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Module 35
Externalities and Public Policy
What’s New in the Fifth Edition?
• Updated business cases
Module Objectives
• Why are some government policies to deal with externalities efficient and others are not?
• Why are network externalities an important feature of high-tech industries?
Teaching Tips
Government Policies to Address Pollution
Creating Student Interest
• Ask students to consider activities like smoking or talking on a cell phone while driving. Do these
activities have externalities associated with them? Research indicates that secondhand smoke and
distracted driving are both hazards to other individuals that result when a person smokes or talks on
a phone while driving. Ask the students what they think should be done about these behaviors? The
possible solutions include doing nothing, letting individuals work out their own solutions,
government regulation (taxes, permits), and prohibition. As part of this discussion, you may want to
point out the difference between political and economic analysis of the optimal solution (and try to
keep them focused on determining the efficient level of the activity).
Presenting the Material
• Carefully define and explain each of the three approaches to regulating emissions—the standard, the
tax, and the tradable emissions permit system. Begin with the standard, as it is the most common
approach in the United States. The EPA website has an abundance of information on environmental
regulation if you care to expand on the topic. The advantages of setting a standard (say, limiting each
firm’s emissions to a certain level) include the perception that it is fair (in treating all firms equally)
and that it sets an exact limit on the level of emissions. The disadvantage of the standard is that it
does not reach the desired emissions target at lowest total cost because firms have different costs of
reducing emissions.
• The emissions tax can in theory achieve the same reduction in emissions at a lower cost to the firms
in total, not including the actual tax revenue paid. With a standard, emissions are essentially free.
With the emissions tax, the firm must pay a dollar amount per unit emitted. Firms therefore have an
incentive to reduce emissions as long as the tax is greater than the cost of reducing emissions, as
measured by marginal benefit. The advantages of the tax include minimizing the amount spent by
firms on pollution control in total. Also, the existence of the tax gives firms a continued incentive to
develop cleaner technologies and thereby avoid having to pay a tax. Another advantage of the tax is
the government collects revenue, which can be used in a variety of ways, including funding research
and development of cleaner technologies. On the downside, the costs of production for the firm will
rise and this will push up prices of goods and services.
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The third option is the tradable emissions permit system. Each firm is issued a certain number of
permits, each of which allows for some level of emissions. Firms are then allowed to use the
Positive Externalities
Creating Student Interest
• In this section, the discussion is expanded to include external benefits. Have students think of
examples of an activity of an individual or firm that creates a benefit for them that they do not pay
for. To get them started, you can present examples like a bakery that creates a pleasant smell for
passersby (as opposed to a firm emitting toxic pollution); a roommate playing music that you enjoy
(as opposed to disturbing your studying with loud music you don’t enjoy); a neighbor who creates
beautiful landscaping that you enjoy and that enhances the value of your own property (as opposed
to piling trash in their front yard); a college student getting an education (as opposed to squandering
their talents and creating no social benefit, and/or becoming a criminal).
• Tell students they have an amazing opportunity to buy a new car. This car has all of the features they
are looking for in a car and it is being sold for a very competitive price. The only catch—the car runs
on natural gas. Will they buy it? Students should realize that finding fuel for the car will be
challenging and therefore they may not want to buy the car. Since there are not many natural gas
fueling sites, many people will not want to buy cars that run on natural gas. Now ask students if there
are any downsides to owning a Mac computer. As students, they may not perceive any. However, in
the business world, many programs run only on Windows-based computers.
Presenting the Material
• Make sure students understand that the preserved farmland example in this section is just the
opposite of the emissions example in the last section. With emissions of a pollutant, the incentive of
the firm is to not control emissions because this is costly and will reduce profit. As a result, society
ends up with too many emissions. The firms fail to consider the external costs imposed on members
Module Outline
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I. Government Policies to Address Pollution
A. In 1970 Congress adopted the Clean Air Act (CAA), which established the Environmental
Protection Agency. The CAA was amended in 1977 and 1990. For more information, go to
www.epa.gov.
B. Environmental standards
1. The government’s main policy tool to deal with externalities is environmental standards.
2. Most current environmental standards are inflexible and wind up being inefficient.
C. Emissions taxes versus environmental standards
1. An emissions tax is more efficient than environmental standards because it ensures that
the marginal benefit of pollution is equal for all sources of pollution, while an
environmental standard does not.
D. Tradable emissions permits
1. Tradable emissions permits are licenses to emit limited quantities of pollutants that can
be bought and sold by polluters.
2. The key point is that these permits are tradable. Firms that find it easier to reduce
pollution will sell some of their permits to those that find it more difficult.
E. The Economics of Climate Change and the Great Energy Transition
1. Science has conclusively shown that emissions of greenhouse gases are changing
Earth’s climate.
Case Studies in the Text
Economics in Action
Cap and Trade—This EIA explains cap and trade through the permit systems for acid rain in the US and
greenhouse gases in the European Union.
Web Resources
There are two excellent classroom experiments related to externalities on the Expernomics website.
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Handout 35-1
Date_________ Name____________________________ Class________ Professor________________
The following table shows the MB of polluting to firm A and firm B (which represents the MC of
abatement of pollution to the firms).
A. Imagine an environmental standard where each firm is allowed to emit 11 units.
Emissions
MB firm A
MB firm B
20
0
0
19
4
2
18
8
4
17
12
6
12
32
16
11
36
18
10
40
20
9
44
22
8
48
24
7
52
26
5
60
30
3
68
34
1
76
38
0
80
40
16
16
8
15
20
10
14
24
12
13
28
14
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1. What is the total cost of this standard to firm A?
2. What is the total cost of this standard to firm B?
3. What is the total cost to the industry made up of these two firms?
B. Now suppose that a tax of $24 per unit of emissions is imposed.
1. How many units of emissions will firm A choose to emit and at what cost?
2. How many units of emissions will firm B choose to emit?
3. What is the total cost to this industry for the reduction in emissions?
C. Now suppose each firm is issued 11 permits in a tradable emissions permits market.
1. Who will purchase permits? Who will sell?
2. Where will the price of permits sell?
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Answers:
A. Imagine an environmental standard where each firm is allowed to emit 11 units.
B. Now suppose that a tax of $24 per unit of emissions is imposed.
C. Now suppose each firm is issued 11 permits in a tradable emissions permits market.