ECON1210 Tutorial 8

Externalities
TA: Julie Lu
Email: julielu@connect.hku.hk

1
 Outline
1. Externalities
2. Pigouvian tax/subsidy & Transferrable permits
3. Coase Theorem

ECON1210 Tutorial 8 (Chapter 8: Externalities) 2

 1. Externalities
Compare the following two conditions:
Social Marginal Cost = Private Marginal Cost + External
Cost
Social Marginal Cost = Private Marginal Cost
the costs of production are NOT all borne by the sellers
all the costs of production are borne by the sellers
Social Marginal Benefit = Private Marginal Benefit +
Social Marginal Benefit = Private Marginal Benefit
External Benefit
all the benefits of consumption goes to buyers
the benefits of consumption does NOT all go to buyers

Welfare is maximized in the unregulated Welfare is NOT maximized in the unregulated

market, unregulated market is the best. market, unregulated market is NOT the best.
Any intervention will cause welfare loss. There EXISTS some regulation(s) that can
improve the welfare

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 1. Externalities
(1) Concepts
Externalities: collective name of external costs and external benefits. Externalities arise when
costs or benefits that result from an activity accrue to people not directly involved in the activity.

External cost: a cost paid by people other than the consumer or the producer trading in the
market

External benefit: a benefit received by people other than the consumer or the producer trading in
the market

ECON1210 Tutorial 8 (Chapter 8: Externalities) 4

 1. Externalities
(2) Look at the market from the society's perspective
Social cost = private cost (supply) + external cost
Social benefit = private benefit (demand) + external benefit

Think from margin...

Marginal social benefit (Qefficient) = Marginal social cost (Qefficient)
Unregulated market
Marginal private benefit (Qmkt) = Marginal private cost (Qmkt)
equilibrium does not
guarantee social efficiency!

ECON1210 Tutorial 8 (Chapter 8: Externalities) 5

 1. Externalities
(2) Look at the market from the society's perspective: when external cost exists
Marginal social cost = Marginal private cost (supply) + External cost

Costs are underestimated (external

costs not taken into account)
The market quantity is greater than
the socially efficient level
Negative externalities: too much
activity

ECON1210 Tutorial 8 (Chapter 8: Externalities) 6

 1. Externalities
(2) Look at the market from the society's perspective: when external benefit exists
Marginal social benefit = Marginal private benefit (demand) + External benefit

Benefits are underestimated (external

benefits not taken into account).
The market quantity is lower than the
socially efficient level.
Positive externalities: too little
activity

ECON1210 Tutorial 8 (Chapter 8: Externalities) 7

 1. Externalities
(3) Deal with the inefficiency caused by externalities: government's intervention

ECON1210 Tutorial 8 (Chapter 8: Externalities) 8

 1. Externalities
In-class Quiz 1: Go to Moodle page Inclass Exercises During Tutorials section

ECON1210 Tutorial 8 (Chapter 8: Externalities) 9

 1. Externalities
In-class Quiz 1
Consider the market for recycling bags. The demand and social marginal benefit are
summarized by the following equations.
Demand: P = 800 - 0.6Q
Social marginal benefit: MB = 1100 - 0.4Q
The external benefit at quantity 470 is ____ dollar(s) for an additional bag.
(In decimal numbers, with two decimal places, please.)

ECON1210 Tutorial 8 (Chapter 8: Externalities) 10

 1. Externalities
In-class Quiz 1
Consider the market for recycling bags. The demand and social marginal benefit are summarized by the
following equations.
Demand: P = 800 - 0.6Q
Social marginal benefit: MB = 1100 - 0.4Q
The external benefit at quantity 470 is ____ dollar(s) for an additional bag.

A nswer:
At Q = 470,
Private benefit = MB = 800 – 0.6*470 = 518
Social benefit = 1100 – 0.4*470 = 912
External benefit = social benefit – private benefit = 912 – 518 = 394

ECON1210 Tutorial 8 (Chapter 8: Externalities) 11

 Outline
1. Externalities
2. Pigouvian tax/subsidy & Transferrable permits
3. Coase Theorem

ECON1210 Tutorial 8 (Chapter 8: Externalities) 12

 2. Pigouvian tax/subsidy & Transferrable permits
(1.1) Pigouvian tax

When there exists a negative externality

—> over-production
Marginal Private Cost
= Supply

Marginal External Cost

—> To eliminate the over-production and
= Pigouvian tax
achieve social optimal, we can impose
a tax on sellers by the amount of marginal
external cost

ECON1210 Tutorial 8 (Chapter 8: Externalities) 13

 2. Pigouvian tax/subsidy & Transferrable permits
(1.2) Pigouvian subsidy

When there exists a positive externality

—> under-production
—> To eliminate the under-production and
achieve social optimal, we can impose
a subsidy on buyers by the amount of
Marginal External Benefit
= Pigouvian subsidy

marginal external benefit.

Marginal Private Benefit
= Demand

ECON1210 Tutorial 8 (Chapter 8: Externalities) 14

 2. Pigouvian tax/subsidy & Transferrable permits
(2) Transferrable permits
When an external cost presents, the government can issue transferrable permits (or allowances)
to manage the supply.

Check the lecture example of Pollution permits

ECON1210 Tutorial 8 (Chapter 8: Externalities) 15

 2. Pigouvian tax/subsidy & Transferrable permits
(3) Summary
Note that the efficient implementation of both Pigouvian taxes/subsidies and transferrable
permits needs a perfect information environment. In reality when such assumption can not be
met, we can only reach the goal by research and trial-and-error.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 16

 2. Pigouvian tax/subsidy & Transferrable permits
(3) Summary
With perfect information, a tax set equal to the level of the external cost is equivalent to tradable
allowances when the number of allowances is set equal to the efficient quantity.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 17

 Outline
1. Externalities
2. Pigouvian tax/subsidy & Transferrable permits
3. Coase Theorem

ECON1210 Tutorial 8 (Chapter 8: Externalities) 18

 3. Coase Theorem
(1) Arrive at an ideal private solution
Coase Theorem: If property rights are fully assigned and if people can negotiate costlessly with
one another, they will always arrive at efficient solutions to problems caused by externalities.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 19

 3. Coase Theorem
Example 1. Jane owns a house near the peak overlooking the harbour, from which she enjoys a
commanding sunset view. Now Andy purchases the property below Jane’s and is considering which of
two houses to build: a one-story house that would leave Jane’s view intact; or a two-story design that
would completely block Jane’s view. Suppose the gain to Jane from an unobstructed view is $120, the
gain to Andy from having a onestory house is $220, and the gain to Andy from a two-story house is $300.
It is assumed that negotiations between the two parties were costless and Andy has the right to build as
tall as he can. What is the optimal private solution to the problem?
A. Andy builds a one-story house by receiving $40 from Jane.
B. Andy builds a one-story house by receiving $90 from Jane.
C. Andy builds a two-story house without negotiating with Jane.
D. Andy builds a two-story house by paying Jane $40.
E. Andy builds a two-story house by paying Jane $90.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 20

 3. Coase Theorem
Example 1. Jane owns a house near the peak overlooking the harbour, from which she enjoys a
commanding sunset view. Now Andy purchases the property below Jane’s and is considering which of
two houses to build: a one-story house that would leave Jane’s view intact; or a two-story design that
would completely block Jane’s view. Suppose the gain to Jane from an unobstructed view is $120, the
gain to Andy from having a onestory house is $220, and the gain to Andy from a two-story house is $300.
It is assumed that negotiations between the two parties were costless and Andy has the right to build as
tall as he can. What is the optimal private solution to the problem?

ECON1210 Tutorial 8 (Chapter 8: Externalities) 21

 3. Coase Theorem
Negotiations between the two parties were costless and Andy has the property right.
Gain from two plans:

One-story Two-story
Jane 120 0
Andy 220 300

Andy will not agree to build a one-story unless he receives a compensation of $80 (= $300 - $220);
Jane is willing to provide Andy up to $120 (= $120 - $0) to ask him to build a one-story house, instead of
a two-story house;
Private solution: Andy will build a one-story house by receiving an amount between $80 to $120 from
Jane.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 22

 3. Coase Theorem
Example 1. Jane owns a house near the peak overlooking the harbour, from which she enjoys a
commanding sunset view. Now Andy purchases the property below Jane’s and is considering which of
two houses to build: a one-story house that would leave Jane’s view intact; or a two-story design that
would completely block Jane’s view. Suppose the gain to Jane from an unobstructed view is 120, the gain
to Andy from having a onestory house is 220, and the gain to Andy from a two-story house is 300. It is
assumed that negotiations between the two parties were costless and Andy has the right to build as tall as
he can. What is the optimal private solution to the problem?
A. Andy builds a one-story house by receiving $40 from Jane.
B. Andy builds a one-story house by receiving $90 from Jane.
C. Andy builds a two-story house without negotiating with Jane.
D. Andy builds a two-story house by paying Jane $40.
E. Andy builds a two-story house by paying Jane $90.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 23

 3. Coase Theorem
Negotiations between the two parties were costless and Andy has the property right.
Gain from two plans:

One-story Two-story
Jane 120 0
Andy 220 300

Social benefit of building a one-story house = $120 + $220 = $340

Social benefit of building a two-story house = $0 + $300 = $300
$340 > $300 ⟹ social efficiency: build a one-story house

ECON1210 Tutorial 8 (Chapter 8: Externalities) 24

 3. Coase Theorem
What about Jane has the property right to appreciate the view?

Negotiations between the two parties were costless and Jane has the property right.
Gain from two plans:

One-story Two-story
Jane 120 0
Andy 220 300

Jane will not agree Andy to build a two-story unless she receives a compensation of $120 (= $120 - $0);
Andy is willing to provide Jane up to $80 (= $300 - $220) to ask her permission to build a two-story
house, instead of a one-story house;
Private solution: Andy will build a one-story house => social efficiency

ECON1210 Tutorial 8 (Chapter 8: Externalities) 25

 3. Coase Theorem
Example 2.
A competitive firm pollutes the air. The following graph shows the demand for the firm’s
product and the private and social marginal cost curves. The numbers in the graph represent
areas measured in dollars. Suppose that there are no transaction costs, that there is no legal
penalty for polluting, and that it is impossible
for the neighbors to move. According to the
Coase Theorem, a deal would be struck
between the firm and the neighbors to produce
_____ units of output, thereby generating an
_____ additional gain of to the society.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 26

 3. Coase Theorem
Example 2.
A competitive firm pollutes the air. The following graph shows the demand for the firm’s
product and the private and social marginal cost curves. The numbers in the graph represent
areas measured in dollars. Suppose that there are no transaction costs, that there is no legal
penalty for polluting, and that it is impossible
for the neighbors to move. According to the
Coase Theorem, a deal would be struck
between the firm and the neighbors to produce
_____ units of output, thereby generating an
_____ additional gain of to the society.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 27

 3. Coase Theorem
Example 2.

Without any deal, the firm will produce 80

units and thus enjoys a producer surplus of
$25 (8+12+5).
But there is an external cost of $24
(12+5+7) borne by the neigbours.
Hence, the net social surplus is $1.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 28

 3. Coase Theorem
Example 2.

Since the assumptions of Coase Theorem is

satisfied, two parties can negotiate and trade.
The efficient outcome is to produce 70 units
yielding $8 of social surplus.

Moving from 80 units to 70 units will thus

generate $8-$1= $7 of additional social gain.

ECON1210 Tutorial 8 (Chapter 8: Externalities) 29

 3. Coase Theorem
In-class Quiz 2: Go to Moodle page Inclass Exercises During Tutorials section

ECON1210 Tutorial 8 (Chapter 8: Externalities) 30

 3. Coase Theorem
In-class Quiz 2:
Li can produce with or without a filter on his smokestack. Production without a filter results in
greater smoke damage to Fung, say to Fung’s health. Suppose Li is not liable for smoke damages
and if the two parties can negotiate costlessly with one another. The following table shows the gain
and loss of the two persons under different scenarios.

Production with smoke filter Production without smoke filter

Gains to Li $100/week $145/week

Damage to Fung $25/week $105/week

What is the maximum amount that Fung would be willing to pay such that Li would install a filter?

ECON1210 Tutorial 8 (Chapter 8: Externalities) 31

 3. Coase Theorem
In-class Quiz 2:
Li can produce with or without a filter on his smokestack. Production without a filter results in
greater smoke damage to Fung, say to Fung’s health. Suppose Li is not liable for smoke damages
and if the two parties can negotiate costlessly with one another. The following table shows the gain
and loss of the two persons under different scenarios.

Production with smoke filter Production without smoke filter

Gains to Li $100/week $145/week

Damage to Fung $25/week $105/week

What is the maximum amount that Fung would be willing to pay such that Li would install a filter?
Answer: $105 – $25 = $80

ECON1210 Tutorial 8 (Chapter 8: Externalities) 32

 3. Coase Theorem
(2) Arrive at a public solution
When conditions in Coase Theorem (fully-assigned property rights and costless negotiation) are
NOT satisfied (for example, there exists high negotiation cost), what can we do?
Government can step in, interfere the market and equalize the private and social optimum by
means of Pigouvian tax, Pigouvian subsidy, tradable allowances …

ECON1210 Tutorial 8 (Chapter 8: Externalities) 33

 Reminder
Quiz8: Nov. 02, 10:30PM to Nov. 09, 10:30PM
Late Quiz8: Nov. 09, 10:30PM to Nov. 11, 10:30PM

ECON1210 Tutorial 8 (Chapter 8: Externalities) 34

 Acknowledgement
Materials of this tutorial are developed from the work of Dr. Ka-fu Wong, Mr. Mu
Haoxin, and Miss Wei Xinyu

ECON1210 Tutorial 8 (Chapter 8: Externalities) 35