Topic 4:

Externalities, Pollution
and Global Warming
ECON 1210
Economics and Society
Fall 2023

1
Introduction
⚫ Recall: Markets are usually a good way to
organize economic activity
⚫ In the absence of market failures, the market
outcome is efficient, maximizes total surplus
⚫ One major type of market failure: externalities
⚫ Externality: the uncompensated impact of
one person’s actions on the well-being of a
bystander

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Externalities and Efficiency
⚫ In the presence of externality, market
equilibrium is no longer efficient
⚫ Individual’s estimates of resources value (or
cost) are not correct (from the society’s point
of view)
⚫ Traditional belief: Government to step in to
ensure efficient resource allocation
⚫ And to protect the interest of bystanders as
well
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Negative Externality
⚫ Negative Externality: the effect on bystanders
is adverse
Example:
⚫ the neighbor’s barking dog

⚫ talking on cell phone while driving makes the

roads less safe for others
⚫ health risk to others from second-hand smoke

⚫ noise pollution from construction projects

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Pollution: A Negative
Externality
⚫ Firms burn huge quantities of fossil fuels
(coal, natural gas, oil) that cause acid rain
and global warming
⚫ Firms dump toxic waste into rivers, lakes, and
oceans
⚫ These environmental issues are
simultaneously everybody’s problem and
nobody’s problem

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Pollution: A Negative
Externality
⚫ Example of negative externality:
Air pollution from factory
⚫Firm does not bear the full cost

of its production, so will produce

more than the socially efficient quantity
⚫ How govt may improve the market outcome:
⚫ Impose a corrective tax on the firm equal to
the external cost of the pollution it generates
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 Recap of Welfare Economics
P The market for gasoline
$5
The market eq’m
maximizes consumer
+ producer surplus.
4
Supply curve shows
3 private cost, the costs
$2.50 directly incurred by sellers.
2
Demand curve shows
private value, the value
1
to buyers (the prices they
are willing to pay).
0
0 10 20 25 30 Q
(gallons) 7
Analysis of a Negative
Externality
⚫ Key: distinguish private and social costs
⚫ Private costs and social costs diverge in
the presence of externality
⚫ Producer concerns private cost, which
neglect the external cost (pollution cost)
⚫ Social cost represents the resource cost to a
society
⚫ social cost = private cost + external cost

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Analysis of a Negative Externality
P The market for gasoline
$5 Social cost
=private+ external cost
4 external
cost External cost
3 = value of the
negative impact
2 on bystanders
= $1 per gallon
1 (value of harm
Supply (private cost)
from smog,
0 greenhouse gases)
0 10 20 30 Q
(gallons) 9
Analysis of a Negative Externality
P The market for gasoline
The socially
$5 optimal quantity
Social
cost is 20 gallons.
4
S At any Q < 20,
3 value of additional gas
exceeds social cost.
2
At any Q > 20,
D
social cost of the
1
last gallon is
greater than its value
0
0 10 20 25 30 Q to society.
(gallons) 10
Analysis of a Negative Externality
P The market for gasoline
$5 Mkt eqm (Q = 25)
Social
cost is greater than
4 social optimum
S
(Q = 20).
3 overproduction
resulted in DWL
2 (red triangle)
D One solution:
1 impose a corrective
tax of $1/gallon on
0 sellers, shift supply
0 10 20 25 30 Q
(gallons) curve up $1 11
 Internalizing the Externality
⚫ Internalizing the externality: altering
incentives so that people take account of the
external effects of their actions
⚫ previous example: $1/gallon tax on sellers
makes sellers’ costs equal to social costs
⚫ When market participants must pay social costs,
the market eqm matches the social optimum.
⚫ Imposing the tax on buyers would achieve the
same outcome: market Q will equal optimal Q
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Summary For Pollution: A
Negative Externality
With negative externality, QMarket >QSocial Optium
firms over-produce (DWL exist)
→Remedy: The government can internalize the
externality by imposing corrective tax
Price S’

S Q = Qmarket = initial eqm

tax
Q’ = QSocial Optium = eqm after tax
D

Q’ Q Quantity 13
Externality in Consumption
⚫ Consumption of alcohol, tobacco, and
gasoline (private driving) all create negative
externality to the society
⚫ Govt impose a heavy corrective tax on these
goods to alter the incentives of customers, in
order to mitigate of negative externality

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Corrective Tax Rate
(Levy / Charges) in HK
⚫ Alcohol: 100% tax rate for alcohol with
strength of more than 30% by volume
⚫ Cigarettes: $2.5 / each cigarette, tax for a
pack of 20-stick cigarettes = $50
⚫ About 67% of the selling price of $74 / pack

⚫ Unleaded petrol: $6.06 / litre

⚫ About 25% of the selling price of each litre
of gasoline
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Example: Gasoline Tax Targets
3 Negative Externalities
⚫ Congestion: the more you drive, the more
you contribute to congestion
⚫ Accidents: larger vehicles cause more
damage in an accident
⚫ Pollution: burning fossil fuels produces
greenhouse gases

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Case Study: Environmental
Levy on Plastic Shopping Bags
in HK
⚫ Survey indicates that some 8 billion
(8,000,000,000) plastic shopping bags are
disposed of at landfills every year in HK
⚫ This translates into more than 3 plastic
shopping bags per person per day, which
apparently go beyond our needs

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Case Study: Environmental Levy
on Plastic Shopping Bags in HK
⚫ Address the problem of
abuse, gov introduced
an levy of $1 HKD on
each plastic shopping
bag at the retail level
⚫ Estimated negative
externality of each
plastic bag = ?

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 Positive Externality
⚫ Positive Externality: the effect on bystanders is
beneficial
Example:
⚫ When you get a flu vaccination, everyone you
come into contact with benefits
⚫ Research and Development (R&D) creates
knowledge others can use
⚫ Renovating your house increases neighboring
property values
⚫ Restores of historical building 19
Positive Externalities from
Education
⚫ A more educated population benefits society:
⚫ lower crime rates: educated people have
more opportunities, so less likely to rob and
steal
⚫ better government: educated people make
better-informed voters
⚫ People do not consider these external
benefits when deciding how much education
to “purchase”
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Positive Externalities from
Education
⚫ Result: market eqm Q of education too low
⚫ How govt may improve the market outcome:
⚫ subsidize cost of education

⚫ In the presence of a positive externality,

the social value of a good includes
⚫ private value: the direct value to buyers

⚫ external benefit: the value of the

positive impact on bystanders
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Analysis of a positive externality
P The market for flu shots
External benefit
$50 = $10/shot

40
▪ Draw the social
value curve
S
30 ▪ Find the socially
optimal Q
20 ▪ What policy
would internalize
10 this externality?
D

0 Q 22
0 10 20 30
Analysis of a positive externality
Mkt eqm Q = 20
P The market for flu shots
$50 Social optimal Q = 25
external Underproduction
40 benefit resulted in DWL (red
triangle)
S
30
Social value
20 = private value
+ $10 external benefit
10 To internalize the
D
externality, use
0 Q subsidy = $10/shot
0 10 20 25 30 23
Summary: Corrective Tax and
Subsidy to Deal With
Externalities
⚫ If negative externality
⚫ market produces a larger quantity than is
socially desirable
⚫ If positive externality
⚫ market produces a smaller quantity than is
socially desirable

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Summary: Corrective Tax and
Subsidy to Deal With
Externalities
⚫ remedy the problem: “internalize the
externality”
⚫ tax goods with negative externalities
⚫ ideal corrective tax = external cost

⚫ subsidize goods with positive externalities

⚫ ideal corrective subsidy = external benefit

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Public Policies Toward
Negative Externalities
Market-based policies
⚫ provide incentives so that private decision-
makers will choose to solve the problem on
their own
⚫ Corrective Tax

⚫ Tradable Pollution Permits

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Public Policies Toward
Negative Externalities
Command-and-control policies: Regulation
⚫ regulate behavior directly. Examples:

⚫ limits on quantity of pollution emitted

⚫ requirements that firms adopt a particular

technology to reduce emissions

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Policy Option: Example

⚫ “Ace Electric” and “Billy Power” both are

running coal-burning power plants
⚫ Each emits 40 tons of sulfur dioxide per
month
⚫ SO2 causes acid rain & other health issues

⚫ Policy goal: reducing SO2 emissions 25% to

60 tons/month

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Policy Option: Regulation Vs
Corrective Tax
⚫ Policy options
⚫ 1. regulation: require each plant to cut
emissions by 25%
⚫ 2. corrective tax: make each plant pay a tax
on each ton of SO2 emissions. Set tax at
level that achieves goal.

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Policy Option: Regulation Vs
Corrective Tax
⚫ Under Policy option 1, regulation, firms have
no incentive to reduce emissions beyond the
25% target
⚫ Suppose cost of reducing emissions is
lower for “Ace Electric” than for “Billy
Power”
⚫ Socially efficient outcome: “Ace Electric”
reduces emissions more than “Billy
Power”
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Policy Option: Regulation Vs
Corrective Tax
⚫ Corrective tax is a price on the right to pollute
⚫ Under policy option 2, tax on emissions gives
firms incentive to continue reducing emissions
as long as cost of doing so is less than the tax
⚫ If a cleaner technology available, tax gives
firms incentive to adopt it
⚫ Tax payment is money!

⚫ So, corrective taxes enhance efficiency by

aligning private with social incentives
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Policy Option: Tradable
Pollution Permits
⚫ Recall: “Ace Electric” and “Billy Power” each
emit 40 tons SO2, total of 80 tons.
⚫ Goal: reduce 25% emissions to 60
tons/month
⚫ Policy option 3: Tradable Pollution Permits
⚫ issue 60 permits, each allows its holder to
emit one ton of SO2
⚫ govt sell 30 permits to each firm

⚫ establish market for trading permits

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Policy Option: Tradable
Pollution Permits
⚫ Each firm can choose among these options:
⚫ emit 30 tons of SO2, using all its permits

⚫ emit < 30 tons, sell unused permits

⚫ buy additional permits so it can emit > 30

tons

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Policy Option: Tradable
Pollution Permits
⚫ A system of tradable pollution permits
achieves goal at lower cost than regulation
⚫ Firms with low cost of reducing pollution
(Ace Electric) sell whatever permits they
can
⚫ Firms with high cost of reducing pollution
(Billy Power) buy permits
⚫ Result: incentive to reduce pollution: permit =
money
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Tradable Pollution Permits
in the Real World
⚫ Emission of greenhouse gases causes the
global warming
⚫ The primary greenhouse gas in the
atmosphere is the emission of carbon dioxide
⚫ Carbon emissions trading is a form of
emissions trading that specifically targets
carbon dioxide

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Tradable Pollution Permits
in the Real World
⚫ Carbon emissions permits traded in Europe
since Jan 1, 2005
⚫ Recall: permit = money

⚫ Firms will have strong incentive to reduce

carbon emissions

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