Lecture 2

Externalities
Marco Faravelli
University of Queensland
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Questions
• What are externalities?
• Why do externalities cause market failures?
• How to deal with the market failures due to externalities?
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Road Map
• Basic Concepts
• Examples
• Remedies for Externalities

▶ Private Bargaining
▶ Corrective Taxation
▶ Cap-and-Trade
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What are Externalities?
Definition:
Externalities arise whenever the actions of one party directly
affects the welfare of another party, yet the first party neither
bears the costs nor receives the benefits of doing so.
• “directly ” means that it is not because the first party’s

actions effect the market price.
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Definition:

• The activity can be consumption or production.
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Definition:

• The activity can be consumption or production.
• An externality can be negative or positive.
▶ negative externalities: the activity negatively affects
another.
▶ positive externalities: the activity positively affects
another.
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Examples
• Traveling by cars imposes several kinds of negative
externalities on others by:
▶ adding to traffic congestion and increases the traveling
time and delays of others;
▶ increasing the risk of hitting someone else;
▶ contributing to air pollution.
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Examples
• Use of fossil fuels imposes negative externalities on

everyones by contributing to global warming.
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Examples
• Use of fossil fuels imposes negative externalities on

everyones by contributing to global warming.
• Vaccination and preventive measures against contagious
diseases have positive externalities because they reduce
the risks of transmitting diseases to others.
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Measuring Externalities
• Air Pollution on House Value

(Chay and Greenstone, 2005)
• Traffic Congestion and Infant Health

(Currie and Walker, 2011)
• Accident Externalities of Driving

(Edlin and Karaca-Mandic, 2006)
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Does Air Quality Matter?
Evidence from the Housing Market
• Air pollution regulations are often controversial due to

lack of empirical evidence on their costs and benefits.
• If people value clean air, the air quality in a local area

should be capitalized into house prices.
• Chay and Greenstone (2005) investigate the effects of the

Clean Air Act Amendments on local air quality and
housing markets.
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• Total suspended particulates (TSPs)
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• Total suspended particulates (TSPs)
• Clean Air Act Amendments of 1970

▶ attainment counties (TSPs < 75µg/m3 )
▶ nonattainment counties (TSPs ≥ 75µg/m3 )
• Far more stringent regulations on polluters in

nonattainment counties.
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U.S. Air Quality since Clean Air Act Amendments of 1970
388
Fig. 1.—National trends in TSPs pollution, 1969–90. The data points are derived from the 169 counties that are continuously monitored in this
period. These counties had a total population of approximately 84.4 million in 1980. The annual county means were calculated as the weighted average
of the monitor-specific geometric means, where the weight is the number of monitor observations. The year-specific average is calculated as the weighted
average of the county-specific means, where the weight is the 1980 population.
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How Do We Know the Regulation Worked?
• Questions:
▶ Maybe the pollution was trending downward anyway.
▶ Maybe it was because something else.
• What if there was no Clean Air regulation?
• The fundamental challenge in causal inference:

▶ We don’t observe the counterfactual.
• Methods for causal inference:

▶ Randomized control experiment
▶ Natural experiments + econometric analysis
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A Detour: Difference-in-Differences
The Idea:
Look at a comparison group that is likely to have a parallel
trend of outcome in the absence of the intervention.
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How Much did the Presidency Age Obama?
An Illustration of an Empirical Question
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Before and After: 2009 v.s. 2016
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Treatment-Control Difference: 2008
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Difference-in-Differences
Diff-in-Diff = TC Difference in 2016 - TC Difference in 2008
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Attainment Counties & Nonattainment Counties
Fig. 6.—Incidence of 1975–76 TSPs nonattainment status. In the primary sample of 988 counties, there are 280 nonattainment and 708 attainment
counties. They are pictured in black and gray, respectively. The 2,169 counties without complete data are depicted in white. The nonattainment
designations are determined from the EPA’s Air Quality Subsystem Database. See the Data Appendix for further details.
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Average TSPs Concentration
396
Fig. 2.—1967–75 trends in TSPs concentrations, by 1972 attainment status. The data points are derived from the 228 counties that were continuously
monitored in this period. The 116 attainment counties had a 1970 population of approximately 25.8 million people, whereas about 63.4 million people
lived in the 112 nonattainment counties in the same year. Each data point is the unweighted mean across all counties in the relevant regulatory category.
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• Related to house value in attainment counties, house
value of nonattainment counties increases by about 2%.
• 1 µg/m3 reduction in TSPs results in 0.2% - 0.4%

increase in mean housing values.
• TSPs nonattainment designations lead to:

▶ Improved air quality
▶ $45 billion aggregate gain for homeowners
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Traffic Congestion and Infant Health
Evidence from E-ZPass
Motor Vehicles are a major source of air pollution:

• 50% of carbon monoxide (CO)
• 34% of nitrogen dioxide (NO2 )
• 29% of hydrocarbon emissions
• 10% of fine particulate matter (PM) emissions
These statistics are from the U.S. but keep in mind that Australia has the
highest per-capita carbon emission among developed countries.
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• Places with traffic congestion
have high concentration of
polluted air.
• Pregnant women and their

babies are particularly
vulnerable.
• Does traffic congestion

weaken health of newborns?
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• Why not compare newborns in places with traffic
congestion with those in places without?
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• Difficult to isolate all confounding factors and pin down

causality.
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causality.
• For example, omitted socio-economic statuses of mothers

may induce spurious correlation.
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causality.
• For example, omitted socio-economic statuses of mothers

may induce spurious correlation.
▶ Low incomes household may live in areas with more
traffic congestion.
▶ Infants born to mothers with low socio-economic status
may have poor health due to inadequate nutrition and
health care duration pregnancy.
▶ Positive correlation between traffic congestion and poor
health of newborns even if no causality exists!
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A Natural Experiment
Staggered Introduction of EZ-Pass
E-ZPass: an electronic toll collection system
Similar Systems in
Australia
QLD: Go Via
NSW: E-Toll
VIC: E-Tag
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Old-fashion toll collections create bottlenecks for traffics.
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Introduction of E-ZPass greatly reduced both traffic
congestion and vehicle emissions near highway toll plazas.
(e-TAG toll points on Melbourne’s CityLink)
Among mothers within 2 km of a toll plaza, introduction of

E-ZPass reduced:
• prematurity by 10.8%
• low birth weight 11.8%
(relative to mothers 2-10 km from a toll plaza)

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The Accident Externality from Driving
(Edlin & Karaca-Mandic, 2006)
• One’s driving increases the risks of others being involved

in an accident, either due to his/her faults or not.
• But after an accident, one only pays the damages
according to the apportionment of liabilities.
• A very cautious driver could still increase the others’ costs
of driving due to higher accident risks, simply because
there would be more cars on the roads to be hit.
• When a person decides to whether drive or not, he/she
does not include the social costs of increasing accident
probabilities.
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• Thus, the social costs of making traffic denser are not
internalized in decision-making.
• But how do we know? Maybe having more cars on the
roads slows down the traffic to the extend that it reduces
accidents?
• In that case, although driving has negative externalities
on traffic congestion and delay, it may even have positive
externalities on accidents.
• Since insurance companies pay out money to cover
damages from accidents, the insurer costs would partially
capture the accident externalities.
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Traffic Density and Insurer Costs
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Road Map
• Basic Concepts
• Examples

▶ Corrective Taxation
▶ Cap-and-Trade
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The Coase Theorem
If property rights are clearly assigned, parties could bargain to

internalize all costs and benefits, achieving social optimum.
• Ronald Coase (1960), hence a.k.a. Coasian solutions.

• For efficiency, it does not matter to which side the rights
are given.
• It works for both negative and positive externalities.
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How Coasian Bargaining Works?
An Example
• A textile factory can produce a ton of fabric to profit

$200 and pollute the river next to it.
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An Example

• A fisherman fishing in an unpolluted river can gain $500
but only $200 in a polluted river.
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An Example

• The socially optimal outcome is no fabric production and
no pollution.
▶ No fabric & no pollution: $500
▶ Produce & pollute: $400 = $200 + $200
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An Example

• The socially optimal outcome is no fabric production and
no pollution.
▶ No fabric & no pollution: $500
▶ Produce & pollute: $400 = $200 + $200
• But if the rights to use the river are unclear (or for other
reasons there is no bargaining), the textile factory ignores
the externalities of its production.
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Coasian Bargaining
• Suppose the fisherman has the rights to use the river

▶ No fabric production and no pollution
• Suppose the factory has the rights to use the river

▶ The fisherman could bargain with the factory to pay
them between $200 and $300 not to pollute.
▶ The factory would accept.
• In either case, socially optimal outcome is achieved.
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Limitations of Coasian Solutions
Private bargaining may not be practical if:
• the costs of bargaining are high.
▶ no point to bargain if gains is not enough to compensate
the bargaining costs.
▶ e.g. legal fees, time etc.
• the harmed parties can not identify who cause the

damages.
▶ otherwise bargain with whom?
▶ same for benefited parties (positive externalities).
• too many parties are involved.

▶ problems of coordination
▶ people have incentives to free ride
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Other Private Solutions
• Mergers
▶ To internalize the otherwise external costs or benefits,
the affected firms could merge with the firms generating
the externalities.
▶ The merged firms earn higher profits by setting the
“socially” efficient production level.
• Social conventions
▶ Social norms assign implicit property rights.
▶ inexpensive but takes time
• Class action lawsuits
▶ A large group of harmed individuals are collectively
represented by one or a few members of the group.
▶ The threads of class action lawsuits help with some
coordination problems but not all.
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Road Map
• Basic Concepts
• Examples

▶ Corrective Taxation / Subsidies
▶ Cap-and-Trade
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Positive Externality
An Example at A Korean Palace (Changdeokgung)
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Hanbok
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Hanbok inside the Palace
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Tourists on Hanbok Provide Positive Externalities
to Other Tourists
• Other tourists’ experience may be enhanced by the visual

of tourists wearing Hanbok in the old palace.
• Tourists on Hanbok hanging around the palace could be

considered a positive externality on other tourists.
• To encourage the provision of such visual “services,” the

palace waived the admission fees for visitors wearing
Hanbok.
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Corrective Tax or Subsidies
Recall that surpluses are maximized in market equilibrium
because:
1 Marginal Cost (MC) = Marginal Benefit (MB)
2 Without externalities:
private MC = private MB ⇒ social MC = social MB
With externalities:
private MC = private MB ⇏ social MC = social MB
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Market Equilibrium with Perfect Competition
Price
Supply
Demand
Quantity
Price
Supply
Demand
Quantity
Price
Supply
Demand
Quantity
Price
Supply
Demand
Quantity
Price
Supply
Demand
Quantity
Price
Supply
Demand
Quantity
Price
Supply
Demand
Quantity
Restoring Efficiency
• With positive production externalities, impose a subsidy
on production so that
private MC = social MC
• With negative production externalities, impose a tax on

production so that
private MC = social MC
a.k.a. Pigouvian taxation, due to Arthur Pigou (1920)
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An Example
• Demand:
P = 100 − Q
• Supply:
MC = P = 30
• One unit of production generates a negative externality:
Ext = 20
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P
Q
P
Demand
Q
P
Demand
30
MC
Q
P
Demand
30
MC
70 Q
P
Demand
50
MC + Ext
30
MC
70 Q
P
Demand
50
MC + Ext
30
MC
50 70 Q
P
Demand
50
MC + Ext
30
MC
50 70 Q
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Limitations of Corrective Taxes and Subsidies
To implement corrective taxes or subsidies and achieve social
optimum, the government needs information of the
externalities, which may depend on the production level.
Q
P
Demand
Q
P
Demand
30
MC
Q
P
Demand
30
MC
70 Q
P
MC + Ext
Demand
MC + Tax
30
MC
70 Q
P
MC + Ext
Demand
MC + Tax
30
MC
70 Q
P
MC + Ext
Demand
MC + Tax
30
MC
70 Q
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Emission Fees
• Corrective taxes weaken the incentives for the polluters to
produce.
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Emission Fees
produce.
• But what we really want is for the producers to just
reduce pollution.
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Emission Fees
produce.
reduce pollution.
• What if for the same level of production some firms
pollute less than others?
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Emission Fees
produce.
reduce pollution.
• What if firms can choose / invest in greener production
technologies?
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Emission Fees
produce.
reduce pollution.
technologies?
• Facing an uniform corrective tax on outputs, polluters
have no incentives to opt for greener production
processes.
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Emission Fees
produce.
reduce pollution.
technologies?
• Facing an uniform corrective tax on outputs, polluters
have no incentives to opt for greener production
processes.
• If practical, it may be better to charge emission fees than
to tax outputs.
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Cap-and-Trade
• Instead of imposing taxes or fees, the government could
issues permits to pollute.
• But unused permits could be sold to other polluters

needing more permits.
• Trading prices of pollution permits are more responsive to

inflation than fixed emission fees.
• But depending on situations, cap-and-trade may or may

not be more responsive to uncertainties of pollution
reduction costs and benefits.
• Cap-and-trade is transfer between firms, while emission

fee is a transfer from polluters to the government.
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Australia’s Carbon Pricing Scheme
• Enacted by the Gillard Government in 2012.
• It was scheduled to transition into cap-and-trade in 2015.
• But first with fixed emission fees (i.e. carbon tax).

▶ Effective July 1st, 2012
▶ $23.00 per tonne of emmited CO2 in FY 2012-13
▶ Applicable for entities which emit over 25,000 tonnes of
CO2 equivalent greenhouse gases per year.
▶ Exclude those in transport and agriculture sectors.
▶ The revenue raised was used to reduce income tax
through lifting tax-free thresholds.
• The whole scheme was repealed by the Abbott
Government in 2014.
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Command-and-Control Regulation
• Incentive-based regulations:
▶ Emissions fees
▶ Cap-and-trade
• Command-and-Control Regulation
▶ Technology standards
▶ Performance standards
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Command-and-Control Regulation
• Examples:
▶ corporate average fuel economy standards for all new
passenger vehicles
▶ Mandating all new power plants to install “scrubbers” to
remove particulates and reduce emissions.
• Less flexible
• But it could be better if it is very hard or costly for the

government to monitor emissions.
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Lecture 2

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Externalities

• What are externalities?

• Why do externalities cause market failures?

• How to deal with the market failures due to externalities?

• Remedies for Externalities

• “directly ” means that it is not because the first party’s

• “directly ” means that it is not because the first party’s

• “directly ” means that it is not because the first party’s

• Use of fossil fuels imposes negative externalities on

• Use of fossil fuels imposes negative externalities on

• Air Pollution on House Value

• Traffic Congestion and Infant Health

• Accident Externalities of Driving

• Air pollution regulations are often controversial due to

• If people value clean air, the air quality in a local area

• Chay and Greenstone (2005) investigate the effects of the

• Clean Air Act Amendments of 1970

• Far more stringent regulations on polluters in

• What if there was no Clean Air regulation?

• The fundamental challenge in causal inference:

• Methods for causal inference:

• 1 µg/m3 reduction in TSPs results in 0.2% - 0.4%

• TSPs nonattainment designations lead to:

Motor Vehicles are a major source of air pollution:

• Pregnant women and their

• Does traffic congestion

• Difficult to isolate all confounding factors and pin down

• Difficult to isolate all confounding factors and pin down

• For example, omitted socio-economic statuses of mothers

• Difficult to isolate all confounding factors and pin down

• For example, omitted socio-economic statuses of mothers

(e-TAG toll points on Melbourne’s CityLink)

Among mothers within 2 km of a toll plaza, introduction of

(relative to mothers 2-10 km from a toll plaza)

• One’s driving increases the risks of others being involved

• Remedies for Externalities

If property rights are clearly assigned, parties could bargain to

• Ronald Coase (1960), hence a.k.a. Coasian solutions.

• A textile factory can produce a ton of fabric to profit

• A textile factory can produce a ton of fabric to profit

• A textile factory can produce a ton of fabric to profit

• A textile factory can produce a ton of fabric to profit

• Suppose the fisherman has the rights to use the river

• Suppose the factory has the rights to use the river

• In either case, socially optimal outcome is achieved.

• the harmed parties can not identify who cause the

• too many parties are involved.

• Remedies for Externalities

• Other tourists’ experience may be enhanced by the visual

• Tourists on Hanbok hanging around the palace could be

• To encourage the provision of such visual “services,” the

private MC = private MB ⇒ social MC = social MB

private MC = private MB ⇏ social MC = social MB

• With negative production externalities, impose a tax on

a.k.a. Pigouvian taxation, due to Arthur Pigou (1920)

• One unit of production generates a negative externality:

• But unused permits could be sold to other polluters

• Trading prices of pollution permits are more responsive to

• But depending on situations, cap-and-trade may or may

• Cap-and-trade is transfer between firms, while emission

• It was scheduled to transition into cap-and-trade in 2015.

• But first with fixed emission fees (i.e. carbon tax).

• But it could be better if it is very hard or costly for the