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182
Chapter 10
Externalities
WHAT’S NEW IN THE SIXTH EDITION:
There are two new
In the News
features on “The Externalities of Country Living” and “Cap and Trade.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ what an externality is.
CONTEXT AND PURPOSE:
Chapter 10 is the first chapter in the microeconomic section of the text. It is the first chapter in a three-
chapter sequence on the economics of the public sector. Chapter 10 addresses externalities—the
uncompensated impact of one person’s actions on the well-being of a bystander. Chapter 11 will address
public goods and common resources (goods that will be defined in Chapter 11) and Chapter 12 will
address the tax system.
EXTERNALITIES
10
0
Chapter 10/Externalities ❖ 183
KEY POINTS:
• When a transaction between a buyer and seller directly affects a third party, that 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
technology spillovers, the socially optimal quantity is greater than the equilibrium quantity.
CHAPTER OUTLINE:
I. Definition of externality: the uncompensated impact of one person’s actions on the well-
being of a bystander.
A. If the impact on the bystander is adverse, we say that there is a negative externality.
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
price that the marginal buyer is willing to pay.
B. Negative Externalities
184 ❖ Chapter 10/Externalities
1. Example: An aluminum firm emits pollution during production.
2. Social cost is equal to the private cost to the firm of producing the aluminum plus the
external costs to those bystanders affected by the pollution. Thus, social cost exceeds the
private cost paid by producers.
Figure 1
Figure 2
ALTERNATIVE CLASSROOM EXAMPLE:
A coal-fired power plant.
Chapter 10/Externalities ❖ 185
6. Definition of internalizing an externality: altering incentives so that people take
account of the external effects of their actions.
7.
In the News: The Externalities of Country Living
C. Positive Externalities
1. Example: education.
4. If there is a positive externality, the social value of the good is greater than the private value,
and the optimum quantity will be greater than the quantity produced in the market.
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,
186 ❖ Chapter 10/Externalities
6.
Case Study: Technology Spillovers, Industrial Policy, and Patent Protection
a. A technology spillover occurs when one firm’s research and production efforts impact
another firm’s access to technological advance.
III. Public Policies Toward Externalities
A. When an externality causes a market to reach an inefficient allocation of resources, the
government can respond in two ways.
B. Command-and-Control Policies: Regulation
1. Externalities can be corrected by making certain behaviors either required or forbidden.
C. Market-Based Policy 1: Corrective Taxes and Subsidies
1. Externalities can be internalized through the use of 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
Make sure that students realize how heavily subsidized education is in the United
States – both primary education and secondary education.
Chapter 10/Externalities ❖ 187
3.
Case Study: Why Is Gasoline Taxed So Heavily?
a. In the United States, almost half of what drivers pay for gasoline goes to gas taxes.
D. Market-Based Policy 2: Tradable Pollution Permits
1. Example: EPA regulations restrict the amount of pollution that two firms can emit at 300 tons
2. Social welfare is increased if the EPA allows this situation. Total pollution remains the same
3. If the EPA issued permits to pollute and then allowed firms to sell them, this would also
increase social welfare. Firms that could control pollution most inexpensively would do so and
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.
188 ❖ Chapter 10/Externalities
E. Objections to the Economic Analysis of Pollution
1. Some individuals dislike the idea of allowing companies to purchase the right to pollute.
F.
In the News: Cap and Trade
1. President Obama has proposed a cap and trade system for carbon that would create tradable
permits.
IV. Private Solutions to Externalities
A. We do not necessarily need government involvement to correct externalities.
B. The Types of Private Solutions
1. Problems of externalities can sometimes be solved by moral codes and social sanctions.
2. Many charities have been established that deal with externalities. The government
encourages this private solution by allowing a deduction for charitable contributions in the
determination of taxable income.
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.
2. Example: Dick owns a dog Spot who disturbs a neighbor (Jane) with its barking.
a. One possible solution to this problem would be for Jane to pay Dick to get rid of the dog.
3. Whatever the initial distribution of rights, the parties involved in an externality can potentially
solve the problem themselves and reach an efficient outcome where both parties are better
off.
D. Why Private Solutions Do Not Always Work
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Examples of negative externalities include pollution, barking dogs, and consumption of
alcoholic beverages. Examples of positive externalities include the restoration of historic
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.
Regulation prohibiting pollution beyond some level is good because it is often effective at
reducing pollution. But doing so successfully requires the government to have a lot of
King of Queens, “Dog Days.”
(Season 1, 12:25-16:09). Doug's neighbor has a
190 ❖ Chapter 10/Externalities
pollution and to adopt new technologies that pollute less. The disadvantage of corrective
taxes is that the government needs to know a lot of information to pick the right tax rate.
3. Examples of private solutions to externalities include moral codes and social sanctions,
charities, and relying on the interested parties entering into contracts with one other.
Questions for Review
1. Examples of negative externalities include pollution, barking dogs, and consumption of
2. Figure 1 illustrates the effect of a negative externality. The equilibrium quantity provided by
the market is
Q
market. Because of the externality, the social cost of production is greater than
Chapter 10/Externalities ❖ 191
3. The patent system helps society solve the externality problem from technology spillovers. By
giving inventors exclusive use of their inventions for a certain period, the inventor can
4. Corrective taxes are taxes enacted to correct the effects of a negative externality. Economists
prefer corrective taxes over regulations as a way to protect the environment from pollution
5. Externalities can be solved without government intervention through moral codes and social
sanctions, charities, merging firms whose externalities affect each other, or by contract.
6. According to the Coase theorem, you and your roommate will bargain over whether your
roommate will smoke in the room. If you value clean air more than your roommate values
Problems and Applications
1. The Club conveys a negative externality on other car owners because car thieves will not
attempt to steal a car with The Club visibly in place. This means that they will move on to
2. a. The statement, "The benefits of corrective taxes as a way to reduce pollution have to be
weighed against the deadweight losses that these taxes cause," is false. In fact,
corrective taxes reduce the inefficiency of pollution by reducing the quantity of the good
3. a. Fire extinguishers exhibit positive externalities because even though people buy them for
their own use, they may prevent fire from damaging the property of others.
192 ❖ Chapter 10/Externalities
b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social
value curve is above the demand curve and the social cost curve is the same as the
supply curve.
4. a. The extra traffic is a negative externality because it imposes a cost on other drivers.
b. Figure 3 shows the market for theater tickets. The value of the external cost is the
vertical distance between the private cost and the social cost curves.
Chapter 10/Externalities ❖ 193
c. This is a positive externality because it provides external benefits to those who reside
near the theater.
Figure 4
e. A tax of $3 will lead to the efficient outcome. The market equilibrium quantity will be
equal to the social optimum.
5. a. The market for alcohol is shown in Figure 5. The social cost curve is above the supply
curve because of the negative externality from increased motor vehicle accidents caused
by those who drink and drive. The free-market equilibrium level of output is
Q
market and
the efficient level of output is
Q
optimum.
194 ❖ Chapter 10/Externalities
6. a. It is efficient to have different amounts of pollution reduction at different firms because
the costs of reducing pollution differ across firms. If all firms were made to reduce
pollution by the same amount, the costs would be low at some firms and prohibitive at
others, imposing a greater burden overall.
7. a. At a price of $1.50, each Whovillian will consume 4 bottles of Zlurp. Each consumer’s
total willingness to pay is $14 (= $5 + $4 + $3 + $2). The total spent by each Whovillian
on Zlurp is $6 (= $1.50 4). Therefore, each consumer receives $8 in consumer surplus
(=$14 − $6).
d. The $1 tax raises the price of a bottle of Zlurp to $2.50. (The entire tax will be borne by
consumers because supply is perfectly elastic.) Each resident will purchase only 3 bottles at
the higher price and each consumer’s total willingness to pay is now $12 (= $5 + $4 + $3).
The private cost of the bottles for each resident is $7.50 (= $2.50 3). The external resident
8. a. The externality is noise pollution. Ringo’s consumption of rock and roll music affects
Luciano, but Ringo does not consider that in deciding how loud he plays his music.
b. The landlord could impose a rule that music could not be played above a certain decibel
level. This could be inefficient because there would be no harm done by Ringo playing
his music loud if Luciano is not home.
9. a. An improvement in the technology for controlling pollution would reduce the demand for
pollution rights, shifting the demand curve to the left. Figure 6 illustrates what would
happen if there were a corrective tax, while Figure 7 shows the impact if there were a
Chapter 10/Externalities ❖ 195
b. With a corrective tax, the price of pollution remains unchanged and the quantity of
pollution declines, as Figure 6 shows. With pollution permits, the price of pollution
declines and the quantity of pollution is unchanged, as Figure 7 illustrates.
10. a. In terms of economic efficiency in the market for pollution, it does not matter if the
government distributes the permits or auctions them off, as long as firms can sell the
permits to each other. The only difference would be that the government could make
196 ❖ Chapter 10/Externalities
firms would not matter for efficiency. But it would affect the distribution of wealth,
because those who got the permits and sold them would be better off.
11. a. A permit is worth $25 to firm B, $20 to firm A, and $10 to firm C, because that is the cost
of reducing pollution by one unit. Because firm B faces the highest costs of reducing
pollution, it will keep its own 40 permits and buy 40 permits from the other firms, so that
it can still pollute 80 units. That leaves 40 permits for firms A and C. Because firm A
