Chapter 10

Externalities
 Table of contents

1) Introduction
2) Externalities and Market Inefficiency
3) Public Policies toward Externalities
4) Private Solutions to Externalities
5) Conclusion

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 1. Introduction
One of the Ten Principles of Economic is government
action can sometimes improve market outcomes.
Sometimes markets fail to allocate resources efficiently.
As a result, government policies can potentially improve
upon the market’s allocation and offer policies that
mitigate this market inefficiency.
Market failure is the inability of some unregulated
markets to allocate resources efficiently.
An example of market failure are externalities.
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 1. Introduction

Externality is the uncompensated impact of

one person’s actions on the well-being of a
bystander.
In other words, they are unintended side effects
or consequences of an economic activity that
affect third parties who are not directly
involved in the activity.
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 1. Introduction
If the impact on the bystander is adverse, it is
called a negative externality.
Example: air pollution from factories, traffic
congestion, climate change, noise pollution.
If it is beneficial, it is called a positive
externality.
Example: education and quality of life, vaccination
and herd immunity, research and accidental
discoveries, bakeries and a great smell. 5
 1. Introduction
In the presence of externalities, society’s interest in a
market outcome extends beyond the well-being of
buyers and sellers who participate in the market to
include the well-being of bystanders who are affected
indirectly.
Because buyers and sellers do not take into account the
external effects of their actions when deciding how
much to demand or supply, the market equilibrium is
not efficient when there are externalities.
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 1. Introduction
Externalities come in many forms, as do the policy responses that try
to deal with them.
Example:
• The exhaust from automobiles causing people to breathe
smog (negative externality) Setting emission standards for
cars;
• Restored historic buildings (positive externality) Regulating
the destruction of historic buildings and providing tax breaks to
owners;
• Barking dogs (negative externality) Making it illegal to
“disturb the peace”;
• Research into new technologies (positive externality)
implementing a patent system. 7
 2. Externalities and Market Inefficiency
2.1. A market without
externalities
In the absence of
externalities, the
market equilibrium is
efficient.

The Market for Steel

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 2. Externalities and Market Inefficiency
2.2. Negative externalities
How does an externality affect
the efficiency of the market
outcome?
In the presence of a negative
externality, such as pollution, the
social cost of the good exceeds
the private cost.
The optimal quantity, QOPTIMUM, is
therefore smaller than the
equilibrium quantity, QMARKET .
Externatility and the Social Optimum 9
 2. Externalities and Market Inefficiency
2.2. Negative externalities
• External cost are the costs borne by third parties who are
not directly involved in the economic transaction (ex:
pollution, environmental degradation, health problems)
• Private cost are the costs directly incurred by individuals or
businesses engaged in a particular economic activity (ex:
production costs, labor cost)
• Social cost refers to the total cost incurred by society as a
whole due to a particular economic activity (External costs +
Private costs)
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 2. Externalities and Market Inefficiency
2.2. Negative externalities
How to achieve the optimal outcome?
One way would be to internalize the externality.
Internalizing the externality is altering incentives so that
people take into account the external effects of their actions.
Example: taxing steel producers for each ton of steel sold.
Internalizing the externality gives buyers and sellers in the market
an incentive to take into account the external effects of their
actions.
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 2. Externalities and Market Inefficiency
2.3. Positive externalities
In the presence of a positive
externality, the social value
of the good exceeds the
private value.
The optimal quantity,
QOPTIMUM, is therefore larger
than the equilibrium
quantity, QMARKET .

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 2. Externalities and Market Inefficiency
2.3. Positive externalities
How to achieve the optimal outcome?
One way would be to internalize the externality.
The appropriate policy to deal with positive externalities is
exactly the opposite of the policy for negative externalities.
To move the market equilibrium closer to the social optimum, a
positive externality requires a subsidy.
Example: Education is heavily subsidized through public schools
and government scholarships.
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 2. Externalities and Market Inefficiency
2.3. Positive externalities
To summarize:
• Negative externalities lead markets to produce a larger
quantity than is socially desirable.
• Positive externalities lead markets to produce a smaller
quantity than is socially desirable.
• To remedy the problem, the government can internalize
the externality by taxing goods with negative
externalities and subsidizing goods with positive
externalities. 14
 2. Externalities and Market Inefficiency
Application
Which of the following is an example of a positive
externality?
a. Dev mows Myra’s lawn and is paid $100 for the service.
b. Dev’s lawnmower emits smoke that Myra’s neighbor Xavier
has to breathe.
c. Myra’s newly cut lawn makes her neighborhood more
attractive.
d. Myra’s neighbor Xavier offers to pay her if she keeps her
lawn well groomed.
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 3. Public Policies toward Externalities
In practice, both public policymakers and private
individuals respond to externalities in various ways.
All of the remedies share the goal of moving the allocation of
resources closer to the social optimum.
The government can respond to externalities in one of two
ways:
• Command-and-control policies regulate behavior directly.
• Market-based policies provide incentives so that private
decision makers will choose to solve the problem on their
own. 16
 3. Public Policies toward Externalities
3.1. Command-and-control policies: Regulation
The government can remedy an externality by either
requiring or forbidding certain behaviors.
Example: it is a crime to dump poisonous chemicals into the
water supply.
Despite the stated goals of some environmentalists, it would
be impossible to prohibit all polluting activity.
Instead, society has to weigh the costs and benefits to
decide the kinds and quantities of pollution it will allow.
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 3. Public Policies toward Externalities
3.2. Market-based policies 1: Corrective Taxes and
Subsidies
Instead of regulating behavior in response to an externality,
the government can use market-based policies to align
private incentives with social efficiency.
Taxes enacted to deal with the effects of negative
externalities are called corrective taxes.
They are also called Pigovian taxes after economist Arthur
Pigou (1877–1959), an early advocate of their use.
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 3. Public Policies toward Externalities
3.2. Market-based policies 1: Corrective Taxes and
Subsidies
Corrective tax is a tax designed to induce private decision
makers to take into account the social costs that arise
from a negative externality.
An ideal corrective tax would equal the external cost from
an activity with negative externalities.
An ideal corrective subsidy would equal the external benefit
from an activity with positive externalities.
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 3. Public Policies toward Externalities
3.3. Market-Based Policy 2: Tradable Pollution Permits
Tradable Pollution Permits give companies a legal
right to pollute a certain amount per fixed time
span.
They are used to control and reduce the emissions of
pollutants into the environment.
This approach aims to achieve environmental goals in a
cost-effective manner by allowing industries to buy
and sell permits that represent the right to emit a
certain amount of pollutants. 20
 4. Private Solutions to Externalities
Although externalities tend to cause markets to be
inefficient, government action is not always needed to
solve the problem.
In some circumstances, people can develop private
solutions.
Sometimes the problem of externalities is solved with
moral codes and social sanctions.
Example: Why most people do not litter?
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 4. Private Solutions to Externalities
Another private solution to externalities involves
charities.
Example: colleges and universities receive gifts
from alumni, corporations, and foundations in
part because education has positive
externalities for society.

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 4. Private Solutions to Externalities
The private market can often solve the problem of
externalities by relying on the self-interest of the relevant
parties.
Example: An apple grower and a beekeeper are located next
to each other.
Each business confers a positive externality on the other: By
pollinating the flowers on the trees, the bees help the orchard
produce apples, while the bees use the nectar from the apple
trees to produce honey.
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 5. Conclusion
The invisible hand is powerful but not omnipotent.
when there are external effects, such as pollution, evaluating
a market outcome requires taking into account the well-being
of third parties as well.
In this case, the invisible hand of the marketplace may fail to
allocate resources efficiently.
Governments pursue various policies to remedy the
inefficiencies caused by externalities.

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