
Corrective Subsidies: A Means of Internalizing Positive Externalities

Property Rights to Resource Use and Internalization of Externalities: The Coase Theorem
Exchange of Property Rights to Internalize a Negative Externality: An Example
Illustrating the Coase Theorem
An Alternative Property Rights Assignment
Significance of the Coase Theorem
Applying the Coase Theorem: Pollution Rights
Efficient Pollution Abatement Levels

Public Policy Perspective: Recycling

Environmental Protection Policies in the United States

Emissions Standards versus Corrective Taxes
Command and Control Policies and Environmental Quality

Public Policy Perspective: Markets for Pollution Rights in Practice–Sulfur Dioxide

Allowances
More on Market-based Approaches to Pollution Control: How Trading Pollution
Rights Can Reduce the Cost of Environmental Protection

International View: Global Pollution—Externalities that Cross Borders

MAJOR POINTS AND LECTURE SUGGESTIONS

1. Emphasize that an externality is basically an unpriced cost or benefit of market activity. You may
wish to point out that nonmarket activities could also generate externalities. For example, home
production of goods and services not for sale is basically an implicit transaction for which the
producer is also the consumer. In such cases the producer could impose marginal costs or benefits
on his neighbors that are not considered in his decisions.

2. Students readily grasp the idea that a negative externality prevents attainment of efficiency because
the marginal social cost exceeds the marginal social benefit of output at the competitive equilibrium.
Figure 3.1 in the text makes this clear to the student and demonstrates that the equilibrium occurs at
the point at which MSB = MSC. Efficiency requires that MPC + MEC = MSB. You could point out
to your students that common environmental problems, such as pollution, constitute externalities
only if the marginal external cost is in fact positive. If an environmental resource that has no
alternative use is damaged by pollution, there is no externality because the MEC = 0.

3. Students seem to have more difficulty grasping the concept of a positive externality than they do in
grasping negative externalities. The example in the text relating to inoculations is one that students
seem to understand easily. First make clear to students that when a positive externality exists, MSB
> MSC at the market equilibrium. To achieve efficiency, output must be increased up to the point at
which MPBi + MEB = MSB. To accomplish this, the price paid by consumers must decline to
induce them to purchase more of the good. However, the price received by sellers must increase

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except in cases for which supply is perfectly inelastic. Figure 3.2 in the text shows the gains in
efficiency possible from internalizing a positive externality.

4. Note that Figure 3.3 shows how the market can achieve an efficient output for a positive externality
whose marginal value declines with output. This is an important conclusion. It implies that no
government intervention is required in cases for which MEB = 0 at the market output.

5. Note that my development of the notion of internalizing an externality is much more complete than
that found in competing texts. I emphasize the information costs involved in identifying parties
involved in an externality and in measuring the monetary value of the marginal costs and benefits.

6. Students are very receptive to the discussion of corrective taxes in the text. They often ask me why
the technique is not used more often. They do, however, readily understand the political problems
involved in agreeing on the tax and its magnitude. I emphasize the political aspects of the tax by
pointing out the gainers and losers in the process. I also make it clear to students that the tax does
not reduce emissions to zero. It merely forces emitters to pay the marginal external cost of their
emissions. I also point out the possible uses for the collected tax revenue, including compensation
for the total external cost remaining after the externality is internalized.

7. I also introduce the theory of second best with an analysis of internalization of externalities in
noncompetitive markets. The important point for students to understand here is that when
monopolistic power results in less than the efficient output, a corrective tax to internalize an
externality must be less than the marginal external cost. In the example used in the text the
distortion due to monopolistic power exactly offsets the distortion due to the negative externality.
No corrective tax is necessary to achieve efficiency in this case.

8. The analysis of corrective subsidies emphasizes how the subsidy must reduce the price paid by
consumers by MEB to achieve efficiency. Go through this example carefully in class because
students seem to have a hard time with it. In addition, return to Figure 3.3 in the text and ask
students to determine the corrective tax required for efficiency for each of the supply curves S and
S'.

9. My discussion of the Coase theorem is much more complete than that found in any competing text.
I believe that a discussion of the Coase theorem helps students understand the source of externalities
and the role of government in controlling their undesirable effects. I emphasize that government can
internalize externalities when transactions costs of exchanging property rights are zero merely by
assigning those rights and encouraging their exchange. I also make clear to the students that this
assures efficiency independent of which competing user for the resource in dispute is assigned the
property right. The example in the text uses land as the disputed resource. The two competing users
are a beef producer and a wheat farmer. The graphs in Figure 3.7 of the text show how the marginal
cost of wheat depends on the output of beef. Make it clear to students that when the beef producer
has the right to use all unfenced land for grazing, his costs include the foregone payment of the
farmer to reduce the size of his herd. This increases his marginal costs in the same way as would be
the case if he were liable for damages. Note as well how the text shows that no matter who is
assigned the rights, the users will choose the alternative to internalize the externality that gives them
maximum profits. The mix of wheat and beef output on the land will be efficient no matter who is
granted the property right.

10. The application of the Coase theorem to pollution rights is particularly relevant because markets for
pollution rights are now being established. The Public Policy Perspective in the chapter discusses
how the Clean Air Act of 1990 established a market for pollution rights. There is a discussion of

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how the provisions of the act have been put into practice and a graph shows how the price of the
allowances has varied since the inception of the trading program to control sulfur dioxide emissions
and reduce acid rain.

11. Emissions standards remain the dominant means of controlling externalities in the United States.
The graphs in Figures 3.10 and 3.11 show students how rigid emissions standards cause losses in
efficiency when the marginal social benefit of emissions (in terms of increased profits of emitters)
differs among firms, or the marginal external cost of emissions varies among regions. Students
really see the light when comparing the current policies with the idea of the corrective tax. Also
point out to them that standards allow emitters to emit wastes free of charge up to the point at which
they reach the standards then now more emissions are allowed no matter what the value of the right
to emit to the firm. Also point out that emissions standards are often difficult to enforce as are most
command and control policies.

12. When discussing pollution rights point out how trading of rights to emit can achieve a given
reduction in pollution at lower cost that command and control policies. The text now includes a
numerical example to help convince students on the cost savings that can result from market-based
approaches to pollution control.

13. It is important for students to have an international perspective on environmental problems. The
international view at the end of the chapter discusses issues relating to ozone depletion and global
warming.

14. Students might be surprised to find out that recycling is not necessarily an efficient means of
dealing with the problem of disposal of solid wastes. The Public Policy Perspective in this policy
might be a useful way of showing how economic analysis helps focus on resource use and
efficiency.

QUESTIONS AND PROBLEMS

TRUE-FALSE QUESTIONS

1. If a negative externality exists for sales of gasoline in a competitive market, more than the efficient
amount of gasoline will be sold per year. (T)

2. If the marginal external cost of pollution increases with the annual output of polluting goods, then
the total external cost will increase at a constant rate with annual output. (F)

3. When a positive externality exists, benefit to third parties other than the buyers and sellers of a good
will result from market exchange of the good. (T)

4. The marginal external benefit of the sale of smoke detectors in a city declines with annual output.
The total external benefit of smoke detectors will therefore eventually become zero. (F)

5. When a negative externality exists, the marginal social cost of annual output sold in a competitive
market will exceed the marginal social benefit of that output in equilibrium. (T)

6. If a negative externality is associated with the sale of wood stoves, then the marginal private cost of
those stoves is less than their marginal social cost. (T)

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7. If a positive externality is associated with college enrollment, then when college instruction is
provided in a competitive market, the marginal social benefit of enrollment will exceed its marginal
social cost in equilibrium. (T)

8. At the current level of annual supply of inoculations against polio, the marginal external benefit of
an inoculation is zero. To achieve efficiency, a corrective subsidy must be provided to those being
inoculated. (F)

9. To internalize an externality, a corrective tax must be set equal to the marginal external cost. (T)

10. According to the Coase theorem, corrective taxes are necessary to internalize negative externalities
when the transactions costs of exchanging property rights to use resources are zero. (F)

MULTIPLE-CHOICE QUESTIONS

1. A negative externality results from the sale of firewood in competitive markets. It follows that the
marginal private
a. cost of firewood is less than its marginal social cost.
b. cost of firewood exceeds its marginal social cost.
c. benefit of firewood is less than its marginal social benefit.
d. benefit of firewood exceeds its marginal social benefit.

2. If a negative externality prevails in a competitive market for air travel, then

a. more than the efficient amount of annual air travel will be consumed in equilibrium.
b. less than the efficient amount of annual air travel will be consumed in equilibrium.
c. the marginal social cost of air travel will exceed its marginal social benefit in equilibrium.
d. both (a) and (c) are true.
e. both (b) and (c) are true.

3. A positive externality results from the purchase of smoke detectors. If smoke detectors are sold in a
competitive market,
a. the marginal social benefit of smoke detectors is less than the marginal private benefit received
by any consumer.
b. marginal social benefit will exceed the marginal private benefit received by any consumer.
c. in equilibrium the marginal social cost of smoke detectors will equal the marginal social benefit.
d. in equilibrium the marginal social benefit of smoke detectors is zero.

4. The marginal external cost associated with air pollution increases with the annual output of a
polluting industry. At the current competitive equilibrium level of output per year, the marginal
external cost is $10 per unit output. To achieve efficiency, a corrective
a. tax of $10 per unit output is required.
b. tax of more than $10 per unit output is required.
c. tax of less than $10 per unit of output is required.
d. subsidy of $10 per unit output is required.
e. subsidy of less than $10 per unit output is required.

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5. The marginal external cost associated with paper production is constant at $10 per ton per year. The
competitive market equilibrium for paper production is currently 10 million tons per year. A
corrective tax on paper production will
a. collect $100 million annually.
b. collect more than $100 million annually.
c. collect less than $100 million annually.
d. reduce annual damages to those other than buyers and sellers of paper to zero.
e. Both (a) and (d) are true.

6. The marginal external cost per unit of effluent discharged into a river by a perfectly competitive
chemical industry is currently estimated at $50 per ton per year.
a. Efficiency can be achieved with a $50 per ton annual effluent charge.
b. At the competitive equilibrium output, the marginal social benefit of discharging effluent is $50.
c. Efficiency can be achieved by banning discharge of effluent.
d. At the efficient output, the marginal social benefit of discharging effluent will be zero.

7. Electric power is produced by an unregulated monopoly in a certain region. The monopolistic

electric power company’s production of electricity results in $10 per kilowatt hour of pollution
damage to parties other than the buyers of electricity in the region. To achieve efficiency,
a. a $10 per kilowatt hour corrective tax is required.
b. more than $10 per kilowatt hour corrective tax is required.
c. a $10 corrective subsidy is required.
d. less than $10 per kilowatt hour corrective tax is required.

8. The competitive market equilibrium price of sanitation services in a small town with no government
supplied sanitation services is $2 per trash pickup. There is a $1 marginal external benefit associated
with each trash pickup. The elasticity of supply of garbage pickups is infinite in the long run
implying a horizontal supply curve. To achieve the efficient output of sanitation services,
a. a corrective subsidy must increase the price received by suppliers per pickup to $3.
b. a corrective subsidy must decrease the price paid by consumers of sanitation services to $1 per
pickup .
c. a corrective tax of $1 per pickup is required.
d. a corrective subsidy must increase the price paid by buyers to $3 per pickup.

9. The current competitive market price of fish is $3 per pound. A chemical producer emits effluent
into a lake used by a commercial fishing firm. Each ton of chemical output causes a 20 pound
reduction in the annual catch of the fishing firm. Assuming that transactions cost are zero, and the
chemical firm has the legal right to dump effluent in the lake,
a. the fishing firm would be willing to pay up to $60 per ton of chemicals per year to induce the
chemical firm to reduce chemical output.
b. the fishing firm would be willing to pay up $3 per ton of chemicals per year to induce the
chemical firm to reduce chemical output.
c. the chemical firm would never consider the damage caused by its effluent.
d. government intervention is required to achieve efficiency

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10. According to the Coase theorem, externalities can be internalized when transactions costs are zero
through
a. corrective taxes and subsidies.
b. effluent fees.
c. assigning property rights to resource use but outlawing their exchange.
d. assignment of property right to use resources and allowing free exchange of assigned property
rights.

ESSAY QUESTIONS

1. The marginal external cost associated with the emissions of sulfur dioxide is estimated to be $30 per
pound of this chemical per year. Assume that each ton of steel produced per year results in five
pounds of sulfur dioxide emissions. Suppose that the supply of steel is infinitely elastic at a price of
$500 per ton. The current equilibrium output of steel produced by a competitive industry is 10,000
tons.

a. Show how a corrective tax can be used to achieve efficiency. Predict the impact of the tax on
the equilibrium price and quantity of steel. Explain how steel companies will react to the tax.
Indicate the amount of tax revenue collected.

b. Discuss the political support for the tax. In your discussion show the net gain in well-being
possible from the tax and indicate which groups will gain and which groups will lose as a result
of its imposition.

2. How would you select an appropriate policy to internalize negative externalities associated with
pollution? In your answer indicate the information required to internalize a negative externality.
How do the transactions costs of exchanging the right to pollute affect the choice of policy? Explain
why there would be no negative externalities associated with pollution if the transactions costs of
establishing and exchanging the rights to pollute (or to have a pollution-free environment) were
zero.

ANSWERS TO TEXT PROBLEMS

1. P = $66.67 per ton and the quantity sold is 333,350 tons per year when sold in a competitive market.
To calculate the efficient output of paper add $20 to the demand price in the second equation and re-
solve for the efficient price. The efficient price is $83.33 and the efficient quantity is 316,670 tons
per year. A corrective tax of $20 per ton can achieve the efficient output.

2. The demand curve is obtained by plotting the data for MPB on the vertical axis and plotting quantity
on the horizontal axis. The difference between the marginal social benefit and marginal private
benefit is the MEB. At a price of $25 per gallon the market equilibrium is not efficient because there
is a marginal external benefit of $6 when 30 million gallons are sold per year. At a $15 price the
marginal external benefit is zero and the market equilibrium is therefore efficient.

3. a. The cost of meeting the standards is obtained by multiplying cost per ton for each plant and
summing the results, which gives $220,000 per year.

b. The least cost method would be to have plant 5 reduce its emissions by 500 tons per year,
which would cost only $100,000 per year

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4. At a $450 per ton charge, Plants 4 and 5 would cut back emissions at a total cost of $60,000. Plants
1, 2, and 3 would find it cheaper to pay the $450 fee rather than cut back emissions. The total
revenue generate buy the purchase of the pollution rights by these firms for the 300 ton reduction in
annually emissions would therefore be $135,000.

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