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CHAPTER 10

Externalities

EXTERNALITY SOME COMMON EXTERNALITIES

• Externality is the uncompensated impact of • The exhaust from cars is a negative externality
one person’s actions on the wellbeing of a because it creates smog that other people
bystander. have to breathe. As a result of this externality,
• A positive externality makes the bystander drivers tend to pollute too much.
better off. • Restored historic buildings convey a positive
• A negative externality makes the bystander externality because people who walk or drive
worse off. by them enjoy their beauty and the sense of
history.

SOME COMMON EXTERNALITIES A RECAP OF WELFARE ECONOMICS

• Lawn-mowers create a negative externality

when neighbours are disturbed by the noise.
• Research into new technologies provides a
positive externality because it creates
knowledge that other people can use.

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A RECAP OF WELFARE ECONOMICS NEGATIVE EXTERNALITIES IN

PRODUCTION
• The demand curve reflects the value buyers
derive from consuming a good.
• The supply curve reflects the cost to sellers of
producing the good.
• In the absence of government intervention the
price adjusts to balance supply and demand.
• The market quantity maximises the total value
that buyers and sellers receive from
participating in the market.

NEGATIVE EXTERNALITIES IN NEGATIVE EXTERNALITIES IN

PRODUCTION PRODUCTION
• Suppose that with each unit of the good that is • A benevolent social planner maximises the
produced, sellers emit a certain amount of value to consumers minus the cost of
pollution. production, including the external costs.
• The pollution creates a health risk for those who • The planner would choose the level of
breathe the air. production at which the demand curve crosses
• The cost to society of producing a unit of the the social cost curve.
good is the private costs of sellers plus the costs
to bystanders who are adversely affected.

NEGATIVE EXTERNALITIES IN POSITIVE EXTERNALITIES IN

PRODUCTION PRODUCTION

• Below QOptimum the value of the good to

consumers exceeds the social cost of
producing it. Above QOptimum the social cost
exceeds the value to consumers.

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POSITIVE EXTERNALITIES IN POSITIVE EXTERNALITIES IN

PRODUCTION PRODUCTION
• Much of the benefit of education is private: the
consumer reaps benefit in the form of higher wages. • Once again, the government can correct the market
failure by inducing market participants to internalise the
• Education also yields positive externalities: externality.
– a more educated population leads to more informed • The appropriate response in the case of positive
voters, which means better government for externalities is exactly the opposite to the case of
everyone. negative externalities.
– a more educated population tends to result in lower • To move the market equilibrium closer to the social
crime rates. optimum, a positive externality requires a subsidy.
– a more educated population may encourage • Thus education is heavily subsidised throughout
development and dissemination of technological
advances, leading to higher productivity and wages Australia.
for everyone

NEGATIVE EXTERNALITIES IN NEGATIVE EXTERNALITIES IN

CONSUMPTION CONSUMPTION
• The consumption of alcohol can yield negative
externalities if consumers drive under the
influence, or engage in violent or antisocial
behaviour.
• Because of the external costs associated with
consumption, the social value is less than the
private value.
• The planner would want to lower the quantity
produced and consumed to QOptimum.

POSITIVE EXTERNALITIES IN PRIVATE SOLUTIONS TO

CONSUMPTION EXTERNALITIES
• Vaccines yield positive externalities because
they lower the risk of catching diseases for • Sometimes the problem of externalities is
everyone in the population, even those who solved by moral codes and social sanctions.
are not vaccinated. • Consider why most people do not litter.
• Because of the external benefits associated Although there are laws against littering, these
with consumption, the social value is greater laws are not vigorously enforced. Most people
than the private value. choose not to litter simply because it is the
• The planner would want to increase the wrong thing to do.
quantity produced and consumed to QOptimum.

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PRIVATE SOLUTIONS TO PRIVATE SOLUTIONS TO

EXTERNALITIES EXTERNALITIES
• Another private solution to externalities is • Consider an apple grower and a beekeeper
charities, many of which are established to located next to each other. By pollinating the
deal with externalities. flowers on the trees, the bees help the orchard
• For example, private individuals and produce apples. At the same time, the bees
corporations sometimes sponsor scholarships use the nectar they get from the apple trees to
and prizes for university students, in part produce honey.
because education has positive externalities
for society.

PRIVATE SOLUTIONS TO
COASE THEOREM
EXTERNALITIES
• When the apple grower is deciding how many • Coase theorem is the proposition that if private
trees to plant and the beekeeper is deciding how parties can bargain without cost over the
many bees to keep, they neglect positive allocation of resources, they can solve the
externality. Thus, the apple grower plants too few problem of externalities on their own.
trees and the beekeeper keeps too few bees.
• These externalities could be internalised if the
beekeeper bought the apple orchard or if the
apple grower bought the beehive.

WHY PRIVATE SOLUTIONS DO NOT

COASE THEOREM
ALWAYS WORK
• For example, the Coase theorem suggests • The Coase theorem applies only when the
that a contract between the apple grower and interested parties have no trouble reaching
the beekeeper can solve the problem of too and enforcing an agreement.
few trees and too few bees. The contract can • Sometimes the interested parties fail to solve
specify the number of trees, the number of an externality problem because of transaction
bees and perhaps a payment from one party costs – the costs that parties incur in the
to the other. process of agreeing and following through on
a bargain.

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WHY PRIVATE SOLUTIONS DO NOT COMMAND-AND-CONTROL

ALWAYS WORK POLICIES: REGULATION
• At other times, bargaining simply breaks • The government can remedy an externality by
down. The recurrence of wars and strikes either requiring or forbidding certain activities.
shows that reaching agreement can be For example, it is a crime to dump poisonous
difficult and that failing to reach agreement chemicals into the water supply.
can be costly. • Alternatively, the environmental regulator can
• Reaching an efficient bargain is especially dictate a maximum level of pollution that
difficult when the number of interested parties factories may emit, or require firms to adopt a
is large because coordinating everyone is particular technology.
costly.

COMMAND-AND-CONTROL
MARKET-BASED POLICIES
POLICIES: REGULATION
• Difficulties include that the regulator needs to • Instead of regulating behaviour in response
know the details about specific industries and to an externality, the government can use
about the alternative technologies that those market-based policies to align private
industries could adopt. This information is incentives with social efficiency.
often difficult for government regulators to • Market-based policies provide market
obtain. participants with incentives to take
externalities into account in their production
and consumption decisions.

CORRECTIVE TAXES AND

MARKET-BASED POLICIES
SUBSIDIES
• Difficulties include that the government must • The government can internalise externalities by
be able to determine the magnitude of the taxing activities that have negative externalities
externality. Moreover, market-based policies and subsidising activities that have positive
often impose monitoring costs on externalities.
government and compliance costs on firms. • An ideal corrective tax equals the external cost
from an activity with negative externalities, and
an ideal corrective subsidy equals the external
benefit from an activity with positive externalities.

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CORRECTIVE TAXES AND

TRADEABLE POLLUTION PERMITS
SUBSIDIES
• Corrective taxes alter the incentives that the • Another way to internalise the externality is to
market participants face to account for the issue tradeable pollution permits.
presence of externalities and thereby move • Each permit allows a firm to emit a unit of
the allocation of resources closer to the social pollution, effectively limiting the country’s total
optimum. emissions.
• Thus, while corrective taxes raise revenue for
the government, they enhance economic
efficiency.

TRADEABLE POLLUTION PERMITS TRADEABLE POLLUTION PERMITS

• A market to trade these permits will develop • A firm’s willingness to pay for the right to
and that market will be governed by the forces pollute, in turn, will depend on its cost of
of supply and demand. The permits will end up reducing pollution: the more costly it is for a
in the hands of those firms that value them firm to cut back on pollution, the more it will be
most highly, as judged by their willingness to willing to pay for a permit.
pay.

EQUIVALENCE OF CORRECTIVE
TAXES AND POLLUTION PERMITS