Unit 12 Economics of the Public Sector:

Externalities
Instructor: Nguyen Tai Vuong
School of Economics and Management
Hanoi University of Science and Technology

Objectives
In this unit, look for the answers to these questions:
• What is an externality?
• Why do externalities make market outcomes inefficient?
• How can people sometimes solve the problem of externalities on
their own? Why do such private solutions not always work?
• What public policies aim to solve the problem of externalities?

1
Introduction
• Recall one of the Ten Principles from unit 1:
Markets are usually a good way
to organize economic activity.

• Lesson from unit 5:

In the absence of market failures,
the competitive market outcome is efficient, maximizes total
surplus.

Introduction

• One type of market failure: externalities.

• Externality: the uncompensated impact of
one person’s actions on the well-being of a bystander
• Negative externality:
the effect on bystanders is adverse
• Positive externality:
the effect on bystanders is beneficial

2
Introduction
• Self-interested buyers and sellers
neglect the external effects of their actions,
so the market outcome is not efficient.
• Another principle from unit 1:
Governments can sometimes
improve market outcomes.

Pollution: A Negative Externality

• Example of negative externality:
Air pollution from a factory.
• The firm does not bear the
full cost of its production,
and so will produce
more than the
socially efficient quantity.
• How govt may improve
the market outcome:
• Impose a tax on the firm equal to the
external cost of the pollution it generates
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3
Other Examples of Negative Externalities
• the neighbor’s barking dog
• late-night stereo blasting from the dorm room next to yours
• noise pollution from construction projects
• talking on cell phone while driving makes the roads less safe for
others
• health risk to others from second-hand smoke

Positive Externalities from Education

• A more educated population benefits society:
• lower crime rates: educated people have more opportunities,
so less likely to rob and steal
• better government: educated people make better-informed
voters
• People do not consider these external benefits when deciding
how much education to “purchase”
• Result: market eq’m quantity of education too low
• How govt may improve the market outcome:
• subsidize cost of education
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4
Other Examples of Positive Externalities

• Being vaccinated against

contagious diseases
protects not only you,
but people who visit the
salad bar or produce section after you.
• R&D creates knowledge others can use
• Renovating your house
increases neighboring Thank you for
not contaminating
property values the fruit supply!
9

Recap of Welfare Economics

P The market for gasoline
$5 The market eq’m
maximizes consumer
4 + producer surplus.
Supply curve shows private
3 cost, the costs directly
$2.50 incurred by sellers
2
Demand curve shows
1 private value, the value to
buyers (the prices they are
willing to pay)
0
0 10 20 25 30 Q
(gallons) 10

5
Analysis of a Negative Externality
P The market for gasoline
$5 Social cost
= private + external cost
4 external
cost Supply (private cost)
3 External cost
= value of the
2 negative impact
on bystanders
1 = $1 per gallon
(value of harm
0 from smog,
0 10 20 30 Q greenhouse gases)
(gallons) 11

Analysis of a Negative Externality

P The market for gasoline The socially
$5 optimal quantity
Social
cost is 20 gallons.
4
S
3 At any Q < 20,
value of additional gas
2 exceeds social cost
D At any Q > 20,
1 social cost of the
last gallon is
0 greater than its value
0 10 20 25 30 Q
(gallons)
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6
Analysis of a Negative Externality
P The market for gasoline
$5
Social Market eq’m
cost (Q = 25)
4 is greater than
S
social optimum
3 (Q = 20)

2 One solution:
D
tax sellers
1 $1/gallon,
would shift
0 supply curve
0 10 20 25 30 Q up $1.
(gallons)
13

“Internalizing the Externality”

• Internalizing the externality: altering incentives so that people take
account of the external effects of their actions
• In the previous example, the $1/gallon tax on sellers makes sellers’
costs equal to social costs.
• When market participants must pay social costs, the market eq’m
matches the social optimum.
(Imposing the tax on buyers would achieve the same outcome;
market Q would equal optimal Q.)

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7
Positive Externalities
• In the presence of a positive externality,
the social value of a good includes
• private value – the direct value to buyers
• external benefit – the value of the positive impact on
bystanders

• The socially optimal Q maximizes welfare:

• At any lower Q, the social value of additional units exceeds
their cost.
• At any higher Q, the cost of the last unit exceeds its social
value.

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ACTIVE LEARNING 1:
Analysis of a positive externality
P The market for flu shots
External benefit
$ 50 = $10/shot
• Draw the social
40 value curve.
S • Find the socially
30 optimal Q.
• What policy would
20 internalize this
externality?
10
D

0 Q
0 10 20 30 16

8
Answers
Socially optimal Q
P The market for flu shots
= 25 shots
$ 50 To internalize the
external externality, use
40 benefit subsidy = $10/shot.
S
30

Social value
20 = private value
+ external benefit
10
D

0 Q
0 10 20 25 30 17

Effects of Externalities: Summary

If negative externality
 market produces a larger quantity than is socially desirable
If positive externality
 market produces a smaller quantity than is socially desirable
To remedy the problem, “internalize the externality”
 tax goods with negative externalities
 subsidize goods with positive externalities

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9
Private Solutions to Externalities
Types of private solutions:
• moral codes and social sanctions,
e.g., the “Golden Rule”
• charities, e.g., the Sierra Club
• contracts between market participants and the affected
bystanders
The Coase theorem:
If private parties can bargain without cost over the allocation of
resources, they can solve the externalities problem on their own.

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The Coase Theorem: An Example

Dick owns a dog named Spot.

Negative externality:
Spot’s barking disturbs Jane, Dick’s neighbor.
The socially efficient outcome
maximizes Dick’s + Jane’s well-being.
• If Dick values having Spot more
See Spot bark.
than Jane values peace & quiet,
the dog should stay.
Coase theorem: The private market will reach the efficient
outcome on its own…
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10
The Coase Theorem: An Example
• CASE 1:
Dick has the right to keep Spot.
Benefit to Dick of having Spot = $500
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome: Spot goes bye-bye.
• Private outcome:
Jane pays Dick $600 to get rid of Spot,
both Jane and Dick are better off.
• Private outcome = efficient outcome.

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The Coase Theorem: An Example

• CASE 2:
Dick has the right to keep Spot.
Benefit to Dick of having Spot = $1000
Cost to Jane of Spot’s barking = $800
• Socially efficient outcome: See Spot stay.
• Private outcome:
Jane not willing to pay more than $800,
Dick not willing to accept less than $1000,
so Spot stays.
• Private outcome = efficient outcome.
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The Coase Theorem: An Example
• CASE 3:
Benefit to Dick of having Spot = $500
Cost to Jane of Spot’s barking = $800
But Jane has the legal right to peace & quiet.
• Socially efficient outcome: Dick keeps Spot.
• Private outcome:
Dick pays Jane $600 to put up with Spot’s barking.
• Private outcome = efficient outcome.

The private market achieves the efficient outcome regardless of the

initial distribution of rights.
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ACTIVE LEARNING 2:
Brainstorming
Collectively, the 1000 residents of Green Valley value swimming in
Blue Lake at $100,000.
A nearby factory pollutes the lake water, and would have to pay
$50,000 for non-polluting equipment.
A. Describe a Coase-like private solution.
B. Can you think of any reasons why this solution might not
work in the real world?

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12
Why Private Solutions Do Not Always Work

• Transaction costs: the costs that parties incur in the process of

agreeing to and following through on a bargain
• Sometimes when a beneficial agreement is possible, each party
may hold out for a better deal.
• Coordination problems & costs when the number of parties is
very large.

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Public Policies Toward Externalities

Two approaches
• Command-and-control policies
regulate behavior directly. Examples:
• limits on quantity of pollution emitted
• requirements that firms adopt a particular technology to
reduce emissions
• Market-based policies
provide incentives so that private decision-makers will choose to
solve the problem on their own.

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13
Market-Based Policy #1: Corrective Taxes & Subsidies
• Corrective tax: a tax designed to induce private decision-makers
to take account of the social costs that arise from a negative
externality
• Also called Pigouvian taxes after Arthur Pigou (1877-1959).
• The ideal corrective tax = external cost
• For activities with positive externalities,
ideal corrective subsidy = external benefit

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Market-Based Policy #1: Corrective Taxes & Subsidies

• Example:
Acme, US Electric run coal-burning power plants. Each emits 40
tons of sulfur dioxide per month. SO2 causes acid rain & other
health issues.
• Policy goal: reducing SO2 emissions 25%
• Policy options
• regulation:
require each plant to cut emissions by 25%
• corrective tax:
Make each plant pay a tax on each ton of SO2 emissions. Set
tax at level that achieves goal.

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14
Market-Based Policy #1: Corrective Taxes & Subsidies
• Suppose cost of reducing emissions is
lower for Acme than for US Electric.
• Socially efficient outcome: Acme reduces emissions more than
US Electric.
• The corrective tax is a price on the right to pollute.
• Like other prices, the tax allocates this “good” to the firms who
value it most highly (US Electric).

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Market-Based Policy #1: Corrective Taxes & Subsidies

• Under regulation, firms have no incentive to reduce emissions
beyond the 25% target.
• A tax on emissions gives firms incentive to continue reducing
emissions as long as the cost of doing so is less than the tax.
• If a cleaner technology becomes available,
the tax gives firms an incentive to adopt it.

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15
Market-Based Policy #1: Corrective Taxes & Subsidies
• Other taxes distort incentives and move economy away from the
social optimum.
• But corrective taxes enhance efficiency by aligning private with
social incentives.

31

Example of a Corrective Tax: The Gas Tax

The gas tax targets three negative externalities:
 congestion
the more you drive, the more you contribute to congestion
 accidents
larger vehicles cause more damage in an accident
 pollution
burning fossil fuels produces greenhouse gases

32

16
ACTIVE LEARNING 3:
Discussion question
Policy goal:
Reducing gasoline consumption
Two approaches:
A. Enact regulations requiring automakers
to produce more fuel-efficient vehicles
B. Significantly raise the gas tax

Discuss the merits of each approach. Which do you think would

achieve the goal at lower cost? Who do you think would support
or oppose each approach?
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Market-Based Policy #2: Tradable Pollution Permits

• Recall: Acme, US Electric each emit 40 tons SO2, total of 80
tons.
• Goal: reduce emissions 25% (to 60 tons/month)
• Suppose cost of reducing emissions is
$100/ton for Acme, $200/ton for US Electric.
• If regulation requires each firm to reduce 10 tons,
cost to Acme: (10 tons) x ($100/ton) = $1,000
cost to USE: (10 tons) x ($200/ton) = $2,000
total cost of achieving goal = $3,000

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Market-Based Policy #2: Tradable Pollution Permits

• Alternative:
• issue 60 permits, each allows its bearer one ton of SO2
emissions (so total emissions = 60 tons)
• give 30 permits to each firm
• establish market for trading permits

• Each firm can choose among these options:

• emit 30 tons of SO2, using all its permits
• emit < 30 tons, sell unused permits
• buy additional permits so it can emit > 30 tons

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Market-Based Policy #2: Tradable Pollution Permits

Suppose market price of permit = $150
One possible equilibrium:
Acme
• spends $2,000 to cut emissions by 20 tons
• has 10 unused permits, sells them for $1,500
• net cost to Acme: $500
US Electric
• emissions remain at 400 tons
• buys 10 permits from Acme for $1,500
• net cost to USE: $1,500
Total cost of achieving goal: $2,000
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Market-Based Policy #2: Tradable Pollution Permits
• A system of tradable pollution permits achieves goal at lower
cost than regulation.
• Firms with low cost of reducing pollution
sell whatever permits they can.
• Firms with high cost of reducing pollution
buy permits.
• Result: Pollution reduction is concentrated among those firms
with lowest costs.

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Tradable Pollution Permits in the Real World

• SO2 permits traded in the U.S. since 1995.
• Nitrogen oxide permits traded in the northeastern U.S. since
1999.
• Carbon emissions permits traded in Europe since January 1,
2005.

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Corrective Taxes vs. Tradable Pollution Permits
• Like most demand curves, firms’ demand for the ability to
pollute is a downward-sloping function of the “price” of
polluting.
• A corrective tax raises this price and thus reduces the
quantity of pollution firms demand.
• A tradable permits system restricts the supply of pollution
rights, has the same effect as the tax.
• When policymakers do not know the position of this demand
curve, the permits system achieves pollution reduction targets
more precisely.

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Objections to the Economic Analysis of Pollution

• Some politicians, many environmentalists argue that no one
should be able to “buy” the right to pollute, cannot put a price on
the environment.
• However, people face tradeoffs.
• The value of clean air & water
must be compared to their cost.
• The market-based approach reduces the cost of environmental
protection, so it should increase the public’s demand for a clean
environment.

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SUMMARY

• An externality occurs when a market transaction affects a third party. If the

transaction yields negative externalities (e.g., pollution), the market
quantity exceeds the socially optimal quantity.
If the externality is positive (e.g., technology spillovers), the market
quantity falls short of the social optimum.
• Sometimes, people can solve externalities on their own. The Coase
theorem states that the private market can reach the socially optimal
allocation of resources as long as people can bargain without cost. In
practice, bargaining is often costly or difficult, and the Coase theorem does
not apply.
• The government can attempt to remedy the problem. It can internalize the
externality using corrective taxes. It can issue permits to polluters and
establish a market where permits can be traded. Such policies often
protect the environment at a lower cost to society than direct regulation. 41

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