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170
Chapter 10
Externalities
WHAT’S NEW IN THE EIGHTH EDITION:
Three new features have been added, an
In the News
feature on “The Coase Theorem in Action,” an
Ask
the Experts
feature on “Vaccines,” and an
Ask the Experts
feature on “Carbon Taxes.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ what an externality is.
➢ why externalities can make market outcomes inefficient.
➢ the various government policies aimed at solving the problem of externalities.
➢ how people can sometimes solve the problem of externalities on their own.
➢ why private solutions to externalities sometimes do not work.
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.
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
EXTERNALITIES
10
0
Chapter 10/Externalities ❖ 171
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.
• 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
result of this policy is similar to imposing corrective taxes on polluters.
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.
C. In either situation, decision makers fail to take account of the external effects of their behavior.
II. Externalities and Market Inefficiency
A. Welfare Economics: A Recap
2. The supply curve for a good reflects the cost of producing that good.
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.
172 ❖ Chapter 10/Externalities
B. Negative 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.
3. The optimal amount of aluminum in the market will occur where total surplus is maximized.
a. Total surplus is equal to the value of aluminum to consumers minus the cost (social cost)
of producing it.
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 ❖ 173
C. Positive Externalities
1. Example: education.
3. In this case, the demand curve does not reflect the social value of a good.
4. If there is a positive externality, the social value of the good is greater than the private value,
and the optimal quantity will be greater than the quantity produced in the market.
5. To internalize a positive externality, the government could use a subsidy.
6.
Case Study: Technology Spillovers, Industrial Policy, and Patent Protection
a. A technology spillover occurs when one firm’s research and production efforts affect
another firm’s access to technological advance.
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).
Make sure that students realize how heavily subsidized education is in the United
States – both primary education and secondary education.
174 ❖ Chapter 10/Externalities
b. It is difficult to measure the amounts of technology spillover that occur and this leads to
a debate over whether the government should pursue policies to encourage the
production of technology.
c. Patent protection is a type of technology policy of the government because it protects
the rights of inventors who create new technologies. Without patents, there would be
less incentive to develop new ideas and technologies.
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.
1. Command-and-control policies regulate behavior directly.
B. Command-and-Control Policies: Regulation
1. Externalities can be corrected by requiring or forbidding certain behaviors.
3. EPA regulations include maximum levels of pollution allowed or required adoption of a
particular technology to reduce emissions.
4.
Ask the Experts:
Vaccines
a. 100 percent of economic experts agreed that declining to be vaccinated against
contagious diseases imposes costs on others, resulting in a negative externality.
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 decision makers 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
pollution with the least cost are likely to do so (to avoid the tax) while firms that
encounter high costs when reducing pollution will simply pay the tax.
Chapter 10/Externalities ❖ 175
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.
4.
In the News:
What Should We Do about Climate Change?
a. Many policy analysts believe that taxing carbon is the best approach to dealing with
global climate change.
b. This article from
The New York Times
explains how the revenue-neutral carbon tax works
in British Columbia and argues for its implementation in the United States.
5.
Ask the Experts:
Carbon Taxes
a. 98 percent of expert economists on the panel agreed that a proposed carbon tax would
distort the U.S. economy less than a tax increase on labor income that resulted in the
same amount of revenue. The other 2 percent were uncertain.
b. 95 percent of expert economists on the panel agreed that a tax on the carbon content of
fuels would be a less expensive way to reduce carbon dioxide emissions than the
command and control policies affecting fuel efficiency of automobiles.
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
so there are no external effects. If both firms are doing this willingly, it must make them
better off.
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
176 ❖ Chapter 10/Externalities
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.
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
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.
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.
a. Do not litter.
b. The Golden Rule
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.
Figure 4
Chapter 10/Externalities ❖ 177
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
3. The parties involved in this externality (either the seller and the bystander or the consumer
and the bystander) can possibly enter into an agreement to correct the externality.
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.
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.
4.
In the News:
The Coase Theorem in Action
a. This
New York Times
article illustrates how the Coase theorem can be applied to reclining
seats on airlines.
b. With low bargaining costs, passengers with the greatest value over the property right will
end up with it, because the property right is clearly defined initially.
D. Why Private Solutions Do Not Always Work
2. Coordination of all of the interested parties may be difficult so that bargaining breaks down.
This is especially true when the number of interested parties is large.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Examples of negative externalities include pollution, barking dogs, and consumption of
178 ❖ Chapter 10/Externalities
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.
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.
Chapter Quick Quiz
1. c
Questions for Review
1. Examples of negative externalities include pollution, barking dogs, and consumption of
Chapter 10/Externalities ❖ 179
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
Figure 1
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
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
180 ❖ Chapter 10/Externalities
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. 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.
b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social-
3. a. The market for alcohol is shown in Figure 3. The social-value curve is the same as the
demand curve in this case. The social-cost curve is above the supply curve because of
Chapter 10/Externalities ❖ 181
Figure 3
4. a. It is efficient to have different amounts of pollution reduction at different firms because
b. Command-and-control approaches that rely on uniform pollution reduction among firms
c. Corrective taxes or tradable pollution rights give firms greater incentives to reduce
5. a. At a price of $1.50, each Whovillian will consume 4 bottles of Zlurp. Each consumer’s
182 ❖ Chapter 10/Externalities
6. a. The externality is noise pollution. Bruno’s consumption of rock and roll music affects
c. Bruno and Placido could negotiate an agreement that might, for example, allow Bruno to
7. a. An improvement in the technology for controlling pollution would reduce the demand for
pollution rights, shifting the demand curve to the left. Figure 4 illustrates what would
b. With a corrective tax, the price of pollution remains unchanged and the quantity of
Chapter 10/Externalities ❖ 183
8. 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
occurring if firms use resources to lobby for additional permits.
b. If the government allocated the permits to firms who did not value them as highly as
other firms, the firms could sell the permits to each other so they would end up in the
9. a. The firms with the highest cost of reducing pollution will buy permits rather than reduce
their pollution. Firms that can sell their permits for more than it costs them to reduce
b. If the permits could not be traded, then firm A would have to reduce its pollution by 10
