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Module 34
Externalities
What’s New in the Fourth Edition?
• Updated business cases
• Handouts to use in class
Module Objectives
• What are externalities and why do they lead to inefficiency?
• Why do externalities often require government intervention?
• How do negative externalities, positive externalities, and network externalities differ?
• What is the Coase theorem and how does it explain that private individuals can sometimes remedy
externalities?
Teaching Tips
The Economics of Negative Externality: Pollution
Creating Student Interest
• Ask students to consider the idea of having zero pollution.
First, is it possible to have zero pollution? The discussion of this question will center on the
definition of pollution. If pollution is the creation of any waste from production and consumption,
it is impossible to live without polluting. For example, squirrels will use up acorns and leave acorn
shells and squirrel waste—is this pollution? If pollution is defined as the creation of more waste
than the environment can absorb, then it is more conceivable that we could have zero pollution.
Next, even if it is possible, would we want to achieve zero pollution? What would we have to do
to achieve zero pollution? We would have to reduce the waste created by production and
consumption or pay to deal with the waste we create so that it does not enter the environment as
Presenting the Material
• Explain that pollution imposes costs on society as a whole and benefits for individual firms who are
polluting. The benefits go to firms that do not have to pay for pollution-reducing equipment. The
marginal social cost shown in the graph below is more intuitive for students to understand. The
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greater the quantity of pollution, the harder it is for the natural world to handle the damage, and the
additional costs to society rise.
The marginal social benefit of pollution represents the willingness of polluters to pay for the right
to pollute; their willingness to pay is equal to the cost of reducing pollution by that quantity of
emissions. In the graph below, as we move from point A to point B, it becomes progressively
harder to achieve lower amounts of pollution and therefore more expensive to achieve these lower
amounts of pollution. To produce less pollution, a polluter would have to spend a greater amount
of money on pollution-reducing equipment or production methods; therefore, the marginal social
benefit of producing that unit of pollution is high. The socially optimal quantity of pollution is
where marginal social cost and marginal social benefit are equal.
The Economics of Positive Externalities
Creating Student Interest
• Ask students to think about their roommate having an incredibly good Bose Bluetooth speaker that
he or she plays very loudly with music that is of questionable quality. The resident assistant happens
to like said music and refuses to enforce the noise regulations in the dorm. Ask how the students
might negotiate to reduce irritation. As they answer, ask how those negotiated settlements might
fail. Ask how they might never reach a negotiated settlement. Be sure also to ask who has the
Presenting the Material
• This might be a good time to introduce students to economic research articles by discussing Coase’s
article or examples in it. It reads fairly easily and the lack of mathematics in the article makes it a
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Module Outline
I. Externalities: An Overview
A. External costs and benefits are known as externalities; external costs are negative externalities,
and external benefits are positive externalities.
B. Externalities can lead to individual decisions that are not optimal for society as a whole.
II. The Economics of a Negative Externality: Pollution
A. Pollution leads to an external cost because, in the absence of government intervention, those
who pollute have no incentive to take into account the costs that this pollution imposes on
others.
B. Costs and Benefits of Pollution
1. The socially optimal quantity of pollution equates the marginal social benefits of
pollution with its marginal social costs.
2. Left to itself, a market economy will not arrive at the socially optimal quantity of
pollution.
C. Why a market economy produces too much pollution
1. The marginal social benefit (MSB) of a unit of pollution is the saved opportunity cost
from not having to reduce pollution by that one unit. The MSB is enjoyed by the polluter.
2. The marginal social cost (MSC) of a unit of pollution includes the health and other costs
of a unit of pollution. The MSC is borne by society.
3. The polluter has a nonzero private marginal cost (MC) of pollution only if it is required
to pay for the right to pollute.
4. If the polluter is not required to pay for the right to pollute, its private MC is zero. It will
therefore produce pollution up to the point where the MSB of polluting is also zero.
Polluters, therefore, will spend nothing to reduce the amount of pollution they generate.
This is illustrated in text Figure 34-2, shown next.
Figure 34-2
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III. The Economics of Positive Externalities
A. According to the Coase theorem, even in the presence of externalities an economy can always
reach an efficient solution as long as transaction costs are sufficiently low.
B. The implication of Coase’s analysis is that externalities need not lead to inefficiency because
Case Studies in the Text
Economics in Action
Talking, Texting, and Driving—This FIM discusses the negative externalities of driving while talking or
texting on a cell phone (the risk to other drivers, as it tends to cause erratic driving).
Ask students the following questions:
1. How many traffic accidents were attributable to cell phone use in 2016? (1 in 4.)
2. What is the externality associated with cell phone use? (Drivers not using cell phones,
pedestrians, and passengers can be harmed in an accident with a driver using a cell
phone.)
Web Resources
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Handout 34-1
Date_________ Name____________________________ Class________ Professor________________
Is It Positive or Negative?
Are the following positive or negative externalities? Why?
• Students holding onto library reserve books over the time limit
• Smoking on campus expos students to secondhand smoke
• College graduates add to the nation’s supply of skilled workers and add to productivity
• Biotech firms invent new medicines
• Using energy-saving light bulbs reduces the pollution from electricity-generating plants
• Pop-ups and spam
• Alcohol consumption at parties near the campus
• Crowded freeways with heavy truck use expos the surrounding communities to increased health
risks
• Restoring the Amazon forest can reduce global levels of pollution
• Students talking on cell phones as they walk around campus
Answers
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