EXTERNALITY

BY:
Muskan Bhansal
Gara Ashwak
Tejaswini Nagaraju
Reganti Bharat Chandra Sai
 INTRODUCTION

CLASSIFICATION

agenda INTERNALIZATION OF
EXTERNALITY

SOLUTIONS TO
EXTERNALITY
(Coase theorem)

SUMMARY
 Introduction
• Externalities are costs or benefits of market
transactions that are not reflected in the prices.
• When externality prevails, a third party (other
than the buyer or sellers of an item) is affected
either by that items production of consumption.
• The benefit or cost that the third party
undergoes are not considered by the seller or
buyer of that item whose production or use
resulted in the externality
• (Actions of one economic agent makes another
economic agent better off or worse off)
• Intervention of government
• Technical externality
Externality 3
Categorization of
externality
1.Positive production externality
2.Positive consumption externality
3.Negative production externality
4.Negative consumption externality
POSITIVE PRODUCTION EXTERNALITY
• Also called as external benefit or external economy or
beneficiary externality
• Occurs when a third party BENEFITS from the PRODUCTION
of a good. The social cost is less than the private cost.
• Example: building a train station may provide shelter for
homeless when it is raining
• If a company develops new technology, such as a database
programme, this new technology can be implemented by other
firms who will gain a similar boost to productivity. Tim Berners
Lee who developed the world wide web, made it freely
available, creating a very large positive externality

Externality 5
 Other example of positive production externality

• Getting a vaccination provides a benefit to other people in society

because you do not spread infectious diseases.
• A decision to stop smoking causes benefits to other people in
society who longer suffer passive smoking.
• Switching from conventional farming to organic farming helps the
environment as there are fewer chemicals in the environment.
• Picking up litter makes the environment nicer for everyone.

Externality 6
 Positive consumption externality
• Occurs when a third party BENEFITS from CONSUMPTION
of a good. Social benefit is higher than private benefit.
• When you consume education you get a private benefit. But
there are also benefits to the rest of society. E.g you are able
to educate other people and therefore they benefit as a result
of your education
• In a free market without government intervention there will be
under-consumption of goods with positive consumption
externalities; this leads to market failure

Externality 7
 Other example of positive consumption externality

• Good architecture. Choosing a beautiful design for a building

will give benefits to everybody in society.
• Buying flowers for front garden gives benefits to others who
walk past
• Consuming a healthy diet ultimately will benefit others in
society because less health care costs, higher productivity
• Education or learning new skills. With better education, you
are more productive and can gain more skills. But, also the
rest of society benefits from your new skills.

Externality 8
Externality 9
 Encouraging Positive Externalities
• One role for government is to implement economic policies that promote
positive externalities. There are two general approaches to promoting
positive externalities; to increase the supply of, and increase the demand for,
goods, services and resources that generate external benefits.
• Government grants and subsidies to producers of goods and services that
generate external benefits will reduce costs of production, and encourage
more supply. This is a common remedy to encourage the supply of merit
goods such as healthcare, education, and social housing. Such merit goods
can be funded out of central and local government taxation. Public goods,
such as roads, bridges and airports, also generate considerable positive
externalities, and can be built, maintained and fully, or part, funded out of tax
revenue.

Externality 10
 Internalizing Positive Externality
A corrective subsidy is a payment made by government to either buyers or sellers of
a good so that the price paid by consumers is reduced. The payment must equal the
marginal external benefit of the good or
Examples of corrective subsidies:
The provision of certain government services at levels below the marginal cost of
such services; municipal governments make special pickups of trash and such
large waste items as discarded furniture at prices well below marginal cost. The
difference between the actual price and the marginal cost of the pickup can be
regarded as a corrective subsidy designed to avoid accumulation of trash and
unauthorized dumping.
Some city governments also subsidize property owners who plant trees by the
curbs of their property. They might, for example, pay half the price of those trees.
This is designed to internalize the positive externality associated with property
beautification service.

Externality 11
A corrective subsidy to consumers increases the demand for inoculations and achieves
the efficient output. After subsidy payments are received by consumers, the net price of
an inoculation falls to $10, inducing them to purchase the efficient amount of 12 million
per year. The area RVXY represents the total subsidy payments at the efficient output.

Externality 12
Research paper analysis

Externality 13
Externality 14
Externality 15
 NEGATIVE EXTERNALITIES AS THE ENGINE OF GROWTH
IN AN EVOLUTIONARY CONTEXT
We present a simple growth model which has two original features: the strategic context considered,
which is an evolutionary game, and the growth mechanism described, in which growth is caused by
negative externalities. The emphasis in this growth mechanism is evidently different from that placed
on positive externalities by current endogenous growth models. In this model welfare depends on
three goods: leisure, a free environmental renewable resource, and a non-storable output. The
environmental resource is subject to negative externalities, that is, it is deteriorated by the production
of the output. Faced with a forced reduction of the resource, agents may react by increasing the labor
supply in order to produce and consume substitutes for the diminishing resource, i. e. they can raise
their defensive expenditures. The increase in production and consumption that follows, i.e. growth,
generates a further deterioration of the environmental resource, thus giving rise to a self-feeding
growth process. The conditions under which multiple equilibria and Pareto worsening growth
dynamics arise, are analyzed. Beside showing the logical possibility that negative externalities are the
engine of growth, we suggest that the case analyzed may be of practical relevance, i.e., that negative
externalities may play an important role in many episodes of growth. This role is widely recognized by
social sciences other than economics. We suggest that the model may be interpreted as a push
development model and that it may also contribute to explain some aspects of growth in advanced
countries.

Externality 16
• Growth
• Negative externality do not exert restraint on growth but only on welfare
• Negative externality generates growth
• Growth generates negative externality- the idea is a stylization in
economic language of a huge body of literature and knowledge
concerning the social, cultural, psychological and environmental
breakdowns associated with growth
• Important resources for welfare like the social climate, the quality of
human relationships, sociability and solidarity, and also to some extent
social discipline, the capacity for collective cooperation and action, the
social virtues of “truth, trust, obligation” (Hirsch (1976)), seem negatively
correlated with growth
• the traditional view that increasing quantities of goods become available
as growth proceeds might be incomplete.

Externality 17
 Negative consumption externality
• When consuming a product causes costs to a third party. For
example, if you smoke in a crowded room, other people have to
breathe in your smoke. This is unpleasant for them and can leave
them exposed to health problems associated with smoking.
• In this case, the social benefit is less than the private benefit
• Drinking alcohol and then driving can lead to accidents which hurt
innocent bystanders.
• Playing loud music annoys your neighbor

Externality 18
 Negative production externality
• This is when producing a good causes an external cost to a third
party. Therefore, the social cost of production is greater than the
private cost
• Making furniture by cutting down rainforests in the Amazon leads to
negative externalities to other people. Firstly it harms the
indigenous people of the Amazon rainforest. It also leads to higher
global warming as there are fewer trees to absorb carbon dioxide.
The social cost of making furniture is greater than the private cost
to a firm.
• Non-organic vegetable growing. Farmers use fertilizers and
pesticides which harm insects and also can get into the food chain,
causing health problems in the future.

Externality 19
Externality 20
 Internalizing Negative Externality
• Through corrective tax- a charge for emitting waste.
designed to adjust the marginal private cost of a good or
service in such a way as to internalize the externality. The
tax must equal the marginal external cost per unit of output
to achieve this objective.
• Not complete reduction in pollutants but enables the polluter
to think about other alternatives of waste disposal
• Using the tax revenue collected
• Enactment of such tax- political concern
• Corrective tax can reduce global warming

Externality 21
Externality 22
 Externality and market efficiency
• Negative externality leads to excess production. Excess
production and price doesn't match actual costs and more
pollution. Internalization leads to decreased production and
efficient equilibrium at socially optimal levelEx: pollution in
paper industry.

Externality 23
• Positive externality leads to decreased production - example of
education- education creates lot of positive externality like job,
high literacy, livelihood- but there are other factors like
intelligence, knowledge, less crime results from education.
These benefits are not taken into account- education under
consumed if these benefits are accounted.

Externality 24
 solutions to externality
• Tax
• Subsidy
• PROPERTY RIGHT- COASE THEOREM

Externality 25
 COASE THEOREM
• What are:
1. Property rights
2. Coase theorem
• An externality example

Externality 26
 Externalities of automobiles
• Negative externalities
Problems Solutions
- Traffic congestion and scarcity - Pigouvian taxes
- Accidents - Congestion pricing
- Air and noise pollution - Subsidizing alternatives
- Climate change - Regulation
- Costs for nature and landscape
- Costs for water and soil
pollution, energy dependency
- Obesity

• Positive externalities
- accessibility and land value, time management and city growth

Externality 27
THANK YOU