Foundations of Economics

Ninth Edition, Global Edition

Chapter 10
Externalities

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How can we Limit Climate Change?

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Externalities
Chapter Checklist
When you have completed your study of this chapter, you will be able to
1. Explain why negative externalities lead to inefficient overproduction and
how government actions can achieve a more efficient outcome.
2. Explain why positive externalities lead to inefficient underproduction and
how government actions can achieve a more efficient outcome.

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Externalities in Our Daily Lives (1 of 4)
An externality is a cost or a benefit that arises from:
• Production that falls on someone other than the producer
• Consumption that falls on someone other than the consumer

Negative externality
A production or consumption activity that creates an external cost.
Positive externality
A production or consumption activity that creates an external benefit.

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Externalities in Our Daily Lives (2 of 4)
Four types of externalities:
• Negative production externalities
• Positive production externalities
• Negative consumption externalities
• Positive consumption externalities

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Externalities in Our Daily Lives (3 of 4)
Negative Production Externalities
Power generators and road transport
are the biggest polluters.
Others are logging and noise pollution.
Positive Production Externalities
Sources of improvements in well-being.
Biggest arise from education, which
creates a pool of talented researchers
who invest, spread, and apply new
technologies.

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Externalities in Our Daily Lives (4 of 4)
Negative Consumption Externalities
Noisy parties, seeing litter left in a park,
but the biggest is plastic waste,
especially when it ends up in the
oceans.
Positive Consumption Externalities
Flu or measles vaccinations lower the
risk that others will be infected.
Also, the restoration of native forest or
an historic building or erect a new
building such as the Getty Museum in
L.A.

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10.1 Negative Externalities: Pollution (1 of 24)
Private Costs and Social Costs
Marginal private cost is the cost of producing an additional unit of a good or
service that is borne by the producer of that good or service.
Marginal external cost is the cost of producing an additional unit of a good or
service that falls on people other than the producer.

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10.1 Negative Externalities: Pollution (2 of 24)
Marginal social cost is the marginal cost incurred by the entire society—by the
producer and by everyone else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal private cost (MC) and
marginal external cost.
MSC = MC + Marginal external cost

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10.1 Negative Externalities: Pollution (3 of 24)
Figure 10.1 shows the relationship
between cost and output.
When output is 4 million gallons of
paint a month:

1. Marginal private cost is 1.00 a gallon.

2. Marginal external cost is $1.25 a
gallon.
3. Marginal social cost is 2.25 a gallon.

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10.1 Negative Externalities: Pollution (4 of 24)
Production and Pollution: How Much?
When an industry is unregulated, the amount of pollution it creates depends
on the market equilibrium price and the quantity of the good produced.
If the industry creates an external cost, the market equilibrium is inefficient.
Too much of the good is produced.

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10.1 Negative Externalities: Pollution (5 of 24)
Figure 10.2 shows inefficiency with an
external cost.
1. The equilibrium price of $1.00 a
gallon and 4 million gallons of paint a
month is inefficient.
2. Marginal social cost exceeds ...
3. Marginal benefit.

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10.1 Negative Externalities: Pollution (6 of 24)
4. The efficient quantity is 2 million
gallons of paint, where marginal
social cost equals marginal benefit.
5. The gray triangle shows the
deadweight loss created by the
pollution externality.

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10.1 Negative Externalities: Pollution (7 of 24)
What can be done to Fix the Inefficiency?
Four methods are available:
• Property rights
• Command-and-control regulation
• Pollution taxes
• Cap-and-trade

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10.1 Negative Externalities: Pollution (8 of 24)
Property Rights
Externalities arise when property rights are missing.
Property rights are legally established titles to the ownership, use, and disposal
of factors of production and goods and services that are enforceable in the
courts.
Establishing property rights is one way of dealing with externalities.

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10.1 Negative Externalities: Pollution (9 of 24)
To see how property rights can work, suppose the paint producers own the
homes and the river.
The rental income they can earn on the homes depends on the amount of
pollution they create.
The effect of pollution on rental income gives the paint producers an incentive
to limit pollution.
They might limit pollution by:
• Using an abatement technology
• Produce less and pollute less

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10.1 Negative Externalities: Pollution (10 of 24)
Use an Abatement Technology
An abatement technology is a technology that reduces or prevents pollution.
A catalytic converter in every U.S. car is an abatement technology.

Produce Less and Pollute Less

The alternative to using an abatement technology is produce less and pollute
less.
Firms will choose the least-cost alternative method.

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10.1 Negative Externalities: Pollution (11 of 24)
The Coase Theorem
Coase theorem is the proposition that if property rights exist, only a small
number of parties are involved, and transactions costs are low, then private
transactions are efficient and the outcome is not affected by who is assigned
the property right.
Transactions costs are the opportunity costs of conducting a transaction.

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10.1 Negative Externalities: Pollution (12 of 24)
Application of the Coase Theorem
If polluting paint factories own homes and river, the rent people willingly pay
decreases as the amount of pollution increases.
If homeowners own the river, the factories must pay homeowners for any
pollution, and the more the factories pollute, the more they pay.
Regardless of who owns the river, so long as someone owns it, the factories
bear the cost of pollution, and the quantity of production and pollution are
efficient.

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10.1 Negative Externalities: Pollution (13 of 24)
Efficient Market Equilibrium With
Property Rights
Figure 10.3 illustrates.
1. With property rights, the MC curve
that excludes the cost of pollution
shows only part of the producers’
marginal cost.

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10.1 Negative Externalities: Pollution (14 of 24)
2. The marginal private cost curve
includes the cost of pollution, and
the supply curve is S = MC.

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10.1 Negative Externalities: Pollution (15 of 24)
3. Market equilibrium is at a price of
$1.50 a gallon and a quantity of 2
million gallons of paint a month and
is efficient because…
4. Marginal social cost equals marginal
benefit.

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10.1 Negative Externalities: Pollution (16 of 24)
Command-and-Control Regulation
Command-and control regulation is the setting of standards that define what is
and is not permitted.
Most countries use command-and control regulation to improve air quality and
water quality.
The Clean Air Act of 1970 gives the Environmental Protection Agency the
authority to issue regulations that require utilities, chemical plants, and steel
mills to limit pollution.
Although command-and-control has improved air and water quality, it doesn’t
always deliver an efficient outcome.

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10.1 Negative Externalities: Pollution (17 of 24)
Pollution Taxes
A pollution tax is a tax on polluting production that are set at a level that
confronts producers with the external costs of their actions.
By setting the tax equal to the marginal external cost, firms can be made to
behave in the same way as they would if they bore the cost of the externality
directly.
But to work out the pollution tax that achieves efficiency, the regulator needs a
lot of information about the industry, which is generally not available.

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10.1 Negative Externalities: Pollution (18 of 24)
Figure 10.4 shows the effects of a pollution tax.
To see how a tax works:
1. Assume that the government has assessed the marginal external cost of
pollution accurately.
2. A tax is levied equal to the marginal external cost at the efficient quantity
of paint.

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10.1 Negative Externalities: Pollution (19 of 24)
1. The pollution tax set equal to the
marginal external cost of pollution.

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10.1 Negative Externalities: Pollution (20 of 24)
With the pollution tax, the supply curve
becomes the marginal private cost
curve, MC, plus the tax— the curve
labeled S = MC + tax.
With the tax equal to the marginal
external cost, the supply curve also
becomes the MSC curve.

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10.1 Negative Externalities: Pollution (21 of 24)
2. Market equilibrium at a price of
$1.50 a gallon and 2 million gallons
of paint a month is efficient
because…
3. Marginal social cost equals marginal
benefit.

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10.1 Negative Externalities: Pollution (22 of 24)
4. The government collects revenue
equal to the area of the purple
rectangle.

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10.1 Negative Externalities: Pollution (23 of 24)
Cap-and-Trade
Cap-and-trade places a cap or ceiling on emissions and assigns or sells emission
rights to individual producers who are then free to trade permits.
It is a tool that seeks to combine the power of government to limit total
emissions with the power of the market to minimize cost and maximize benefit.
To use this method, the government must first estimate the efficient quantity of
pollution, set the overall emissions cap to achieve the efficient outcome, and
allocate the cap to producers.

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10.1 Negative Externalities: Pollution (24 of 24)
The market in permits determines the equilibrium price of emissions.
Each firm, confronted with that price, maximizes profit by setting its marginal
pollution cost or marginal abatement cost, whichever is lower, equal to the
market price of a permit.
By confronting polluters with a price of pollution, trade in pollution permits
can achieve the same efficient outcome as a tax.

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10.2 Positive Externalities: Education (1 of 13)
Private Benefits and Social Benefits
Marginal private benefit is the benefit of an additional unit of a good or service
that the consumer of that good or service receives.
Marginal external benefit is the benefit of an additional unit of a good or
service that people other than the consumer of the good or service enjoy.

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10.2 Positive Externalities: Education (2 of 13)
Marginal social benefit is the marginal benefit enjoyed by society—by the
consumer of a good or service and by everyone else who benefits from it.
Marginal social benefit (MSB) is the sum of marginal private benefit (MB) and
marginal external benefit.
MSB = MB + Marginal external benefit

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10.2 Positive Externalities: Education (3 of 13)
Figure 10.5 shows an external benefit.
When 15 million students attend
college:
1. Marginal private benefit is $10,000
per student.
2. Marginal external benefit is $15,000
per student.
3. Marginal social benefit is $25,000 per
student.

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10.2 Positive Externalities: Education (4 of 13)
Figure 10.6 shows inefficiency with an
external benefit.
1. Market equilibrium is at a tuition of
$15,000 a year and 7.5 million
students and is inefficient because …
2. Marginal social benefit exceeds …
3. Marginal cost.

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10.2 Positive Externalities: Education (5 of 13)
4. The efficient number of students is
15 million.
5. The gray triangle shows the
deadweight loss created because too
few students enroll in college.

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10.2 Positive Externalities: Education (6 of 13)
Government Actions In the Face of External Benefits
Three devices that governments can use to achieve a more efficient allocation
of resources in the presence of external benefits:
• Public provision
• Private subsidies
• Vouchers

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10.2 Positive Externalities: Education (7 of 13)
Public provision is the production of a good or service by a public authority
that receives the bulk of its revenue from the government.
A subsidy is a payment that the government makes to private producers to
cover part of the costs of production.
A voucher is a token that the government provides to households that can be
used to buy specified goods or services.

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10.2 Positive Externalities: Education (8 of 13)
Public Provision
Figure 10.7 shows how public provision
can achieve an efficient outcome.
1. Marginal social benefit equals marginal
cost with 15 million students enrolled
in college.
2. Equal to the efficient quantity.

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10.2 Positive Externalities: Education (9 of 13)
3. Tuition is $10,000 per year.
4. Taxpayers cover the remaining
$15,000 of marginal cost per student.

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10.2 Positive Externalities: Education (10 of 13)
Private Subsidies
Figure 10.8 shows how a subsidy
achieves an efficient outcome of
15 million students.
1. A $15,000 subsidy per student shifts
the supply curve to S = MC – subsidy.
2. The dollar price is $10,000 a student.

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10.2 Positive Externalities: Education (11 of 13)
3. The market equilibrium is efficient
with 15 million students enrolled in
college.
4. Marginal social benefit equals
marginal cost.

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10.2 Positive Externalities: Education (12 of 13)
Vouchers
Figure 10.9 shows how vouchers can
achieve an efficient outcome.
The MSB curve becomes the demand
curve because…
1. With vouchers, buyers are willing to
pay MB plus the value of the
voucher.

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10.2 Positive Externalities: Education (13 of 13)
2. Market equilibrium is efficient with
15 million students enrolled.
3. Price, marginal social benefit, and
marginal cost are equal.
4. Tuition equals the dollar price of
$10,000 plus the value of the
voucher.

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Eye on Climate Change (1 of 9)
How Can We Limit Carbon Emissions ?
The Problem
Earth’s average temperature is rising
and so is…
the amount of carbon dioxide, CO2, in
the atmosphere.
The figure shows these upward trends.

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Eye on Climate Change (2 of 9)
How Can We Limit Carbon Emissions ?
China, the United States, and Europe
create 54 percent of carbon emissions
and
another eight large emitters create a
further 25 percent.
On current trends, by 2050, three
quarters of carbon emissions will come
from developing economies.

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Eye on Climate Change (3 of 9)
How Can We Limit Carbon Emissions ?
On current trends, by 2100, the
temperature will have increased by 3
degrees C to a level that brings extreme
weather and widespread coastal
flooding.

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Eye on Climate Change (4 of 9)
How Can We Limit Carbon Emissions ?
Economist Nicholas Stern, principal
author of The Stern Review on the
Economics of Climate Change, says that
carbon emission is “the greatest market
failure the world has ever seen.”
And to avoid the risk of catastrophic
climate change, the upward CO2 trend
must be stopped.
Most economists agree with Stern and
favor action.

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Eye on Climate Change (5 of 9)
How Can We Limit Carbon Emissions ?
Coping with the Problem

At the 2015 UN climate change conference, 197 countries agreed to:

1. Limit greenhouse gases emitted by human activity.

2. Keep global temperatures “well below” 2°C above pre-industrial levels.
3. Rich countries to pay $100 billion a year to help poorer countries move
straight to renewables.
4. Review each country’s voluntary contribution to cutting emissions every five
years.

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Eye on Climate Change (6 of 9)
How Can We Limit Carbon Emissions ?
If carbon emissions are to be cut, incentives must change.
The cost of carbon-emitting activities must rise and the cost of alternative
clean-energy technologies must fall.
Disagreement centers on how to change incentives.
Should countries use carbon taxes or cap emissions and introduce carbon
trading?
Should clean energy and the research to develop new green technologies be
subsidized?

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Eye on Climate Change (7 of 9)
How Can We Limit Carbon Emissions ?
For example, Americans pay a much lower gas tax than Europeans pay.
The figure shows the stark difference between the United States and the
United Kingdom.

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Eye on Climate Change (8 of 9)
How Can We Limit Carbon Emissions ?
Why is Not More Being Done?
Four reasons are:
1. Developing economies want low-cost energy and coal is an attractive choice
for them.
2. Getting global agreement is hard.
3. The costs are certain and are borne now while most of the benefits come in
the future.
4. Technology is advancing and the cost of cleaner energy is falling, so a
temptation is to rely on this trend continuing.

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Eye on Climate Change (9 of 9)
How Can We Limit Carbon Emissions ?
Considering costs and benefits, Bjørn
Lomborg, author of The Skeptical
Environmentalist, says that
“For little environmental benefit, we
could end up sacrificing growth, jobs,
and opportunities for the big majority,
especially in the developing world.”

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