TOPIC 12

Externalities

MARKET FAILURE

• Previously we saw that Adam Smith’s

“invisible hand” leads buyers & sellers in a
competitive market to maximise their
benefits.

• But market failures do happen.

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 EXTERNALITY
• Externality is the uncompensated impact of
one person’s actions on the wellbeing of a
bystander.
– A positive externality makes the bystander better
off.
– A negative externality makes the bystander
worse off.

• Externalities make markets inefficient

– markets fail to maximise total surplus.

SOME COMMON EXTERNALITIES

• Negative externalities
– Pollution
– automobile exhaust fumes
– secondary cigarette smoking
– barking dogs
– loud music in an apartment building

• Negative externalities lead markets to produce

more than is socially desirable
– polluting firms produce too much since they don’t
pay the costs of their actions for others.

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 SOME COMMON EXTERNALITIES
• Positive externalities
– Immunisations
– restored historic buildings
– public research into new technologies
– perhaps education.

• Positive externalities lead to underprovision

– too few people will immunise themselves if they pay
the full market price for immunisation since they
don’t account for benefits to others.

A RECAP

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 A RECAP
• The demand curve reflects the value buyers
derive from consuming a good.
• The supply curve reflects the cost to sellers of
producing the good.
• In the absence of government intervention the
price adjusts to balance supply and demand.
• If there are no externalities, the market quantity
maximises the total value that buyers and
sellers receive from participating in the market.

NEGATIVE EXTERNALITIES IN
PRODUCTION: POLLUTION
• Suppose that with each unit of aluminium that is
produced, sellers emit a certain amount of
pollution.
– The pollution creates a health risk for those who
breathe the air.
– The social cost of producing a unit of the good is the
private costs of sellers plus the costs to those who
are adversely affected.

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 NEGATIVE EXTERNALITIES IN
PRODUCTION: POLLUTION

NEGATIVE EXTERNALITIES IN
PRODUCTION: POLLUTION
• The intersection of the demand curve & the
social-cost curve determines the socially best
output.
– This social optimum is less than the market output.

• Producing the market output creates a DWL.

– Above QOptimum the social cost exceeds the value to
consumers.
– Also, with pollution, the free market price is too low.

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 CAN GOVERNMENT POLICY
RESTORE EFFICIENCY
• Internalising a negative externality involves
altering incentives so people are forced to
account for the external cost.

• The government can internalise a negative

externality by taxing producers to raise private
costs to social costs.
– Such taxes are called corrective taxes or Pigovian
taxes.

CAN GOVERNMENT POLICY

RESTORE EFFICIENCY
Price of
Social
aluminum
cost
Set tax equal to
Cost of pollution
Supply
(private cost)

Optimum DWL
Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

aluminum

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 POSITIVE EXTERNALITIES IN
PRODUCTION: TECHNOLOGY
SPILLOVER
• Suppose that with each unit of the good that is
produced, there is a chance that a seller will
make a technological breakthrough.
– Technological advances create benefits for society
as a whole, known as spillovers, because they add
to our pool of knowledge.

• Similarly education may provide positive

externalities
– less crime, better social decisions, etc.

POSITIVE EXTERNALITIES IN
PRODUCTION: TECHNOLOGY
SPILLOVER

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 POSITIVE EXTERNALITIES IN
PRODUCTION: TECHNOLOGY
SPILLOVER
• Optimal output of robots exceeds the market
equilibrium.
– The market produces less than is socially desirable
since the social value of good exceeds its private
value.

• Corrective (Pigovian) Subsidies (equal to

distance between demand & social benefits
curve) internalise positive externalities by raising
demand so it reflects social value.

CAN GOVERNMENT POLICY

RESTORE EFFICIENCY
Price of
education
DWL avoided
Supply
(private cost)

Subsidy
paid to
students

Education Social
costs paid Demand
value
by students (private value)

0 QMARKET QOPTIMUM Quantity of

education

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 CAN GOVERNMENT POLICY
RESTORE EFFICIENCY
• Students should pay that fraction of their fees
reflecting private value of education to
themselves – increasing their income,
consumption pleasures etc.

• Society should pay the external benefits as a

subsidy.

• Notice: Making education free creates a

deadweight loss.

NEGATIVE EXTERNALITIES IN
CONSUMPTION: DRINKING

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 NEGATIVE EXTERNALITIES IN
CONSUMPTION: DRINKING
• The consumption of alcohol can yield negative
externalities
– if consumers drive under the influence, or
– engage in violent or antisocial behaviour.

• Because of the external costs associated with

consumption, the social value is less than the
private value.

POSITIVE EXTERNALITIES IN
CONSUMPTION: IMMUNISATION

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 POSITIVE EXTERNALITIES IN
CONSUMPTION: IMMUNISATION
• Vaccines yield positive externalities because
– they lower the risk of catching diseases for
everyone in the population, even those who are not
vaccinated.

• Because of the external benefits associated

with consumption, the social value is greater
than the private value.

PRIVATE SOLUTIONS TO
EXTERNALITIES
• A.C. Pigou (1877-1959) suggested that
government needs to be involved whenever
externalities arose through corrective taxes
and subsidies.

• Many now question this claim.

– There exist private solutions to externalities

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 PRIVATE SOLUTIONS TO
EXTERNALITIES
• Sometimes the problem of externalities is
solved by moral codes and social sanctions.

• Consider why most people do not litter.

– Although there are laws against littering, these laws
are not vigorously enforced.
– Most people choose not to litter simply because it is
the wrong thing to do.

PRIVATE SOLUTIONS TO
EXTERNALITIES
• Another private solution to externalities is
charities, many of which are established to
deal with externalities.
– For example, private individuals and corporations
sometimes sponsor scholarships for university
students, in part because education has positive
externalities for society.

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 PRIVATE SOLUTIONS TO
EXTERNALITIES
• Integrating different businesses / Mergers
– Consider an apple grower and a beekeeper located
next to each other.
– By pollinating the flowers on the trees, the bees help
the orchard produce apples.
– At the same time, the bees use the nectar they get
from the apple trees to produce honey.

PRIVATE SOLUTIONS TO
EXTERNALITIES
• When the apple grower is deciding how many
trees to plant and the beekeeper is deciding how
many bees to keep they neglect the positive
externalities.
– Thus, the apple grower plants too few trees and
– the beekeeper keeps too few bees.

• These externalities could be internalised if the

beekeeper bought the apple orchard or if the
apple grower bought the beehive.

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 BARGAINING AND COASE
THEOREM
• Background
– People and firms pollute because something (e.g.
environment or water quality) is not owned & sold in
a market.
• Use of the environment/water resource is just treated as a
free good.

• If a Court of Law imposed property rights on

the environment/water resource the externality
would vanish
– since now people would have to pay to pollute.

BARGAINING AND COASE

THEOREM
• Coase theorem is the proposition that if private
parties can bargain over the allocation of
resources, they can solve the problem of
externalities on their own without any
government intervention.
– As long as property rights are well-defined, they
can reach efficient outcomes irrespective of who is
assigned property rights.

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 COASE THEOREM: EXAMPLE
• Notice: In the following example it doesn’t
matter who gets property rights to water so
long as they are assigned to someone.

• An upstream factory currently earns $500

– While doing so it pollutes a downstream fishery.

• Coase theorem suggests

– if property rights to use the stream were given to
either the factory or the fishery (it didn’t matter who)
the parties could bargain to achieve efficiency.

COASE THEOREM: EXAMPLE

• Suppose
– the factory could install a filter to clean water at a
cost of $200 or
– the fishery could treat effluent at a cost of $300.

• Further, suppose
– the fishery gets a benefit from clean water in the
form of an increase in profits from $100 to $500

• Now bargaining between the parties will drive

efficiency – an outcome maximising total
surplus.

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 COASE THEOREM: EXAMPLE
• If property rights of the stream usage are given
to the fishery
– they will insist the factory install a filter or force
them out of business.
– This delivers efficiency.

• If property rights go to factory

– the fishery will find it in its interests to offer money
the factory to install a filter and
– the factory will have incentives to accept this.

COASE THEOREM: EXAMPLE

• An offer of $250 works (it can be anywhere
between the cost of the filter-$200 and the
benefits that the fishery gets-$400).
– Fishery profits rise to $250 (500-250) after paying
the money
– The factory’s profits rise to $550 (500-200+250)
after paying for the filter & getting the money.
– Total is the efficient level; of profits $800.

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 COASE THEOREM: EXAMPLE
Profits
Mill Fishery Total
profits profits profits

No filter, no effluent 500 100 600

treatment

Filter, no effluent 500-200 500 800

treatment = 300 (efficient
(Fishery has the right) outcome)
Filter, no effluent 500-200 500-250 800
treatment +250 =250 (efficient
(Factory has the right) = 550 outcome)
No Filter and effluent 500 500-300 700
treatment = 200

WHY PRIVATE SOLUTIONS DO NOT

ALWAYS WORK
• Sometimes the interested parties fail to solve
an externality problem because of transaction costs
– if millions of people are affected by air pollution.

• Bargaining doesn’t always drive efficient outcomes

– what if the cost of the filter to the factory exceeded the
benefits to the fishery. e.g. Cost = $300 and benefit =
$200.
– In this case the most that the fishery can offer is $200
which is insufficient to induce the factory to install the
filter.

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 COMMAND-AND-CONTROL
POLICIES: REGULATION
• The government can remedy an externality by
either requiring or forbidding certain activities.
– For example, it is a crime to dump poisonous
chemicals into the water supply.
– Alternatively, the government can dictate a
maximum level of pollution that factories may emit,
or require firms to adopt a particular technology.
– Immunisation requirements

MARKET-BASED POLICIES
• Instead of regulating behaviour in response
to an externality, the government can use
market-based policies
– Corrective taxes and subsidies (already
discussed)
– Tradeable pollution permits

• Market-based policies provide market

participants with incentives to take
externalities into account in their production
and consumption decisions.

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 CORRECTIVE TAXES AND
SUBSIDIES
• As discussed earlier, the government can
internalise externalities by
– taxing activities that have negative externalities and
– subsidising activities that have positive externalities.

• Corrective taxes alter the incentives that the

market participants face to account for the
presence of externalities
– move the allocation of resources closer to the social
optimum.

TRADEABLE POLLUTION PERMITS

• Another way to internalise the externality is to

issue tradeable pollution permits.

• Each permit allows a firm to emit a unit of

pollution, limiting the country’s total emissions.
– Effectively this is a regulation

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TRADEABLE POLLUTION PERMITS

• Making these permits tradeable is combining

regulations with market; hence a market based
policy
– A market to trade these permits will develop and
that market will be governed by the forces of supply
and demand.
– The permits will end up in the hands of those firms
that value them most highly, as judged by their
willingness to pay.

TRADEABLE POLLUTION PERMITS

• A firm’s willingness to pay for the right to
pollute, in turn, will depend on its cost of
reducing pollution
– the more costly it is for a firm to cut back on
pollution, the more it will be willing to pay for a
permit.

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TRADEABLE POLLUTION PERMITS
• In other words,
– a firm that can reduce pollution at a low cost will sell
its permit
– to firms that can only reduce pollution at a high cost
– delivering efficiency.

• Notice: The effects of pollution permits are

equivalent to those of corrective taxes

EQUIVALENCE OF CORRECTIVE
TAXES AND POLLUTION PERMITS

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TRADEABLE POLLUTION PERMITS
• Tradeable pollution permits may control the
externality more efficiently
– In order to determine the appropriate level of
Pigovian taxes the government must be able to
estimate the exact magnitude of the externality, as
well as, the demand for pollution.
– This is usually not possible.

SUMMARY
• Negative externalities create overprovision –
case for Pigovian tax.

• Positive externalities create underprovision –

case for Pigovian subsidy.

• Those affected by externalities can sometimes

achieve efficiency by bargaining. Coase
suggests bargaining – given property rights –
will realise efficiency.

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 SUMMARY
• When private parties cannot adequately deal
with externalities, the government often steps
in.

• The government can use Pigovian taxes or

subsidies or issue pollution permits.

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