Externalities

Chapter 10

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IN THIS CHAPTER
• Externality: one type of market failure
• Negative and positive Externality
• Solutions: Internalizing the externality
• Public Policies
• Command-and-control policies:
• Regulations(Regulate behavior directly)
• Market-based policies:
• Corrective taxes(≠ TAX!) and subsidies
• Tradable pollution permits
• Private solution: The Coes Theorem

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Externalities
• Externality: one type of market failure
− Arises when a person engages in an activity that
influences the well-being of a bystander
• But neither pays nor receives compensation for that
effect
• Negative externality
− Impact on the bystander is adverse
• Positive externality
− Impact on the bystander is beneficial

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Market Inefficiency
• Self-interested buyers and sellers
− Do not take into account the external effects of their
actions: market outcome is not efficient

• “Government action can sometimes improve upon market

outcomes”
− Why markets sometimes fail to allocate resources
efficiently
− How government policies can potentially improve the
market’s allocation
− What kinds of policies are likely to work best
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Example: Negative Externalities
• Negative externalities
− Air or water pollution from a factory
− The neighbor’s barking dog or late-night party
− Noise pollution from construction projects
− Second-hand smoke
− Texting while driving or walking

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 Recap of welfare economics, no externalities
P
$300
The market for paper • Supply curve shows private
cost, the costs directly
240 incurred by sellers.
• Demand curve shows private
180
$150 value, the value to buyers
120 (the prices they are willing to
pay).
60 • The market equilibrium
0
maximizes consumer
0 10 20 25 30 Q + producer surplus.
(tons of paper per day)
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 Example: Analysis of a negative externality
P
The supply of paper Social cost
$300
= private + external cost
240 external
cost Supply (private cost)
180
External cost
120 = value of the negative impact on
bystanders
60
= $60 per ton
0 (value of harm
0 10 20 30 Q from air and water pollution)
(tons of paper per day)
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 Example: Analysis of a negative externality
P
The market for paper
$ 300
Social The socially optimal quantity is
cost 20 tons of paper!
240
S
• At any Q < 20, value of
180
additional paper (WTP) exceeds
120 the social cost.
D
• At any Q > 20, social cost of the
60
last ton of paper exceeds its
0 value to society.
0 10 20 25 30 Q
(tons of paper per day)
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Remedy for a Negative externality
• Internalizing the externality:
− Altering incentives so that people take into account the
external effects of their actions
− In our example, a $60/ton tax on sellers will make sellers’
costs = social costs.

• If market participants pay social costs

− Finally, Market equilibrium = social optimum!

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 Remedy for a Negative externality
P
The market for paper
$300
Social
cost • Market equilibrium (Q = 25) is
240
S greater than the social
180 optimum (Q = 20).

120 • One solution:

D tax sellers $60/ton, would
60 shift S curve up by $60.
0
0 10 20 25 30 Q
(tons of paper per day)
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Example: Positive Externalities
• Positive externalities
− Research into new technologies
− Being vaccinated against contagious diseases
− People going to college raise the population’s education
level, which reduces crime and improves government

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 Example: Analysis of Positive externalities
P The demand of flu shots
$ 50
external be External benefit
40 nefit = value of the positive im
pact on bystanders
30
Social value
20 = private value
+ $10 external benefit
10
D (private value)
0 Q
0 10 20 30
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Remedy for a Positive externality
• Internalizing the externality:
− Altering incentives so that people take into account the
external effects of their actions
− In our example, a $10 subsidy on vaccinators = social
value

• If market participants receive a subsidy

− Finally, Market equilibrium = social optimum!

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 Example: Analysis of Positive externalities
P The market for flu shots
$ 50 Market equilibrium (Q = 20)

40 is lower than the social

optimum (Q = 25).
S
30
One solution:
20 Social
subsidize buyers $10 (external
value
benefit), would shift D curve up
10
D by $10
0 Q
0 10 20 25 30
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Effects of Externalities: Summary
• If negative externality
− Market quantity > than socially desirable

• If positive externality
− Market quantity < than socially desirable

• To remedy the problem, “internalize the externality”

− Corrective Tax goods with negative externalities
− Subsidize goods with positive externalities

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Solutions

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How to solve externalities
Solutions: Internalize the externality
1. Public Policies
1) Command-and-control policies:
• Regulations(Regulate behavior directly)
2) Market-based policies:
i) Corrective taxes(≠ TAX!) and subsidies
ii) Tradable pollution permits

2. Private solution
1) The Coes Theorem

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Public Policies toward Externalities
1) Command-and-control policies
• Regulate behavior directly by requiring or forbidding
certain behaviors
• Impossible to prohibit all polluting activity
• Examples:
− Decide a maximum level of pollution
− Require that firms adopt a particular technology to
reduce emissions

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Public Policies toward Externalities
2) Market-based policies
− To align private incentives with social efficiency
− Private decision makers will choose to solve the problem
on their own
i) Corrective taxes and subsidies
ii) Tradable pollution permits

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i) Corrective Taxes
• Corrective taxes (Pigovian taxes)
− Align private incentives with society’s interests
− Induce private decision makers to take into account the
social costs of a negative externality
− Should equal the external cost
− Places a price on the right to pollute
− Reduce pollution at a lower cost to society (than
regulation)
− Raise revenue for the government
− Enhance economic efficiency

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Pigovian taxes
• Corrective taxes (Pigovian taxes)

Arthur Cecil Pigou

Source: NY Times
1877~1959
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Corrective Taxes and Regulations
• A pollution tax is efficient:
− Firms with low abatement costs will reduce pollution to
reduce their tax burden
− Firms with high abatement costs have greater
willingness to pay tax.

• Regulation requiring all firms to reduce pollution by a

specific amount is not efficient
− Firms have no incentive to reduce emission further once
they have reached the required target

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ii) Tradable pollution permits system
• Reduces pollution at lower cost than regulation
− Firms with low cost of reducing pollution
do so and sell their unused permits
− Firms with high cost of reducing pollution
buy permits

• Result: Pollution reduction is concentrated among those

firms with lowest costs

• The initial allocation of the permits among firms does not

matter from the standpoint of economic efficiency
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Corrective Taxes and Pollution Permits
• Reducing pollution using pollution permits or corrective
taxes
− Internalize the externality of pollution
− Firms pay for their pollution
1) Corrective taxes: pay to the government
2) Pollution permits: pay to buy permits

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The Equivalence of Corrective Taxes and Pollution Permits

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Why is Gasoline Taxed so Heavily?
• The gas tax can be vied as a corrective tax targeting three
negative externalities:
− Congestion: The more you drive, the more you contribute to
congestion.
− Accidents: Larger vehicles cause more damage in an
accident.
− Pollution: Cars cause smog. Burning fossil fuels is widely
believed to be the primary cause of global climate change.

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Why is Gasoline Taxed so Heavily?
• The gas tax = corrective tax
− Doesn’t cause deadweight losses
− Makes the economy work better
• Less traffic congestion
• Safer roads
• Cleaner environment

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Private Solutions to Externalities
• The Coase theorem
− If private parties can bargain without cost over the
allocation of resources
• They can solve the problem of externalities on their
own

• Whatever the initial distribution of rights Interested parties

can reach a bargain:
− Everyone is better off
− Outcome is efficient

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Example: Private solutions to externalities
A. Tao has the legal right to play the piano or not
• Tao gets a $500 benefit from playing the piano
• Eva bears an $800 cost from the loud music
• Efficient outcome:
− Eva can offer Taio $600 to stop playing piano in the
apartment
− Tao will gladly accept (he’s better off with $600 cash
than with $500 worth of piano playing)
− Both are better off

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Example: Private solutions to externalities
B. Tao has the legal right to play the piano or not
• Tao gets a $1,000 benefit from playing the piano
• Eva bears an $800 cost from the loud music
• Efficient outcome:
− Tao turns down any offer below $1,000
− Eva will not offer any amount above $800
− Tao keeps playing the piano

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Private Solutions to Externalities
• Why private solutions do not always work
− High transaction costs
• Costs that parties incur in the process of agreeing to
and following through on a bargain
− Bargaining simply breaks down
− Large number of interested parties
• Coordinating everyone is costly

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 CHAPTER IN A NUTSHELL
• Externality: when a transaction between a buyer and seller
directly affects a third party
− For negative externalities, such as pollution, the socially
optimal quantity in a market is less than the equilibrium
quantity.
− For positive externalities, such as technology spillovers,
the socially optimal quantity is greater than the
equilibrium quantity

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 CHAPTER IN A NUTSHELL
• Governments pursue various policies to remedy the
inefficiencies caused by externalities.
− Regulating behavior
− Corrective taxes
− Issuing permits. 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.

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CHAPTER IN A NUTSHELL
• Those affected by externalities can sometimes solve the
problem privately.
− When one business imposes an externality on another
business, the two businesses can internalize the
externality by merging.
− Coase theorem: if people can bargain without cost, then
they can always reach an agreement in which
resources are allocated efficiently.
− In many cases, reaching a bargain among the many
interested parties is difficult.
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