14.

01 Microeconomics
Segment 31

Policy Solutions for Externalities

Sara Fisher Ellison

Possible solutions
• Externalties are ubiquitous and can sometimes be deadly serious (like air
pollution). We have, therefore, come up with a variety of policy levers to
deal with externalities.
• Market mechanism
• Pigouvian tax or subsidy
• Quota (cap)
• Tradable permit
• I’ll talk about how each of these would work and give examples. I will
do so in the case of a negative externality, but you could implement the
opposite (for instance a subsidy instead of a tax) for a positive
externality.
Smoking
• Consider the example of smoking in a restaurant. If three diners want to
smoke and the other 42 diners care a lot about not smelling smoke, the
“efficient” level of smoke in the restaurant would be small.
• Suppose we knew the socially-efficient price per puff was $5.53 and the
socially-efficient quantity was six puffs of smoke. (This would be a
function of the three smokers’ willingness to pay to smoke and the 42
non-smokers’ willingness to accept some amount of smoke.)
Market mechanism
• If we had a market mechanism, then, each smoker would be allowed to
take two puffs and then extinguish the cigarette. And they would each
pay $11.06, to be divided among the non-smokers, for an average
payment of 79¢ each.
• We might accomplish this transfer by the restaurant owners charging
more to smokers and refunding that extra revenue back to non-smokers.
Market mechanism
• The smoking example is a little silly, of course. (That’s not stopping me
from using it, though.)
• But we do see market mechanisms cropping up in certain circumstances
where externalities could be quite important.
• Recall the myriad externalities, positive and negative, that can come up in
a strip mall. The ownership structure of the strip mall was invented in
part to “internalize the externalities.”
• The mall owner could take the opinions of her tenants into consideration
when looking for a new tenant. Or there could be explicit clauses in the
lease contracts that lower all tenants’ rents if there is a vacancy or charge
higher rent to certain types of tenants, like massage parlors and banks.
 Not clear at all how sophisticated strip mall owners are
in internalizing externalities, despite it being in their
Market mechanism interest to do so!
• The smoking example is a little silly, of course. (That’s not stopping me
from using it, though.)
• But we do see market mechanisms cropping up in certain circumstances
where externalities could be quite important.
• Recall the myriad externalities, positive and negative, that can come up in
a strip mall. The ownership structure of the strip mall was invented in
part to “internalize the externalities.”
• The mall owner could take the opinions of her tenants into consideration
when looking for a new tenant. Or there could be explicit clauses in the
lease contracts that lower all tenants’ rents if there is a vacancy or charge
higher rent to certain types of tenants, like massage parlors and banks.
Tax
• We could calculate the tax necessary so that, in a restaurant with 3
smokers and 42 non-smokers, there would be six puffs of smoke.
• What would that amount be?
Tax
• We could calculate the tax necessary so that, in a restaurant with 3
smokers and 42 non-smokers, there would be six puffs of smoke.
• What would that amount be? $5.53 per puff, the amount that the
smokers were willing to pay per puff to be able to take an average of two
puffs each if we actually had a market mechanism.
• Unlike the market mechanism, the non-smokers would not be paid 79¢
each. (Maybe the tax revenues would be used to reimburse non-smokers
in some way.)
Tax
• Taxing negative externalities (and subsidizing positive ones) is common.
• Think about education. We all benefit from an educated population, so
we heavily subsidize it through 12th grade (in fact, it’s free) and then
continue to subsidize it with grants and low-interest loans post
secondary.
• We tax gasoline, because burning it in your car creates air pollution and
climate change, and cigarettes, because burning them in your mouth
creates air pollution and costs on the healthcare system.
Quota/cap
• Back to our smoking in a restaurant example.
• Here, we would just set the cap, or quota, of two puffs per smoker in a
restaurant, the efficient quantity if we had a market.
• Unlike in the tax and the market mechanism, there is no financial
transaction. Smokers do not have to pay. Non-smokers do not receive
compensation.
Quota/cap
• This is actually the solution we use for smoking in restaurants, but we set
the cap at zero puffs per smoker.
• We also use the opposite, a required minimum, for education. We
require that all children attend school until age 16 (I think).
Quota/cap
• This is actually the solution we use for smoking in restaurants, but we set
the cap at zero puffs per smoker.
• We also use the opposite, a required minimum, for education. We
require that all children attend school until age 16 (I think).

While all three of the policy levers we have seen achieve the
socially optimal quantity, the market mechanism is the most
complete we have seen, in some sense: all parties are charged or
compensated fully. A tax (subsidy) does not compensate
(charge) one party. A quota/cap does not charge or compensate
either party.
Tradable permit
• Tradable permits are similar to caps or quotas. The difference is that
market transactions involving those caps are allowed.
• In the smoking example, we would allow two puffs per smoker in a
restaurant, the efficient quantity if we had a complete market.
• The three smokers could decide amongst themselves how to allocate the
six puffs. In particular, if there was one smoker who had a higher
valuation for smoking than the other two, that person might be willing to
pay the other two for their puffs, which would be allowed under a
tradable permit system.
• Note that the initial allocation of permits matters to the distribution of
surplus.
 There can be strong allocative benefits to allowing trades between those
producing negative externalities. The trades help ensure that the
Tradable permit producers with the lowest cost of abatement are the ones that do the most.
• Tradable permits are similar to caps or quotas. The difference is that
market transactions involving those caps are allowed.
• In the smoking example, we would allow two puffs per smoker in a
restaurant, the efficient quantity if we had a complete market.
• The three smokers could decide amongst themselves how to allocate the
six puffs. In particular, if there was one smoker who had a higher
valuation for smoking than the other two, that person might be willing to
pay the other two for their puffs, which would be allowed under a
tradable permit system.
• Note that the initial allocation of permits matters to the distribution of
surplus.
 If the initial allocation of permits was given across all diners, then
the non-smokers could sell their permits and profit from the sale.
Tradable permit Whatever the allocation, the total number of permits should be six.
• Tradable permits are similar to caps or quotas. The difference is that
market transactions involving those caps are allowed.
• In the smoking example, we would allow two puffs per smoker in a
restaurant, the efficient quantity if we had a complete market.
• The three smokers could decide amongst themselves how to allocate the
six puffs. In particular, if there was one smoker who had a higher
valuation for smoking than the other two, that person might be willing to
pay the other two for their puffs, which would be allowed under a
tradable permit system.
• Note that the initial allocation of permits matters to the distribution of
surplus.
Tradable permit
• Tradable permits are similar to caps or quotas. The difference is that
market transactions involving those caps are allowed.
• In the smoking example, we would allow two puffs per smoker in a
restaurant, the efficient quantity if we had a complete market.
• The three smokers could decide amongst themselves how to allocate the
six puffs. In particular, if there was one smoker who had a higher
valuation for smoking than the other two, that person might be willing to
pay the other two for their puffs, which would be allowed under a
tradable permit system.
• Note that the initial allocation of permits matters to the distribution of
surplus. So, in some sense, this is like a cap/quota system that reintroduces the possibility of affected
parties being charged or compensated. But it all depends on the initial allocation.
Tradable permits in action
• Here’s a website where
anyone can buy a permit to
pollute.
• In fact, you could buy one
and choose not to use it,
decreasing the overall
allowable amount of some
pollutant.
• Environmental groups do
this.
 Learn all about these in environmental and/or energy economics.

Tradable permits in action

• Here’s a website where
anyone can buy a permit to
pollute.
• In fact, you could buy one
and choose not to use it,
decreasing the overall
allowable amount of some
pollutant.
• Environmental groups do
this.