CENGAGE

Learning

Principles of

economics 6th Edition

N. Gregory Mankiw
 CHAPTER - 10

Principles of
MICROeconomics
(HSS – 1021)

Externalities
N. Gregory Mankiw
07/30/21 08:49 2
In this chapter,
look for the answers to these questions:

 What is an externality?
 What are different types of externality?
 Why do externalities make market
outcomes inefficient?
 What public policies aim to solve the
problem of externalities?
3
 Introduction
 One of the principles from Chapter 1:
Markets are usually a good way
to organize economy activity.
In absence of market failures, the competitive
market outcome is efficient, maximizes total surplus.
 One type of market failure:
externality, the uncompensated impact of one
person’s actions on the well-being of a bystander.
 Externalities can be negative or positive,
depending on whether impact on bystander is
adverse or beneficial.
EXTERNALITIES 4
 Recall: Adam Smith’s “invisible hand” of
the marketplace leads self-interested
buyers and sellers in a market to maximize
the total benefit that society can derive
from a market.

But market failures can still

happen.
 Self-interested buyers and sellers neglect
the external costs or benefits of their
actions, so the market outcome is not
efficient.
 Another principle from Chapter 1:
Governments can sometimes
improve market outcomes.
In presence of externalities, public policy
can improve efficiency.

EXTERNALITIES 6
 EXTERNALITIES AND MARKET
INEFFICIENCY
 An externality refers to the
uncompensated impact of one
person’s actions on the well-being of a
bystander.
 Externalities cause markets to be
inefficient, and thus fail to maximize
total surplus.
 EXTERNALITIES
 An externality arises...
. . . when a person engages in an activity
that influences the well-being of a bystander
and yet neither pays nor receives any
compensation for that effect.
. . . whenever the actions of one economic
agent make another economic agent worse
or better off, yet the first agent neither bears
the costs nor receives the benefits of doing
so.
 TYPES OF EXTERNALITIES
 Basing on who is generating the externality,
not who is affected by the externality.
 Consumption externality - An externality arising
from consumption.
 Production externality - An externality arising
from production.
 Basing on the impact on bystander,
 Negative externality - When the impact on the
bystander is adverse
 Positive externality - When the impact on the
bystander is beneficial
 On WhichSide is Externality?

 
Production Consumption
Negative Pulp-mill smoking;
pollution, loud music
acid rain

Positive R&D spillovers, Painting

agglomeration house;
gardening
 EXTERNALITIES AND MARKET
INEFFICIENCY
 Negative Externalities
 Air pollution from a factory / Automobile exhaust
 Noise Pollution Barking dogs (loud pets) / Loud
stereos in an apartment building
 Health risk to others from second-hand smoke
 Talking on cell phone while driving makes the roads less
safe for others
 Negative Consumption Externality
„„The typical driver today is in a car that weighs 4,089 pounds. The major culprits in this
evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,500
pounds. „The consumption of large cars such as SUVs produces three types of negative
externalities:

„Environmental Externalities:
„„The contribution of driving to global warming is directly proportional to the amount of
fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or
run their errands, increasing fossil fuel emissions.
„„
Wear and Tear on Roads:
„„Each year, federal, state, and local governments spend $33.2 billion repairing our
roadways. Damage to roadways comes from many sources, but a major culprit is the
passenger vehicle, and the damage it does to the roads is proportional to vehicle weight.
„
Safety Externalities:
One major appeal of SUVs is that they provide a feeling of security because they are so
much larger than other cars on the road. Offsetting this feeling of security is the added
insecurity imposed on other cars on the road.
EXTERNALITIES 12
 EXTERNALITIES AND MARKET
INEFFICIENCY

 Positive Externalities
 Immunizations
 Restored historic buildings
 Research into new technologies
 POSITIVE EXTERNALITIES
Positive production externality: When
a firm’s production increases the well-being of others
but the firm is not compensated by those others.
Example: Beehives of honey producers have a
positive impact on pollination and agricultural output
  
Positive consumption externality: When an
individual’s consumption increases the well-being of
others but the individual is not compensated by
those others.
Example: Beautiful private garden that passers-by
enjoy seeing
 
EXTERNALITIES 14
 Education as Positive Externality
An individual who acquires additional education
will obtain private benefits in the form of
increased earnings.
But the education also benefits society. Going to
school and learning to read, write, and think
makes people better citizens who will be able to
teach their kids how to read and write, who will be
able to pass on knowledge about discoveries they
make to others, and who will be able to read
about proper hygiene and health practices and
thus put less of a burden on the public health
system.
EXTERNALITIES 15
 Active Learning
What type of externality (positive or negative) is present in
each of the following examples? Is the marginal social
benefit of the activity greater than or equal to the marginal
benefit to the individual? Is the marginal social cost of the
activity greater than or equal to the marginal cost to the
individual? Without intervention, will there be too little or
too much (relative to what would be socially optimal) of
this activity?
a.Mr. Mishra plants lots of colorful flowers in his front yard.

b.Mihir, who lives next to an apple orchard, decides to

keep bees to produce honey.
c.Stalin buys a large SUV that consumes a lot of gasoline.
EXTERNALITIES 16
Answer: Active Learning
(a)This is a positive externality: since other people enjoy
looking at Mr. Mishra’s flowers, the marginal social benefit of
looking at the flowers is greater than the marginal benefit to Mr.
Mishra of looking at them. As a result, fewer flowers will be
planted than is socially optimal.
(b)This is a positive externality: since bees pollinate his
neighbour’s apple trees and therefore confer an external
benefit on the owner of the apple orchard, the marginal social
benefit is greater than the marginal benefit to Mihir. Since Mihir
does not take the external benefit into account, he will keep
fewer bees than is socially optimal.
(c)This is a negative externality: the burning of gasoline
produces toxic gases that impose an external cost on others.
The marginal social cost is greater than the marginal cost
incurred by Stalin. As a result, more people will purchase SUVs
than is socially optimal.
EXTERNALITIES 17
 EXTERNALITY THEORY: ECONOMICS OF
NEGATIVE EXTERNALITIES
Negative production externality: When a firm’s production
reduces the well-being of others who are not compensated by the firm.
Negative consumption externality : When an individual’s consumption
reduces the well-being of others who are not compensated by the
individual.
Private marginal cost (PMC): The direct cost to producers of
producing an additional unit of a good, i.e., additional payments made
to factors of productions for producing additional units of a commodity
Marginal damage (MD): Any additional costs
associated with the production of the good that are imposed on others
but that producers do not pay
Social marginal cost (SMC = PMC + MD): The private marginal cost to
producers plus marginal damage
Example: steel plant pollutes a river but plant does not face any
pollution regulation (and hence ignores pollution when deciding how
much to produce) 18
EXTERNALITIES
 Recap of Welfare Economics
P The market for gasoline When a market has no
$5 external costs or benefits
Supply curve shows private
Qs = 10P
cost, the costs directly
4 SPvt incurred by sellers.
Demand curve shows
3 private value, the value to
$2.50 Equilibrium buyers (the prices they are
willing to pay).
2
The market equilibrium
DPvt maximizes total surplus
1 (consumer + producer
Qd = 50 - 10Psurplus) and hence efficient.
The resulting equilibrium
0
0 10 20 25 30 Q quantity and price are
socially optimal.
(gallons)
EXTERNALITIES 19
 Negative Production Externality
When negative externality
P The market for gasoline is present, Social cost
$5 = private + external cost
Ssoc
4 Qs = 10(P-1)
external
cost
3 Supply (private cost)
Qs = 10P External cost
2 = value of the
negative impact
1 on bystanders
= $1 per gallon
0 (value of harm
0 10 20 30 Q
from smog,
(gallons)
EXTERNALITIES greenhouse gases) 20
 Negative production Externality
P The market for gasoline The
The socially
socially optimal
optimal
quantity
quantity (20(20 gallons)
gallons)
$5 Qs = 10(P-1) Ssoc is
is less
less than
than market
market
equilibrium
equilibrium quantity
quantity
4 Spvt (25
(25 gallons).
gallons). There
There isis
S over
over production
production by by 55
3 Optimum gallons.
gallons.
Qs = 10P
Equilibrium At
At any
any Q Q << 20,
20, value
value of
of
2 additional
additional gas
gas exceeds
exceeds
social
social cost.
cost.
Dpvt
Qd = 50 - 10P At
At any
any Q Q >> 20,
20, social
social
1
cost
cost of
of the
the last
last gallon
gallon is
is
greater
greater than
than its
its value
value toto
0 society.
society.
0 10 20 25 30 Q
(gallons) Market becomes
EXTERNALITIES inefficient 21
Negative Production Externality-Internalisation
Corrective Tax
P The market for gasoline Tax sellers by the
$5 magnitude of external
S
Qs = 10(P-1) cost (1/gallon).
4 Ssoc= Supply curve shifts
Spvt to left by $1.
3 Equilibrium Social cost = Private
& Optimum
cost
2 Supply curve after
externality and after
Dpvt imposition of tax
Qd = 50 - 10P
1
coincides.
Qt Equilibrium = Qt
0 at Optimum
0 10 20 25 30 Q
Market becomes
(gallons)
EXTERNALITIES efficient. 22
 “Internalizing the Externality”
 Internalizing the externality: altering incentives
so that people take account of the external effects
of their actions
 In our example, the $1/gallon tax on sellers makes
sellers’ costs = social costs.
 When market participants must pay social costs,
market eq’m = social optimum.
(Imposing the tax on buyers would achieve the
same outcome; market Q would equal optimal Q.)

EXTERNALITIES 23
 Examples of Positive Externalities
 Being vaccinated against
contagious diseases protects
not only you, but people who
visit the salad bar or produce
section after you.
 R&D creates knowledge
others can use.
 People going to college raise
Thank you for
the population’s education not contaminating
level, which reduces crime the fruit supply!
and improves government.
EXTERNALITIES 24
 Positive Externalities benefiting
Consumers
 In the presence of a positive externality,
the social value of a good includes
 private value – the direct value to buyers
 external benefit – the value of the
positive impact on bystanders

 The socially optimal Q maximizes welfare:

 At any lower Q, the social value of
additional units exceeds their cost.
 At any higher Q, the cost of the last unit
exceeds its social value.
EXTERNALITIES 25
ACTIVE LEARNING 1
Analysis of a positive externality
P The market for flu shots
External benefit
$50 = $10/shot

40  Draw the social

QS = P value curve.
SPvt
30  Find the socially
optimal Q.
Equilibrium
20  What policy would
internalize this
10 externality?
DPvt
QD = 40-P
0 Q
0 10 20 30 26
 ACTIVE LEARNING 1
Analysis of a positive externality
When a market has no
P The market for flu shots
external benefits
$50 Demand curve shows
private benefit, the value
directly received by buyers
40 (willing to pay).
QS = P Supply curve shows
SPvt private cost, the cost to
30
sellers.
The market equilibrium
Equilibrium
20 maximizes total surplus
(consumer + producer
surplus) and hence efficient.
10
DPvt The resulting equilibrium
quantity and price are
QD = 40-Psocially optimal.
0 Q
0 10 20 30 27
ACTIVE LEARNING 1 Social Benefit = Private Benefit
Answers + External Benefit ($10)
P The market for flu shots Market equilibrium
quantity, Qpvt (20), is less
$50 than socially optimal
external quantity, Qsoc (25),
40 benefit because individual buyers
QS = P are willing to pay only for
the benefits they reap from
SPvt directly consuming the
30
product.
Optimum
Under-consumption to the
20 Equilibrium extent of 5 units
DSoc
QDS = 40- (P - 10)
10
DPvt Market becomes
QD = 40-P inefficient
0 Q
0 10 20 25 30 28
ACTIVE LEARNING 1 Internalisation of Positive
Answers Externality
P The market for flu shots Subsidy
$50 Subsidy to buyers by
the magnitude of
external benefit ($10).
40
QS = P Demand curve shifts
Spvt to right by $10
30 Social Benefit =
Optimum &
Equilibrium Private Benefit
20
Dsoc = Dpvt
QDS = 40- (P - 10)
10
 Demand curve after externality
and subsidy coincides.
0 Q  Qt Equilibrium = Qt at Optimum
0 10 20 25 30  Market becomes efficient
29
 Effects of Externalities: Summary
IfIf negative
negative externality
externality
 market
market quantity
quantity larger
larger than
than socially
socially desirable
desirable
IfIf positive
positive externality
externality
 market
market quantity
quantity smaller
smaller than
than socially
socially desirable
desirable
To
To remedy
remedy the
the problem,
problem,
“internalize
“internalize the
the externality”
externality”
 tax
tax goods
goods with
with negative
negative externalities
externalities
 subsidize
subsidize goods
goods with
with positive
positive externalities
externalities

EXTERNALITIES 30
 Public Policies Toward Externalities
Two approaches:
 Command-and-control policies regulate behavior
directly. Examples:
 limits on quantity of pollution emitted
 requirements that firms adopt a particular technology to
reduce emissions
 Even and Odd system adopted in New Delhi
 Market-based policies provide incentives so that
private decision-makers will choose to solve the
problem on their own. Examples:
 corrective taxes and subsidies
 tradable pollution permits
EXTERNALITIES 31
 Corrective Taxes & Subsidies
 Corrective tax: a tax designed to induce private
decision-makers to take account of the social
costs that arise from a negative externality
 Also called Pigovian taxes after Arthur Pigou
(1877-1959).
 The ideal corrective tax = external cost
 For activities with positive externalities,
ideal corrective subsidy = external benefit

EXTERNALITIES 32
 Corrective Taxes & Subsidies
 Other taxes and subsidies distort incentives and
move economy away from the social optimum.
 Corrective taxes & subsidies
 align private incentives with society’s interests
 make private decision-makers take into account
the external costs and benefits of their actions
 move economy toward a more efficient
allocation of resources.

EXTERNALITIES 33
 Internalisation of Negative Externality :
Corrective Taxes

EXTERNALITIES 34
 Internalisation of Positive Externality :
Subsidy

EXTERNALITIES 35