CHAPTER 5

EXTERNALITIES

PowerPoint Presentation Prepared by:

Adian McFarlane, Western University

©2023 McGraw Hill Limited

 Learning Objectives

1. Describe how positive externalities differ from negative externalities.

2. Demonstrate how the presence of a positive or negative externality may lead
to an inefficient allocation of resources.
3. Explain how private responses could remedy the externality problem.
4. Explain how public responses (government policies) could remedy the
externality problem.
5. Identify potential distributional implications of private and public responses
to the externality problem.

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 The Nature of Externalities

Externality

• When the activity of one entity (a person or a firm) directly affects the welfare
of another in a way that is not transmitted by market prices.

• Externalities can be produced by consumers and firms.

• Externalities are reciprocal in nature.

• Externalities can be positive or negative.

• The distinction between public goods and externalities is a bit fuzzy.

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 Negative Externalities and Economic Inefficiency: A
Negative Externality Problem

PMC

MD

PMB
0
Q1 Q per year
Actual output
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 Negative Externalities and Economic Inefficiency: A
Negative Externality Problem (cont.)

SMC = PMC + MD
$

PMC

MD

PMB
0
Q* Q1 Q per year
Socially efficient output Actual output
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 Negative Externalities and Economic Inefficiency: Gains
and Losses from Moving to an Efficient Level of Output

$ 200 SMC = 20 + 2Q

Azul gains
area dcg PMC = 20 + Q
h
140 MD = Q
d
110
g
80
c Jules gains
65
45 f area cdhg
b

20
e PMB
a
0
45 60 Q – output per year
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 What Activities Produce Pollutants?

Need to identify types and quantities of harmful pollution.

Transboundary problem:

• Smog

‒A mixture of gases and particulates that causes the air to look hazy.

‒ Linked to a number of health concerns, including allergies, asthma, and

cardiovascular disease.

• Greenhouse gas (GHG)

‒ GHG emissions contribute to global warming regardless of where in the

world the emissions actually occur.

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 Which Pollutants Do Harm?

Total suspended particles (TSPs) are widely considered to be the air pollutant most
damaging to health.

Empirical research on correlation between TSPs and mortality rates:

• Difficult to measure because of inability to perform randomized studies on

pollution effects.

• Must rely on cross-sectional or time-series analysis.

• Studies unable to measure lifetime exposure to air pollution.

Chay and Greenstone (2003) and Currie and Neidell (2005): impact of air pollution
on infant mortality.

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 What is the Value of the Damage Done?

Marginal damage schedule (MD)

• Shows the dollar value of the external costs imposed by each additional unit
of output.

Willingness to pay

• E.g., if you are willing to pay $3,831 for a cargo bicycle, that is how much
you value it.

Measurement problem

• GHG and global warming.

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 Positive Externalities and Economic Inefficiency: A Positive
Externality Example

PMC

PMB

0
R1 Research per year

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 Positive Externalities and Economic Inefficiency: A Positive
Externality Example (cont.)

PMC

PMB
EMB

0
R1 Research per year

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 Positive Externalities and Economic Inefficiency: A Positive
Externality Example (cont.)

PMC

SMB = PMB + EMB

PMB
EMB

0
R1 R* Research per year

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 Positive Externalities and Economic Inefficiency: A Positive
Externality Example (cont.)

PMC

b
c
a
d
SMB = PMB + EMB
e
PMB
EMB
g f
0
R1 R* Research per year

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 Positive Externalities and Economic Inefficiency: A Positive
Externality Example (cont.)

$ The dollar value of this gain in

efficiency is equal to area abc
PMC

b
c
a
d
SMB = PMB + EMB
e
PMB
EMB
g f
0
R1 R* Research per year

©2023 McGraw Hill Limited 5-14

 Private Responses to Externalities: Bargaining and the
Coase Theorem

Coase Theorem

• Two important assumptions played a key role in the preceding analysis:

1. The costs to the parties of bargaining are low.

2. The owners of resources can identify the source of damages to their

property and legally prevent damages.

• If the above holds, then an efficient solution to an externality problem can be

achieved without government intervention.

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 Private Responses to Externalities: Other Private Solutions

Mergers

• Way to internalize the externality.

• The externality transmitter and recipient become one company.

Social conventions

• Littering is irresponsible and not “nice”.

• “Do unto others as you would have others do unto you”.

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5-12
 Public Responses to Externalities: Taxes and Negative
Externalities

PMC

PMB
0
Q1 Q per year
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 Public Responses to Externalities: Taxes and Negative
Externalities (cont.)

PMC

MD

PMB
0
Q1 Q per year
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 Public Responses to Externalities: Taxes and Negative
Externalities (cont.)

SMC = PMC + MD
$

PMC

MD

PMB
0
Q* Q1 Q per year
©2023 McGraw Hill Limited 5-19
 Public Responses to Externalities: Taxes and Negative
Externalities (cont.)

SMC = PMC + MD
$ (PMC + cd)
Pigouvian PMC
tax revenues

d
i

j c
MD

PMB
0
Q* Q1 Q per year
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 Public Responses to Externalities: Subsidies and Negative
Externalities

SMC = PMC + MD
$ (PMC + cd)
PMC
Pigouvian
subsidy

d k
i f
g
j c h
MD

PMB
e
0
Q* Q1 Q per year
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 Public Responses to Externalities: Using an Emissions Fee
to Reduce Pollution

In the absence of the emissions fee, the level of

emissions is E0 - the level of emissions
$ associated with the level of output Q1 that MD
maximizes Azul’s net benefits.
b

a
f*

MAC

d c
E* E0 Emissions
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 Public Responses to Externalities: An Emissions Fee with
Multiple Polluters

$ $ The outcome is cost-

effective
225

180
MACA MACM

0 90 0 90
Azul’s Emissions Madrid’s Emissions
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 Public Responses to Externalities: An Emissions Fee with
Multiple Polluters (cont.)

$ $ The outcome is cost-

effective
225

180
MACA MACM

a d
f*=50

c b e
0 65 90 0 70 90
Azul’s Emissions Madrid’s Emissions
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 Public Responses to Externalities: An Emissions Fee with
,
Multiple Polluters (cont.)

$ $ The outcome is cost-

effective
225

180
MACA MACM

Azul’s tax savings Madrid’s tax savings

75
a d
f*=50
30
c b f e
0 65 75 90 0 60 70 90
Azul’s Emissions Madrid’s Emissions
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 Public Responses to Externalities: A Tradable Permit
Scheme and Negative Externalities

$ $ A cap-and-trade
scheme is cost-
effective
225

180
MACA MACM

112.5 a

f*=50

c b
0 65 90 0 45 70 90
Azul’s Emissions Madrid’s Emissions
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 Public Responses to Externalities: Regulation and Negative
Externalities
What remedies are available to deal with negative externalities?
Command-and-control regulations:
• Require a given amount of pollution reduction and are less flexible than
incentive-based approaches
• Technology standard
‒ Requires polluters to install a certain technology—e.g., “scrubbers” in
power plants be used to clean up or reduce emissions.
• Performance standard
‒ A type of command-and-control regulation that sets an emissions goal
for each polluter.
• Unlikely to be cost-effective

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 Public Responses to Externalities: Positive Externalities

What remedies are available to deal with positive externalities?

Subsidies

• Pigouvian subsidy

‒ Opposite of Pigouvian tax

Regulation

• For example: vaccinations

• Herd immunity

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 Implications for Income Distribution

Who benefits?

• Low- or high-income individuals?

‒ Evidence suggests that poor neighbourhoods have more exposure to air

pollution than high-income neighbourhoods (Gayer, 2000).

Who bears the cost?

• Workers of firms who must reduce output.

• Buyers of firms’ output.

‒ Products could become more expensive if firms are forced to internalize

social costs.

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 Chapter 5 Summary

• An externality occurs when the activity of one person affects another person
outside of the market mechanism. Externalities may generally be traced to
the absence of property rights.

• Externalities cause market price to diverge from social cost, bringing about
an inefficient allocation of resources. Negative externalities generally lead to
too much of an activity while positive externalities typically result in too
little.

• The Coase Theorem indicates that private parties may bargain toward the
efficient output if property rights are established. However, bargaining costs
must be low and the source of the externality easily identified.

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 Chapter 5 Summary (cont.)

• A Pigouvian tax is a tax levied on pollution in an amount equal to the

marginal damage at the efficient level. Such a tax gives the producer a
private incentive to pollute the efficient amount.

• An emissions fee (a tax levied on each unit of pollution) achieves a given

amount of pollution reduction at the lowest feasible cost (i.e., is cost-
effective).

– The cost of emissions reductions is capped by the emissions fee, but the
level of pollution reduction can be uncertain.

• Pollution rights may be traded in markets; A cap and trade system grants
permits to pollute but allows the permits to be traded.
©2023 McGraw Hill Limited 5-31
 Chapter 5 Summary (cont.)

• Command and control regulations are less flexible than incentive-based

approaches, like emissions fees and permit schemes, and therefore tend to
be more costly.

• Positive externalities may be addressed using a subsidy; care must be taken

to avoid wasteful subsidies.

• Policies to deal with externalities can have important consequences for the
distribution of real income.

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