Lecture 15:

Externalities
18 October 2023
ECON 1001
David Burk

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 From the News
One wealthy family installed a glass sculpture in their yard. Then installed a net
over the sculpture.
The sculptures and net were visible from the neighbors’ homes.
Fighting, including blaring of bad music ensued.
What is the effect on economic surplus of those sculptures? Should they be
allowed?

Story and pictures.

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 Recall…
• We have seen that well-functioning, perfectly
competitive markets lead to an efficient outcome.
• Under those conditions, a free market maximizes
economic surplus.
• But in some cases free markets fail.
• Externalities are one such case.

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Setting the Stage for Externalities
• Recall that the demand curve reflects the MB of
demanders and the supply curve reflects the MC of
suppliers.
• We showed that the efficient quantity is given by
where the two curves intersect
• But what if the production and consumption of a good
impacts other people?
• For example, what if a widget factory pollutes the water
which makes the townsfolks sick?
• What if the flowers that your neighbor plants improve the
view from your home office?
• The supply and demand curves don’t capture these
costs or benefits to other people!

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 Externality, Defined
• An activity has an externality if it imposes costs or
benefits on people other than the ones engaged in
the activity.
• Negative externality: When the activity imposes costs
on bystanders.
• E.g., a factory pollutes the water supply poisoning children
• Positive externality: When the activity brings benefits to
bystanders.
• E.g., a chocolate factory brings in tourism, helping local
businesses

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Examples of Externalities
Positive Negative

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 Efficient Quantity of a Good with
an Externality
• Previously, we found the efficient quantity by applying
the rational rule for markets: Produce more of a good
as long as 𝑀𝐵 ≥ 𝑀𝐶.
• But with an externality there are now two kinds of
benefits/costs to keep track of, private and external:
• marginal private benefits and marginal private costs (MPB
and MPC): these are the MB and the MC that the demanders
and suppliers face (up to now we’ve just called them “MB” or
“MC”)
• marginal external benefits and marginal external costs (MEB
and MEC): these are the MB and MC of the good that the
demanders and suppliers don’t consider

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 The Rational Rule for Society:
Revising the Rule to Account for Externalities
• The logic of the rational rule is the same as always:
“Is the MB greater than or equal to the MC? Then
produce another!”
• But now we compare the marginal social benefit of
an additional unit to the marginal social cost,
where
𝑀𝑆𝐵 = 𝑀𝑃𝐵 + 𝑀𝐸𝐵
𝑀𝑆𝐶 = 𝑀𝑃𝐶 + 𝑀𝐸𝐶
• So the rational rule for society is: Produce more of
an item as long as its 𝑀𝑆𝐵 ≥ 𝑀𝑆𝐶
• The efficient quantity is where the MSB and MSC curves
cross.
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Including an Externality on a S&D Graph
1. Draw the supply and demand curves as usual (those
are the MPC and MPB curves).
2. Is it a negative externality or a positive one? If
negative, draw the “new” MSC curve; if positive,
draw the “new” MSB curve. (Either way, the new
curve will be above the corresponding private curve.)
• If there is no positive externality, then
𝑀𝑆𝐵 = 𝑀𝑃𝐵 = 𝐷𝑒𝑚𝑎𝑛𝑑 𝐶𝑢𝑟𝑣𝑒
• If there is no negative externality, then
𝑀𝑆𝐶 = 𝑀𝑃𝐵 = 𝑆𝑢𝑝𝑝𝑙𝑦 𝐶𝑢𝑟𝑣𝑒
3. Find the equilibrium quantity where
𝑀𝑃𝐵 = 𝑀𝑃𝐶 and the efficient quantity where
𝑀𝑆𝐶 = 𝑀𝑆𝐵.

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 Graphing a Negative Externality

Remember: the efficient

quantity is the one that
maximizes surplus

• Negative externalities lead to overproduction.

• That is, when there is a negative externality a the equilibrium quantity is
greater than the efficient quantity.
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 Graphing a Positive Externality

• Positive externalities lead to underproduction.

• That is, when there is a positive externality the equilibrium quantity is less
than the efficient quantity.
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 Welfare Analysis of Externalities
• Recall welfare analysis refers to analyzing the
effects on economic surplus.
• When there’s an externality, how much better off
could society be (relative to the competitive
equilibrium)?
• If you could correct the externality, what would
happen to PS? To CS? To total economic surplus?

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 Some Preliminaries to Analyzing the
Welfare Effects of an Externality
• What does the area UNDER
the supply curve and to the
left of quantity supplied
represent?

• What does the area

between the supply curve
and the MSC curve and to
the left of quantity
supplied represent?

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 Welfare Analysis
Let’s compare economic surplus at (𝑄 !" , 𝑃!" ) and (𝑄 !## , 𝑃!## ).

Comp. Efficient
Eqbm Point

CS A+B+C+D A

PS F+G+H B+C+F+G
External C+D+E+G+
G+C
Cost H
Total
A+B+F - E A+B+F
ES

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Solving Externality
Problems

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 The Problem of Externalities,
and the Solution(s)
• Externalities pose problems because a free market
will NOT produce the efficient quantity.
• That is, economic surplus could be larger than it is at the
free market outcome.
• The way to solve externalities is to get the actors
(usually buyers and sellers) to consider ALL the
costs and benefits of their actions, not just the
private costs and benefits.
• That is called internalizing the externality.

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 Internalize the Externality
• Simone (when she was 3 years old) liked to draw on the walls.
Evidently she had a large benefit from doing it.
• She does not know how to clean the walls, so I clean the walls.
• Consequently, Simone’s “private cost” of drawing on walls was
very low. Though the “external cost” of her drawing on walls was
significant (who bore the external cost? I did!)
• Consequently, Simone drew on the walls more than was efficient.
• How could I help Simone internalize the externality?
• Make her help me clean the walls.
• Yell at her loud enough and consistently enough that she associates a
significant cost—being yelled at—with drawing on the walls.
• Do anything else that makes her think about the whole cost of drawing
on the walls.
• Just give up—Simone will win every time.

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 Various Solutions to Externality
Problems: A Preview
For Externality Problems in General:
1. Private Bargaining
2. (Pigouvian) Corrective Taxes and Subsidies
3. Cap and Trade
4. Laws, Rules, and Regulations

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 Solution 1: Private Bargaining
• The Coase Theorem states that when people can
costlessly bargain they will get to the efficient
outcome.
• Example: You’re my neighbor and you like to have
loud parties on Friday nights. I like peace and quiet
on Friday nights.
• What’s the socially efficient outcome?
It depends on the benefits and costs!
Let’s suppose the benefit to you of the party is $100 and
the benefit to me of a quiet night is $30.

Then the efficient outcome is for you to have the party.

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 Coase Theorem Example
• Suppose the law says “No loud music after 8pm” (and
suppose I’m the only neighbor who would complain)
• No bargaining: When you play loud music at 8:01, I call the
cops. You stop playing loud music. à inefficient outcome
• With bargaining: You come to me and say, “I’ll pay you $50
not to call the cops.” I agree because I’ll better off. à efficient
outcome

• If bargaining is “costly” (or difficult) then might not get

the efficient solution.
• For example, what if you and I hated each other and we
couldn’t bargain?
• What if I had 5 roommates who each had different WTP for a
quiet night?
• [How does this relate to climate change problem?]

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 Solution 2:
aka, Pigouvian Taxes

Corrective Taxes (and Subsidies)

• The externality problem: There are external costs (or
benefits) that the buyers and sellers don’t take
account of when they make their decisions.
• The corrective tax solution: Increase (or reduce) the
costs they face by taxing (or subsidizing) them.
• For a negative externality, set the corrective tax equal to
the external cost.
• For a positive externality, set the corrective subsidy equal
to the external benefit.
• Note that in either case setting the efficient corrective tax
(subsidy) requires knowing the external cost (benefit).
aka, Pigouvian Taxes
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 Examples of Corrective
Taxes and Subsidies
• Cigarettes are taxed at a relatively high rate.
• Gasoline is taxed at a relatively high rate.
• Cutting in line is “taxed” (though not necessarily
financially).
• People sneer at you, insult you, etc.
• Flu shots are subsidized.
• Primary and secondary education are subsidized.
• “I voted” and “I gave blood” stickers are a kind of
subsidy.
• [How? They increase the benefit you get from doing those
activities.]

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 Next Time
• Discuss other solutions to externalities…
• Move on to Chapter 11, The Labor Market.

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