Chapter 3

Externalities and Public Policy

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In this chapter, 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?

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 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

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

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 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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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

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 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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 Other Examples of Positive Externalities

 Being vaccinated against contagious diseases

protects not only you, but other people too

 R&D creates knowledge that others can use

 Renovating your house increases neighboring
property values

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 “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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 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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 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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 Private Solutions to Externalities
 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
A doctor & a baker share an office bulding.
Negative externality:
The baker’s loud machinery disturbed the doctor
Dick’s neighbor.
The socially efficient outcome
maximizes doc’s + baker’s well-being.

Coase theorem: The private market will reach the

efficient outcome on its own…

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 The Coase Theorem: An Example
 CASE 1:
The doctor has the right to control the noise level
The baker buy quiter machine = $1000
The doctor soundproof his walls = $1500
 Socially efficient outcome:
The baker spends $1000 for quieter machine.

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 The Coase Theorem: An Example
 CASE 2:
The baker has the right to control the noise level.
The baker buys quieter machine = $1000
The doctor soundproof his walls = $1500
 Socially efficient outcome:
The doctor pays the baker $1000 to buy quieter
machine.

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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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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 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:
Jimah and Manjung 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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 Market-Based Policy #1:
Corrective Taxes & Subsidies
 Suppose cost of reducing emissions is
lower for Jimah than for Manjung.
 Socially efficient outcome: Jimah reduces
emissions more than Manjung.
 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 (Manjung).

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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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 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.

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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

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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: Jimah, Manjung 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 Jimah, $200/ton for Manjung.
 If regulation requires each firm to reduce 10 tons,
cost to Jimah: (10 tons) x ($100/ton) = $1,000
cost to Manjung: (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:
Jimah
• spends $2,000 to cut emissions by 20 tons
• has 10 unused permits, sells them for $1,500
• net cost to Jimah: $500
Manjung
• emissions remain at 400 tons
• buys 10 permits from Jimah for $1,500
• net cost to Manjung: $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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CHAPTER 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.

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CHAPTER SUMMARY
 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.

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CHAPTER SUMMARY
 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.

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