EXTERNALITIES

Chapter 13
An externality is the cost or benefit that affects a third party
who did not choose to incur that cost or benefit. An
externality is a cost or benefit caused by a producer that is
not financially incurred or received by that producer.
An externality can be both positive or negative and can
stem from either the production or consumption of a good
or service. The costs and benefits can be both private—to
an individual or an organization—or social, meaning it can
affect society as a whole or even resources like a river.
Negative EXternalities
or
External costs
External costs of production
These are the negative spillover costs of consumption or
production that are incurred by third parties.

Examples:

❖ Pollution- air, noise, water etc.

❖ Traffic
❖ Overcrowding
❖ Resource depletion
Positive externalities
Or
External benefits
External benefits
These are the positive spillover benefits of consumption or
production that are enjoyed by third parties.

Examples:

❖ Education
❖ Health care
❖ Vaccinations
❖ Research and development (R&D)
Social costs
Smoking

Private costs: costs of an economic activity to individuals and

firms.

Smoker private cost= $100 spent/ month on cigarettes

Smoking external cost: passive smoking etc.

Social costs: cost of an economic activity to society as well as

the individual or firm

Smoking social cost: $100/ month + passive smoking etc.

Property development
Private cost= $200 m financial
cost of the project

External costs= noise +

congestion etc.

Social costs= $200 m + noise +

congestion + other external
costs/ negative externalities
SOCIAL COSTS = PRIVATE COSTS +
EXTERNAL COSTS
Social benefits
Property development
Private benefits: benefits/ rewards of an
economic activity to individuals and firms.

Private benefit= financial rewards from

investment like rent

External benefit: employment + recreation etc.

Social benefit: benefits of an economic

activity to society as well as the individual
or firm

Social benefit: rent+ employment etc.

SOCIAL benefitS = PRIVATE benefits +
EXTERNAL benefits
Government policies to deal with
externalities
taxation
Reduce external costs of production and consumption

● Tax imposed on polluting firm or good will increase the costs of

production
● Fall in supply, supply curve shifts to the left
● This creates a shortage and prices increase
● This leads to a fall in quantity demanded
● If goods are addictive i.e. inelastic demand, demand may not fall
by much BUT the government will earn a lot of tax revenue which
they can use to fund campaigns to reduce costs etc.
● Amount of tax should be equal to the external cost in theory
● After the tax the firms/ consumers are forced to consider the costs
that they were ignoring- hence higher costs due to taxes will
increase the price. This reduces consumption and creates a more
socially efficient outcome.
● If a good has a negative externality, without a tax, there will be
over-consumption and pollution.
Taxes to reduce external
costs
If the external
costs of driving a
car are estimated
at 2p per mile,
this is how the tax
on petrol should be
calculated.

Taxes INTERNALISE
the externality.
subsidies
Incentive to reduce external
costs
● Subsidies to rail companies
or recycling companies
● Motivate people to recycle
● Take traffic off the roads
and reduce carbon emissions.
Will also reduce demand for
new roads and associated
costs.
Subsidies have opportunity costs for
the government
Incentive to increase
external benefits
● Subsidies to solar energy
or university students
● Both cases - reduction in
cost and price leading to
these products becoming
more affordable and
increasing consumption
Government policies to deal with
externalities
review...
Taxes Subsidies

● Difficult to calculate ● Difficult to calculate

amount of tax amount of subsidy
● Effectiveness depends ● Producers can become
on elasticity complacent
● Tax evasion ● Opportunity costs for
the government
fines
 Reduce external costs
Fines impose a financial
penalty on polluters that
motivates them to stop
polluting. It reduces the
profit of businesses that
pollute e.g. in China six
companies were fined $26m for
discharging waste chemicals
into rivers.
Government
regulations
 Laws to protect the environment
Example- UK Environment Act 1995- was setup to monitor and control pollution- laws
pertaining to polluted land, emissions, national parks etc.

Environment laws in Bangladesh

● The Environment Conservation Act 1995- outlining the standards of the air,
water etc.
● The Environment Court Act 2010- aims to create a speedy disposal of cases
● The Brick Manufacturing and Brick Kilns Establishment (Control) Act 2013-
restrictions regarding areas and use of raw materials like wood for fuel
● The Bangladesh Biodiversity Act 2017
● The Bangladesh Water Act 2013

Not easy to force people to obey laws. Governments may not have the resources or
commitment for enforcement. Polluting companies may be very powerful.Business cost
increases
Permits & Review
Pollution permits
Pollution permits involve giving firms a legal right to
pollute a certain amount e.g. 100 units of Carbon
Dioxide per year. If the firm produces less pollution
it can sell its pollution permits to other firms. This
helps raise profits. However, if it produces more
pollution it has to buy permits from other firms or the
government.

But

● Pollution is difficult to measure so it is difficult

to decide the number of permits.
● Also the costs of permit administration is very high
Review
1. 310/ 90 x 100= 344.4%
2. Pollution levels are extremely high.
a. 16 out of 20 most polluted cities
b. ⅕ of city dwellers breathe in bad hair
c. Airports closed due to bad visibility
d. 60% of underground water supplies is polluted
3. Legislation and a system of fines to combat
air and water pollution
4. Easy to make legislation but difficult to
enforce. But the Chinese authorities have the
resources and power to enforce laws.
Data
https://www.tbsnews.net/bangladesh/environment/bangladesh-earns-
17m-carbon-credits-just-tip-iceberg-613410
Bangladesh earned its first-ever revenue
from carbon credits way back in 2006,
when the Idcol registered its maiden
clean development mechanism project with
the UN Framework Convention on Climate
Change. Since then, Idcol has sold a
whopping 2.53m carbon credits, raking in
$16.25m, equivalent to Tk170 crore at
current exchange rates.

Most of this impressive carbon credit

revenue came from improved cook stoves,
while the remaining amount was generated
from solar home systems.

Bangladeshi suppliers of RMG could soon

emerge as potential buyers of carbon
credits as their global clients are
increasingly demanding carbon emission
offset in their factories.

However, Bangladesh faces several

challenges in realising its goals for
carbon credit sales. Some of these
hurdles include a lack of awareness and
capacity among stakeholders,
insufficient funding, and a shortage of
skilled manpower.