Unit/ Week 3:

Externalities and Government Policy

By the end of this Unit, students should be able to:
 Define an externality, and explain how positive and negative externalities can prevent
efficiency from being achieved even when markets are perfectly competitive.
 Describe how corrective taxes and subsidies can be used to internalize externalities.
 Discuss command and control methods of environmental protection, and compare the
economic effects of these with such market based alternatives as corrective taxes and
marketable pollution rights.

Overview: Business firms in the United States spend billions of dollars on pollution abatement
and control. Some state governments are adopting even more stringent emissions control
legislation than the federal rules. The increased costs of pollution control ultimately will result in
higher prices for many products.

But is it possible to improve the quality of the environment to the same degree at lower cost?
To find out, we need to examine how competing uses for resources result in pollution and the
issues involved when governments limit the rights to emit wastes. We begin by demonstrating
how the rights of some resource users are sometimes ignored as buyers and sellers go about
their business in the marketplace. The market failures examined in this unit fall under a general
category call externalities.

Externality: Externalities are costs or benefits of market transactions not reflected in prices.
When an externality prevails, a third party (other than the buyers or sellers of an item) is
affected by its production or consumption. The benefits or costs of the third party (either a
household or a business) are not considered by either buyers or sellers of an item whose
production or use results in an externality. The third parties are people like you who bear the
costs of polluted air and water. These third parties often organize politically through groups
such as the Sierra Club to lobby legislators and public officials to protect their rights to a clean
environment. In the United States and other industrial nations, environmentalists have emerged
as an effective, potent political force to induce governments to pass laws that limit the rights of
producers and consumers to emit wastes that pollute the air, water, and land.

In another definition, an Externality arises when a person engages in an activity that influences
the well-being of a by stander and yet neither pays nor receives any compensation for that
effect. In other words, Externalities arise whenever an action of one person imposes costs or
confers benefits on another person. If the impact on the bystander is adverse, it is called a
negative externality. If it is beneficial it is called a positive externality. In the presence of
externalities, society‘s interest in a market outcome extends beyond the wellbeing of buyers
and sellers who participate in the market to include the wellbeing of the bystanders who are
affected indirectly. Because buyers and sellers neglect the external effects of their actions when

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deciding how much to demand or supply, the market equilibrium is not efficient when there are
externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole.
The release of dioxin into the environment, for instance, is a negative externality.

A public roadway is in large part public, so one might assume it is non-rival. A road
approximates a purely non-rival good at three o‘clock in the morning, when no other cars are on
the road. Late-night traffic is so scarce in some cities that the normal progression of green,
yellow, and red traffic lights gives way to blinking red and yellow lights. Yet later in the morning,
rivalry will appear as additional cars enter the roadways. A road is fundamentally different than
a totally non-rival good like national defense. With a pure public good such as national defense,
all citizens share an identical position under a nuclear umbrella. With an impure public good
such as a road, a certain degree of rivalry prevents people from sharing the exact same
position. Two automobiles cannot share the same space on the roadway, and any attempt to
violate this principle will result in a traffic accident.

During rush hour, the rivalry of roads escalates to a new level. Each additional car slows travel
on the road, increasing travel times and imposing costs on other drivers. Thus the road, while
still non excludable, becomes more rival in consumption as additional cars clog the road. In rare
instances, a road may become totally impassable, a condition that approaches complete rivalry.
During rush hour, most drivers will find the streets are somewhat, but not totally, rival in
consumption.

Externalities can also modify the rivalry of goods that are theoretically rival. For example, a
dose of vaccine for a contagious disease is rival in that only one person can receive it. If only
one person was vaccinated, the recipient of the vaccine would enjoy all the benefit of the
inoculation. If, however, a significant portion of the population were vaccinated, other
individuals who were not vaccinated would also enjoy a benefit in the form of a reduced risk of
exposure to a contagious disease. If all people were vaccinated, it might be possible to
eradicate the disease altogether. For example, an international smallpox vaccination program
virtually wiped out that disease (Stiglitz, 2000, p. 131). In this instance, not only did each
recipient receive a private good of immunity from the disease, but all future generations also
received a public good of the eradication of the disease.

While a few purely rival or purely non-rival goods may exist, most goods exert at least some
externalities that make them neither purely rival nor purely non-rival. In the real world, most
goods gravitate toward the middle of the continuum.

Some of the private solutions to Externalities include: (1) Moral codes and social sanctions (2)
Charitable organizations (3) Integrating different types of businesses (4) Contracting between
parties

Negative externality: Negative externalities, also called external costs, are costs to third
parties other than the buyers or the sellers of an item not reflected in the market price. An

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example of a negative externality is the damage done by industrial pollution to people and their
property. The harmful effects of pollution are impairments to good health and reductions in the
value of business and personal property and resources.

Another example of a negative externality is the dissatisfaction caused by the noise of low-
flying aircraft as experienced by residents who are located near an airport. Those bearing
pollution damages are third parties to market exchanges between the buyers and the sellers of
goods or services. Their interests are not considered by the buyers and sellers of goods and
services when an externality is present.

In negative externality, the effect on bystanders is adverse (Supply). Occurs when one person‘s
actions confers benefits on another person. When the impact on the bystander is adverse, the
externality is called a negative externality. Negative externalities lead markets to produce a
larger quantity than is socially desirable. Any form of negative externality results in an over
allocation of the good or service associated with the externality.

Society is producing too much of a bad thing. Government might wish to discourage production
or consumption of the good or service through the use of excise taxes, surtaxes, or tariffs
(either on the good/service or input materials related to their production).

The marginal external cost (MEC) is the extra cost to third parties resulting from
production of another unit of a good or service. MEC is part of the marginal social cost
of making a good available. However, it is not reflected in the price of the good. The
marginal cost that producers base their decisions on is the marginal private cost
(MPC). To obtain the marginal social cost, the marginal external cost (MSC) of output,
MEC, must be added to the marginal private costs, MPC: [MPC + MEC = MSC] See
Figure 3.1 on David Hyman‘s Book.

Positive externality: Positive externalities are benefits to third parties other than the buyers or
the sellers of a good or service not reflected in prices. Buyers and sellers of goods that, when
sold, result in positive externalities, do not consider the fact that each unit produced provides
benefits to others. For example, a positive externality is likely to exist for fire prevention,
because the purchase of smoke alarms and fireproofing materials benefits those other than the
buyers and sellers by reducing the risk of the spread of fire. Buyers and sellers of these goods
do not consider the fact that such protection decreases the probability of damage to the
property of third parties. Fewer resources are devoted to fire prevention than would be the case
if it were possible to charge third parties for the external benefits that they receive.

In positive externalities, the effect on bystanders is beneficial (Demand) – Occurs when one
person‘s act imposes costs upon another person. When the impact on the bystander is
beneficial, the externality is called a positive externality.

Positive externalities lead markets to produce a smaller quantity than is socially desirable. A
technology spillover is a type of positive externality that exists when a firm‘s innovation or
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design not only benefits the firm, but enters society‘s pool of technological knowledge and
benefits society as a whole. Any form of positive externality results in an under allocation of the
good or service associated with the externality. Society is not producing enough of a good
thing. Government might wish to encourage production or consumption of the good or service
through the use of subsidies, grants, and tax credits.

Public Policy toward Externalities: When externalities are significant and private solutions
are not found, government may attempt to solve the problem through. (A) command-and-
control policies. (1) Usually take the form of regulations (2) Forbid certain behaviors. (3)
Require certain behaviors.

Examples:

• Requirements that all students be immunized.

• Stipulations on pollution emission levels: o market-based policies:

and subsidies to align private incentives with social efficiency. taxes are taxes
enacted to correct the effects of a negative externality.

will eventually develop. educe pollution at a low cost may prefer to sell its
permit to a firm that can reduce pollution only at a high cost.

Internationalization of Externalities: Internalization of an externality occurs when the

marginal private benefit or cost of goods and services are adjusted so that the users consider
the actual marginal social benefit or cost of their decisions. In the case of a negative externality,
the marginal external cost is added to marginal private cost for internalization. For a positive
externality, the marginal external benefit is added to marginal private benefit to internalize the
externality. Internalizing an externality results in changes in prices which reflects full marginal
social cost or benefit of a good

Internalization of externalities requires identification of the individuals involved and

measurement of the monetary value of the marginal external benefit or cost. The data required
for such identification and measurement are often difficult to obtain. Economic policy toward
externalities is sometimes controversial because of strong differences of opinion concerning the
actual value of the external cost or external benefit. For example, how can all the sources of air
pollution be identified? How are damages done to property and personal well-being evaluated?
This is a formidable scientific, engineering, and economic detective problem.

Because strong disagreement exists among physical and biological scientists as to the costs of
pollution, the necessary information required for internalizing the externality can be elusive.

Corrective Taxes – A Method of Internalizing Negative Externalities - A corrective tax

is designed to adjust the marginal private cost of a good or service in such a way as to
internalize the externality. The tax must equal the marginal external cost per unit of
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 output to achieve this objective. In effect, a corrective tax is exactly like a charge for
emitting wastes.

How a Corrective Tax Could Be Used to Reduce Global Warming - In 1990, 1.5
trillion tons of carbon were emitted in the United States alone! A corrective tax on the
emission of carbon wastes is one possible way to reduce the economic costs
associated with global warming. Global warming results from the ―greenhouse effect‖ of
carbon dioxide and other gases that trap energy in the atmosphere - Carbon dioxide is
a waste from the burning of fossil fuels, such as coal, oil, and gasoline. The tax on
carbon could double current U.S. pollution control costs. To decide whether these
additional costs are worthwhile requires a comparison of the marginal benefit of
preventing global warming. Unfortunately, scientists themselves disagree on the
possible effects of global warming, making calculation of such benefits difficult.

Benefits and Costs of Environmental protection policies in the United States: In practice,
the primary method of treating the problem of pollution in the United States is government
regulation. Market-based corrective taxes or other pollution rights schemes that charge firms for
the damages done by their emissions are the exception rather than the rule in U.S.
environmental protection policies. However, in recent years more market-based policies that
allow trading of pollution rights have been initiated. Let‘s look at how government actually
intervenes in the marketplace to deal with environmental pollution in the United States and
compare the effects of regulation with those we might expect if emissions were reduced by
corrective taxes or the issuance of a limited number of tradable pollution rights.

The costs of environmental policy in the United States have been considerable. In 1990 the
EPA estimated annual compliance costs to be $152 billion and estimates for 2000 indicate that
current costs could be in the range of $225 billion per year.

Questions

1. Do you agree with the following statement? ―Efficiency cannot be achieved when
externalities exist.‖ Explain your view.
2. Why do prices fail to represent the opportunity costs of resources when externalities
exist?
3. Why aren‘t doctors and patients showing up at clinics in poor countries and how can we
improve on that record by incorporating behavioral incentives?

4. What are externalities? Use a supply-and-demand analysis to show how a negative or

positive externality prevents a perfectly competitive market from achieving efficiency.

5. Why does the existence of externalities result in the misallocation of resources, and
should society handle such externalities? Explain using examples.

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Readings

David, N. Hyman (2011), Public Finance – A Contemporary Application of Theory to Policy,

Chapter 3: Externalities and Government Policy

Gruber, Jonathan (2010), Public Finance and Public Policy, Chp 5 &6, Pg 121-149, Worth
Publishers, MIT

A. Myrick Freeman III, ―Environmental Policy Since Earth Day I: What Have We Gained?‖
Journal of Economic Perspectives 16, 1 (Winter 2002): 125–146.

Barthold, Thomas A. ―Issues in the Design of Environmental Excise Taxes.‖ Journal of

Economic Perspectives 8, 1 (Winter 1994): 133–151. An analysis of some of the practical
problems involved in the implementation of corrective taxes to deal with pollution control

Roy Cordato (2007), Efficiency and Externalities in an Open-ended Universe, Kluwer Academic
Publishers

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