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SECTION II - CHAPTER 2

EXTERNALITIES:

PROBLEMS AND SOLUTIONS

Introduction

 Externalities arise whenever the actions of one

party make another party worse or better off, yet
the first party neither bears the costs nor receives
the benefits of doing so.
 As we will see, this represents a market failure for
which government action could be appropriate and
improve welfare.

How many types?

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EXTERNALITY

1. EXTERNALITY THEORY

1. EXTERNALITY THEORY
 Externalities can either be negative or positive, and they can
also arise on the supply side (production externalities) or the
demand side (consumption externalities).
 A negative production externality is when a firm’s
production reduces the well-being of others who are not
compensated by the firm.
 A negative consumption externality is when an
individual’s consumption reduces the well-being of others
who are not compensated by the individual.
 The basic concepts in positive externalities mirror those in
negative externalities.

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a, Economics of Negative Production Externalities

 To understand the case of negative production

externalities, consider the following example:
 A profit-maximizing steel firm, as a by-product of its production,
dumps sludge into a river.
 The fishermen downstream are harmed by this activity, as the fish
die and their profits fall.
 This is a negative production externalities because:
 Fishermen downstream are adversely affected.
 And they are not compensated for this harm.
 Figure 2 illustrates each party’s incentives in this situation.

SMC = PMC +
Price MD S=PMC
of steel

p2

p1

MD (MEC)

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 2 Negative Production Externalities

SMC = PMC +
Price MD S=PMC
of steel

p2
p1
MD (MEC)

D = PMB = SMB

0 Q2 Q1 QSTEEL

General situation of Negative Externalities in Production

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SMC = PMC +
Price MD S=PMC
of steel

p2

p1

MD

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 2 Negative Production Externalities

b, Negative Consumption Externalities

 We now move on to negative consumption

externalities. Consider the following example:
 A person at a restaurant smokes cigarettes.
 That smoking has a negative effect on your enjoyment of
the restaurant meal.
 In this case, the consumption of a good reduces the
well-being of someone else.
 Figure 3 illustrates each party’s incentives in the
presence of a negative consumption externality.

Price of S=PMC=SMC
cigarettes

p1

MD
p2

D=PMB
SMB=PMB-MD

0 Q2 Q1 QCIGARETTES

Figure 3 Negative Consumption Externalities

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Price of S=PMC=SMC
cigarettes

p1

MD
p2

D=PMB
SMB=PMB-MD

0 Q2 Q1 QCIGARETTES

Figure 3 Negative Consumption Externalities

c, Positive Externalities

 Positive externalities can occur in production or

consumption.
 A positive production externality is when a firm’s
production increases the well-being of others, but the firm
is not compensated by those others.
 Research and development is a production externality.
 A positive consumption externality is when an
individual’s consumption increases the well-being of others,
but the individual is not compensated by those others.
 Nice landscaping could be a consumption externality.

c, Positive Externalities

 Let’s consider positive production externalities.

Consider the following example:
 A policeman buys honey near your home.
 As a consequence, the neighbors are safer because of the
policeman’s continued presence.
 In this case, the production of honey increases the
well-being of the neighbors.
 Figure 4 illustrates each party’s incentives in the
presence of a positive production externality.

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Price of S = PMC
honey

SMC = PMC -
p1 EMB
EMB
p2

D = PMB =
SMB

0 Q1 Q2 Qhoney

Figure 4 Positive Production Externalities

Price of S = PMC
honey

SMC = PMC -
p1 EMB
EMB
p2

D = PMB =
SMB

0 Q1 Q2 Qhoney

Figure 4 Positive Production Externalities

Positive Externalities

 Finally, there can be positive consumption

externalities.
 A neighbor’s improved landscape is a good example
of this.
 The graphical analysis is similar to negative
consumption externalities, except that the SMB
curve shifts outward, not inward.

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Positive Externalities

 The theory shows that when a negative externality

is present, the private market will produce too
much of the good, creating deadweight loss.
 When a positive externality is present, the private
market produces too little of the good, again
creating deadweight loss.

EXTERNALITY

2. THE COASE THEOREM

The Solution for Private sector

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The Solution for Private Sector

 The Coase Theorem: When there are well-defined

property rights and costless bargaining, then
negotiations between the parties will bring about
the socially efficient level.
 Thus, the role of government intervention may be
very limited—that of simply enforcing property
rights.

The Solution (Coase Theorem)

 Consider the Coase Theorem in the context of the

negative production externality example from
before.
 Give the fishermen property rights over the amount
of steel production.
 Figure 5 illustrates this scenario.

SMC = PMC +
Price MD S = PMC
of steel

p2

p1

MD

D = PMB
SMB

0 1 2 Q2 Q1 QSTEEL

Figure 5 Negative Production Externalities and Bargaining

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The Solution (Coase theorem)

 Through a process of bargaining, the steel firm will

bribe the fishery to arrive at Q2, the socially optimal
level.
 After that point, the MD exceeds (PMB - PMC), so
the steel firm cannot come up with a large enough
bribe to expand production further.

The Solution (Coase Theorem)

 Another implication of the Coase Theorem is that

the efficient solution does not depend on which
party is assigned the property rights, as long as
someone is assigned them.
 The direction in which the bribes go does depend
on the assignment, however.
 Now, let’s give the property rights to the steel firm
over the amount of steel production.
 Figure 6 illustrates this scenario.

SMC = PMC +
Price MD S = PMC
of steel

p2

p1

MD

D=PMB=SMB

0 Q2 Q1 QSTEEL

Figure 6 Negative Production Externalities and Bargaining

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The Solution (Coase Theorem)

 Figure 6 shows that even though the bargaining

process is somewhat different, the socially efficient
quantity of Q2 is achieved.

Problems with Coasian Solutions

 There are several problems with the Coase

Theorem, however.
 The assignment problem
 The holdout problem
 The free rider problem
 Transaction costs and negotiating problems

Problems with Coasian Solutions

 The “assignment problem” relates to two issues:

 It can be difficult to truly assign blame.
 It is hard to value the marginal damage in reality.

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Problems with Coasian Solutions

 The “holdout problem” arises when the property

rights in question are held by more than one party.
 The shared property rights give each party power over all
others.
 This could lead to a breakdown in negotiations.

Problems with Coasian Solutions

 The “free rider” problem is that when an

investment has a personal cost but a common
benefit, individuals will underinvest.
 For example, if the steel firm were assigned property
rights and you are the last (of many) fishermen to pay,
the bribe is larger than the marginal damage to you
personally.

Problems with Coasian Solutions

 Finally, it is hard to negotiate when there are large

numbers of individuals on one or both sides.

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Problems with Coasian Solutions

 In summary, the Coase Theorem is provocative, but

perhaps not terribly relevant to many of the most
pressing environmental problems.

EXTERNALITY

3. SOLUTIONS OF THE PUBLIC

SECTOR

3. PUBLIC-SECTOR SOLUTIONS FOR

EXTERNALITIES
 Coasian solutions are insufficient to deal with large
scale externalities. Public policy makes use of three
types of remedies to address negative externalities:
 Corrective taxation
 Subsidies
 Regulation

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a, Corrective Taxation

 The government can impose a “Pigouvian” tax

on the steel firm, which lower its output and
reduces deadweight loss.
 If the per-unit tax equals the marginal damage at
the socially optimal quantity, the firm will cut
back to that point.
 Figure 7 illustrates such a tax.

SMC=PMC+MD
Price S=PMC+tax
S=PMC
of steel

p2

Imposing a tax shifts the PMC

p1 curve upward and reduces
steel production.

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 7 Pigouvian Tax

SMC = PMC +
Price MD S=PMC
of steel

p2
p1
MD (MEC)

D = PMB = SMB

MT

0 Q2 Q1 QSTEEL

PIGOUVIAN TAXATION IN CASE OF Negative Externalities in

Production

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Corrective Taxation

 The Pigouvian tax essentially shifts the private

marginal cost.
 The firm cuts back output, which is a good thing
when there is a negative externality.

Corrective Taxation

 The steel firm’s privately optimal production solves:

PMB  PMC  tax

 When the tax equals MD, this becomes:
PMB  PMC  MD  SMC
 But this last equation is simply the one used to
determine the efficient level of production.

b, Subsidies

 The government can impose a “Pigouvian” subsidy

on producers of positive externalities, which
increases its output.
 If the subsidy equals the external marginal benefit at
the socially optimal quantity, the firm will increase
production to that point.
 Figure 8 illustrates such a subsidy.

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Price of S = PMC
honey
Providing a subsidy shifts
the PMC curve downward.

SMC=PMC-EMB
p1

p2

D = PMB =
SMB

Q1 Q2 Qhoney
Figure 80 Pigouvian Subsidy

Subsidies

 The subsidy also shifts the private marginal cost.

 The firm cuts expand output, which is a good thing
when there is a positive externality.

Subsidies

 The donut shop’s production solves:

PMB  PMC  subsidy

 When the subsidy equals EMB, this becomes:

PMB  PMC  EMB  SMC

 But this last equation is simply the one used to
determine the efficient level of production.

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c, Regulation

 Finally, the government can impose quantity

regulation, rather than relying on the price
mechanism.
 For example, return to the steel firm in Figure 9.

SMC = PMC + MD
Price S = PMC
of steel

p2
The
Yet firm
the government
has an incentive
couldto
simply require
produce
it toQproduce
1. no
p1 more than Q2.

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 9 Quantity Regulation

Regulation

 In an ideal world, Pigouvian taxation and quantity

regulation give identical policy outcomes.
 In practice, there are complications that may make
taxes a more effective means of addressing
externalities.

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Recap of Externalities:
Problems and Solutions
 Externality theory
 Private-sector solutions
 Public-sector solutions

NEXT CHAPTER…
 PUBLIC GOODS

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