182
Chapter 10
Externalities
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
feature on “What Should We Do about Climate Change.”
LEARNING OBJECTIVES:
what an externality is.
why externalities can make market outcomes inefficient.
how people can sometimes solve the problem of externalities on their own.
why private solutions to externalities sometimes do not work.
CONTEXT AND PURPOSE:
address the tax system.
In Chapter 10, different sources of externalities and a variety of potential cures for externalities are
addressed. Markets maximize total surplus to buyers and sellers in a market. However, if a market
generates an externality (a cost or benefit to someone external to the market) the market equilibrium
may not maximize the total benefit to society. Thus, in Chapter 10 we will see that while markets are
outcomes.
EXTERNALITIES
10
Chapter 10/Externalities ❖ 183
KEY POINTS:
When a transaction between a buyer and seller directly affects a third party, the effect is called an
externality. If an activity yields negative externalities, such as pollution, the socially optimal quantity
in a market is less than the equilibrium quantity. If an activity yields positive externalities, such as
Governments pursue various policies to remedy the inefficiencies caused by externalities. Sometimes
the government prevents socially inefficient activity by regulating behavior. Other times it internalizes
an externality using corrective taxes. Another public policy is to issue permits. For example, the
government could protect the environment by issuing a limited number of pollution permits. The
Those affected by externalities can sometimes solve the problem privately. For instance, when one
business imposes an externality on another business, the two businesses can internalize the
externality by merging. Alternatively, the interested parties can solve the problem by negotiating a
contract. According to the Coase theorem, if people can bargain without cost, then they can always
CHAPTER OUTLINE:
I. Definition of externality: the uncompensated impact of one person’s actions on the well–
being of a bystander.
B. If the impact on the bystander is beneficial, we say that there is a positive externality.
II. Externalities and Market Inefficiency
A. Welfare Economics: A Recap
1. The demand curve for a good reflects the value of that good to consumers, measured by the
3. In a free market, the price of a good brings supply and demand into balance in a way that
maximizes total surplus (the difference between the consumers’ valuation of the good and
the sellers’ cost of producing it).
Figure 1
Give students several examples of both positive and negative externalities. Use
current health debates or political topics to maintain interest.
184 ❖ Chapter 10/Externalities
B. Negative Externalities
2. Social cost is equal to the private cost to the firm of producing the aluminum plus the
private cost paid by producers.
3. The optimal amount of aluminum in the market will occur where total surplus is maximized.
of producing it.
b. This will occur where the social-cost curve intersects with demand curve. At this point,
4. Because the supply curve does not reflect the true cost of producing aluminum, the market
will produce more aluminum than is optimal.
5. This negative externality could be internalized by a tax on producers for each unit of
aluminum sold.
Figure 2
Make sure that students understand how this pollution by the firm imposes costs on
third parties. Point out that the firm is likely emitting pollution because this is the
cheapest method of production. Stress that the firm is using a resource in production
that it is not paying for.
ALTERNATIVE CLASSROOM EXAMPLE:
A coal-fired power plant emits pollution during production.
Chapter 10/Externalities ❖ 185
6. Definition of internalizing an externality: altering incentives so that people take
7.
In the News: The Externalities of Country Living
more environmentally friendly.
b. This article from
The New York Times
describes research that suggests that city living
C. Positive Externalities
1. Example: education.
2. Education yields positive externalities because better-educated voters lead to a better
4. If there is a positive externality, the social value of the good is greater than the private value,
5. To internalize a positive externality, the government could use a subsidy.
Figure 3
ALTERNATIVE CLASSROOM EXAMPLE:
The purchase of a fire extinguisher when an individual lives in an apartment complex
This is a good time to discuss why the government taxes goods like alcohol, tobacco,
and gasoline. You will find that students have heard the phrase “sin tax,” but they
often do not understand why economists might support such taxes (given the
deadweight loss from taxes discussed in Chapter 8).
186 ❖ Chapter 10/Externalities
6.
Case Study: Technology Spillovers, Industrial Policy, and Patent Protection
b. It is difficult to measure the amounts of technology spillover that occur and this leads to
a debate over whether or not the government should pursue policies to encourage the
production of technology.
III. Public Policies toward Externalities
government can respond in two ways.
1. Command-and-control policies regulate behavior directly.
2. Market-based policies provide incentives so that private decisionmakers will choose to solve
the problem on their own.
B. Command-and-Control Policies: Regulation
2. In the United States, the Environmental Protection Agency (EPA) develops and enforces
regulations aimed at protecting the environment.
3. EPA regulations include maximum levels of pollution allowed or required adoption of a
particular technology to reduce emissions.
C. Market-Based Policy 1: Corrective Taxes and Subsidies
2. Definition of corrective tax: a tax designed to induce private decisionmakers to take
account of the social costs that arise from a negative externality.
a. These taxes are preferred by economists over regulation, because firms that can reduce
b. Thus, this tax allows firms that face the highest cost of reducing pollution to continue to
pollute while encouraging less pollution over all.
Make sure that students realize how heavily subsidized education is in the United
States – both primary education and secondary education.
Chapter 10/Externalities ❖ 187
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c. Unlike other taxes, corrective taxes do not cause a reduction in total surplus. In fact,
they increase economic well-being by forcing decisionmakers to take into account the
cost of all of the resources being used when making decisions.
3.
Case Study: Why Is Gasoline Taxed So Heavily?
b. This is to correct for three negative externalities associated with driving: congestion,
accidents, and pollution.
D. Market-Based Policy 2: Tradable Pollution Permits
2. Social welfare is increased if the EPA allows this situation. Total pollution remains the same
so there are no external effects. If both firms are doing this willingly, it must make them
better off.
additional permits.
4. Tradable pollution permits and corrective taxes are similar in effect. In both cases, firms must
pay for the right to pollute.
a. In the case of the tax, the government basically sets the price of pollution and firms then
choose the level of pollution (given the tax) that maximizes their profit.
b. If tradable pollution permits are used, the government chooses the level of pollution (in
total, for all firms) and firms then decide what they are willing to pay for these permits.
Figure 4
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E. Objections to the Economic Analysis of Pollution
1. Some individuals dislike the idea of allowing companies to purchase the right to pollute.
2. Economists point out that “people face trade-offs” (Principle #1) and we must decide how
much we would be willing to give up in exchange for no pollution. It would likely not be
enough.
3. A clean environment can be viewed as any other good that obeys the law of demand. The
lower the price of environmental protection, the more the public will want.
F.
In the News: What Should We Do about Climate Change?
climate change..
2. This article from
The New York Times
explains how the revenue-neutral carbon tax works in
IV. Private Solutions to Externalities
A. We do not necessarily need government involvement to correct externalities.
B. The Types of Private Solutions
a. Do not litter.
b. The Golden Rule
determination of taxable income.
a. Sierra Club (environment)
b. University Alumni Association (scholarships)
C. The Coase Theorem
1. Definition of Coase theorem: the proposition that if private parties can bargain
without cost over the allocation of resources, they can solve the problem of
externalities on their own.
Stress to students that the socially optimal level of pollution is not “zero.” Make sure
that they understand that society faces a trade-off because of the resources used to
combat pollution.
Chapter 10/Externalities ❖ 189
2. Example: Dick owns a dog Spot who disturbs a neighbor (Jane) with its barking.
value he places on owning Spot.
b. Even if Jane could legally force Dick to get rid of Spot, another solution could occur. Dick
could pay Jane to let him keep the dog.
off.
D. Why Private Solutions Do Not Always Work
1. Definition of transaction costs: the costs that parties incur in the process of
agreeing and following through on a bargain.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
positive externality. The market outcomes do not account for all of the costs (negative
externalities) or benefits (positive externalities) to society.
2. The town government might respond to the externality from the smoke in three ways: (1)
regulation; (2) corrective taxes; or (3) tradable pollution permits.
adopt.
Corrective taxes are a useful way to reduce pollution because the tax can be increased to get
pollution to a lower level and because the taxes raise revenue for the government. The tax is
more efficient than regulation because it gives factories economic incentives to reduce
Tradable pollution permits are similar to corrective taxes but allow the firms to trade the right
to pollute with each other. As a result, the government does not need as much information
about the firms’ technologies. The government can simply set a limit on the total amount of