Chapter 4 - Externalities

Public Finance

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Externality Defined

• An externality is present when the activity of

one entity (person or firm) directly affects the
welfare of another entity in a way that is outside
the market mechanism.
– Negative externality: These activities impose
damages on others.
– Positive externality: These activities benefits on
others.

2
 Examples of Externalities
• Negative Externalities • Positive Externalities
– Pollution – Research & development
– Cell phones in a movie theater – Vaccinations
– Congestion on the internet
– A neighbor’s nice landscape
– Drinking and driving – Students asking good
– Student cheating that changes questions in class
the grade curve
• Not Considered Externalities
– Land prices rising in urban
area
– Known as “pecuniary”
externalities

3
Graphical Analysis:
Negative Externalities

• For simplicity, assume that a steel firm dumps

pollution into a river that harms a fishery
downstream.
• Competitive markets, firms maximize profits
– Note that steel firm only cares about its own profits,
not the fishery’s profits.
– Fishery only cares about its profits, not the steel
firm’s profits.

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Graphical Analysis, continued

• MB = marginal benefit to steel firm

• MPC = marginal private cost to steel firm
• MD = marginal damage to fishery
• MSC = MPC+MD = marginal social cost

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Figure 4.1
Graphical Analysis, continued

• From Figure 4.1, as usual, the steel firm

maximizes profits at MB=MPC. This
quantity is denoted as Q1 in the figure.
• Social welfare is maximized at MB=MSC,
which is denoted as Q* in the figure.

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Numerical Example:
Negative Externalities
• Assume the steel firm faces the following MB and MPC
curves:

M B  300  Q
M PC  20  Q
• Assume the fishery faces the following MD curve:

M D  40  2Q

8
Numerical Example, continued

• The steel firm therefore chooses Q1:

M B  M PC  300  Q  20  Q  Q1  140
• The socially efficient amount is instead Q*:

M B  M SC  M PC  M D
 3 0 0  Q  2 0  Q   4 0  2 Q  Q *
 60

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Numerical Example, continued
• The deadweight loss of steel firm choosing Q1=140 is calculated as
the triangle between the MB and MSC curves from Q1 to Q*.

D W L 
1
2
 
Q 1  Q * M S C Q1  M B Q1 
1
D W L   1 4 0  6 0  4 8 0  1 6 0   $ 1 2 8 0 0
2
• In Figure 4.2, this corresponds to area dhg.

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Numerical Example, continued
• By moving to Q* the fishery reduces its damages by an amount equal
to the trapezoid under the MD curve from Q1 to Q*.

G A IN 
1
2
 
Q 1  Q * M D Q *  M D Q1 
1
G A I N   1 4 0  6 0  1 6 0  3 2 0   1 9 2 0 0
2
• By moving to Q* the steel firm loses profits equal to the triangle
between the MB and MPC curve from Q1 to Q*.

LO SS 
1
2

Q1  Q *
 M B Q *  M C Q * 
1
LO SS   1 4 0  6 0  2 4 0  8 0   $ 6 4 0 0
2

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Calculating Gains & Losses
Raises Practical Questions
• What activities produce pollutants?
– With acid rain it is not known how much is associated with
factory production versus natural activities like plant decay.

• Which pollutants do harm?

– Pinpointing a pollutant’s effect is difficult. Some studies
show very limited damage from acid rain.

• What is the value of the damage done?

– Difficult to value because pollution not bought/sold in market.
Housing values may capitalize in pollution’s effect.

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Coase Theorem

• Insight: root of the inefficiencies from

externalities is the absence of property rights.
• The Coase Theorem states that once property
rights are established and transaction costs are
small, then one of the parties will bribe the
other to attain the socially efficient quantity.
• The socially efficient quantity is attained
regardless of to whom the property rights were
initially assigned.
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Illustration of the Coase Theorem

• Recall the steel firm/fishery example. If the

steel firm were assigned property rights, it
would initially produce Q1, which maximizes
its profits.
• If the fishery were assigned property rights, it
would initially mandate zero production,
which minimizes its damages.

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Figure 4.3
Mergers

• Mergers between firms “internalize” the

externality.
• A firm that consisted of both the steel firm and
fishery would only care about maximizing the
joint profits of the two firms, not either’s profits
individually.
• Thus, it would take into account the effects of
increased steel production on the fishery.
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Social Conventions

• Certain social conventions can be viewed as

attempts to force people to account for the
externalities they generate.
• Examples include conventions about not
littering, not talking in a movie theater, etc.

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Public Responses on Taxes

• Again, return to the steel firm/fishery example.

• Steel firm produces inefficiently because the
prices for inputs incorrectly signal social costs.
Input prices are too low. Natural solution is to
levy a tax on a polluter.
• A Pigouvian tax is a tax levied on each unit of
a polluter’s output in an amount just equal to
the marginal damage it inflicts at the efficient
level of output.
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Figure 4.4
Taxes

• This tax clearly raises the cost to the steel firm

and will result in a reduction of output.
• Will it achieve a reduction to Q*?
– With the tax, t, the steel firm chooses quantity such that
MB=MPC+t.
– When the tax is set to equal the MD evaluated at Q*, the
expression becomes MB=MPC+MD(Q*).
– Graphically, it is clear that MB(Q*)-MPC(Q*)=MD(Q*),
thus the firm produces the efficient level.

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Numerical Example: Pigouvian Taxes

• Returning to the numerical example:

M B  300  Q
M PC  20  Q
M D  40  2Q
• Recall that Q1=140 and Q*=60.

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Numerical Example: Pigouvian Taxes

• Setting t=MD(60) gives t=160. The firm now sets

MB=MPC+t, which then yields Q*.
M B  M P C  t
 300  Q  20  Q  t
 300  Q  20  Q  160
 120  2Q
 Q  6 0

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Public Responses on Subsidies

• Another solution is paying the polluter to not pollute.

• Assume this subsidy was again equal to the marginal
damage at the socially efficient level.
• Steel firm would cut back production until the loss in
profit was equal to the subsidy; this again occurs at Q*.
• Subsidy could induce new firms to enter the market,
however.

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Public Responses Creating a
Market

• Sell producers permits to pollute. Creates

market that would not have emerged.
• Process:
– Government sells permits to pollute in the quantity Z*.
– Firms bid for the right to own these permits, fee
charged clears the market.

• In effect, supply of permits is inelastic.

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Figure 4.6
Creating a Market, continued

• Process would also work if the government

initially assigned permits to firms, and then
allowed firms to sell permits.
– Distributional consequences are different – firms that
are assigned permits initially now benefit.

• One advantage over Pigouvian taxes: permit

scheme reduces uncertainty over ultimate
level of pollution when costs of MB, MPC, and
MD are unknown.

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Regulation

• Each polluter must reduce pollution by a certain

amount or face legal sanctions.
• Inefficient when there are multiple firms with
different costs to pollution reduction. Efficiency
does not require equal reductions in pollution
emissions; rather, it depends on the shapes of
the MB and MPC curves.

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Figure 4.7
Graphical Analysis:
Positive Externalities

• For simplicity, assume that a university

conducts research that has spillovers to a
private firm.
• Competitive markets, firms maximize profits
– Note that university only cares about its own profits,
not the private firm’s profits.
– Private firm only cares about its profits, not the
university’s profits.

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Graphical Analysis, continued

• MPB = marginal private benefit to university

• MC = marginal cost to university
• MEB = marginal external benefit to private firm
• MSB = MPB+MEB = marginal social benefit

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Figure 4.8
Graphical Analysis, continued

• From Figure 4.8, as usual, the university

maximizes profits at MPB=MC. This
quantity is denoted as R1 in the figure.
• Social welfare is maximized at MSB=MC,
which is denoted as R* in the figure.

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