Chapter 3

Externalities and Public Policy

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Externalities
 Externalities are costs or benefits of
market transactions not reflected in
prices.
 Negative externalities are costs to third
parties.
 Positive externalities are benefits to third
parties .

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Externalities and Efficiency
 The marginal external cost is the
dollar value of the cost to third
parties from the production or
consumption of an additional unit
of a good. These occur when
market transactions for a good
produce negative externalities.

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Social Costs

MSC = MPC + MEC

4
 Figure 3.1 Market Equilibrium, A Negative
Externality and Efficiency
Price, Benefit, and Cost (Dollars)

MPC + MEC = MSC

G S = MPC
110
B
105 10
100 A

D = MSB

4.5 5
Tons of Paper Per Year (Millions) 5
Implications of Figure 3.1
 Market equilibrium occurs
where
MPC = MSB
 Efficiency Requires that
MSC = MPC + MEC = MSB
6
Positive externalities
 The marginal external benefit is
the dollar value of the benefit to
third parties from an additional unit
of production or consumption of a
good. These occur when the
market for a good creates positive
externalities.
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Social Benefit

MSB = MPB + MEB

8
 Figure 3.2 Market Equilibrium, A Positive
Externality and Efficiency
Price, Benefit, and Cost (Dollars)

45 Z S = MSC

30 V
25 U

10 H
MPB + MEB = MSB
MPB
0
10 12 Inoculations Per
Year (Millions) 9
 Figure 3.3 A Positive Externality for Which MEB
Declines With Annual Output
Price, Benefit, and Cost (Dollars)

MPBi + MEB = MSB S = MSC

F
30 B S' = MSC'
A
25
C
20 MPBi

0 10 12 16 20
Inoculations per Year (Millions)
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Internalization of Externalities
 An externality can be
internalized under policies
that force market
participants to account for
the costs of benefits of their
actions.
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 Corrective Taxes to Negative
Externalities
 Setting a tax equal to the
MEC will internalize a
negative externality.

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 Figure 3.4 A Corrective Tax
S’ = MPC + T = MSC
Price, Benefit, and Cost (Dollars)

S = MPC
G
110
B Net Gains in
105
Tax Revenue = Total Well-Being
100 T A
External Costs
95

D = MSB

4.5 5
Tons of Paper Per Year (Millions)
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Results of a Corrective Tax
 Price rises.
 The tax revenue is sufficient
to pay costs to third parties.
 Socially optimal levels of
production are achieved.
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Using a Corrective Tax
 The greenhouse effect and a “Carbon
Tax”
 The greenhouse effect is caused by
burning carbon-based fuels. A carbon tax
can be imposed to limit greenhouse
gasses to their socially optimal levels.
 It is called a carbon tax because the
amount of the tax would depend on the
amount of carbon in the fuel.

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Theory of the Second Best
 When one condition for an
optimum is violated, then
maintaining the others will
not guarantee a second-
best solution.

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A Polluting Monopolist
 Chapter 2 showed that monopoly
creates a loss to society. This
chapter shows that a negative
externality causes a loss as well.
 The losses do not necessarily add
to one another. In fact, they can
cancel each other out.

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Figure 3.5 A Second Best Efficient Solution
MPC + MEC = MSC
F
MPC
A
PM
Price

D = MSB
MR

0 QM Q*
Output per Year 18
Corrective Subsidies
 Setting a subsidy equal to
MEB will internalize a
positive externality.

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 Figure 3.6 A Corrective Subsidy
Price, Benefit, and Cost (Dollars)

45 Z
S = MSC

R
30 V
25 U
Subsidy Payments

10 X
Y D' = MPBi +$20 = MSB
D = MPBi
0 10 12
Inoculations per Year (Millions) 20
Property Rights and Internalization
of Externalities
 Externalities arise because some resource
users’ property rights are not considered in
the marketplace by buyers or sellers of
products.
 Governments can give businesses the right
to emit wastes in the air and water or it can
give individuals the right to clean air and
water.
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Coase's Theorem
 By establishing rights to use
resources, government can
internalize externalities
when transactions or
bargaining costs are zero.

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The Significance of Coase’s
Theorem
 The efficient mix of output will result simply as a
consequence of the establishment of
exchangeable property rights.
 It makes no difference which party is assigned the
right to use a resource.
 If the transactions costs of exchanging the rights
are zero, the efficient mix of outputs among
competing uses of the resource will emerge.

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 Figure 3.7 Coase’s Theorem

A B
MPCB + MEC = MSC

Price of Wheat (Dollars)

Price of Beef (Dollars)

MPCB

MCW
PB MCW*

PW

QB* QB1 QW1QW*

Beef Output per Year Wheat Output per Year

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Limitations of Coase’s Theorem
 Transactions costs are not
zero in many situations.
 However you allocate the
property rights, the
distribution of income is
affected.
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Applying Coase's Theorem
 The Clean Air Act of 1990 allows for the sale
of the "right to pollute." Firms face a tradeoff
when they pollute. If they pollute, they forgo
the right to sell their emission permits to
others.
 In markets for electricity, Clean Air Act has
motivated firms to shift to natural gas and
away from coal as a means of producing
electricity.

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 Figure 3.8 Pollution Rights and Emissions
Price and Marginal Social Benefit
S = Supply of Pollution Rights

D = MSB of
$20 Emitting Wastes

0 75,000 100,000
Tons of Annual Emissions
and Number of Pollution Rights 27
Figure 3.9 The Efficient Amount of Pollution
Abatement

Marginal Social Cost and Benefit MSC

MSB

0 A* 100
Percent Reduction in Waste Emitted per Year
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Recycling
 Recycling may be a less efficient and more
polluting use of labor, land and capital than
simple land fill disposal because:
 Collecting waste for recycling costs three
times as much as collecting it for disposal.
 Rural land is inexpensive.
 Recycling paper creates more water pollution
and does not “save” trees; it simply reduces
the number that are planted.

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Regulatory Solutions
 Instead of using market
forces to force firms to
internalize externalities, we
can use emission standards
and apply these to all
market players.
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 Figure 3.10 Regulating Emissions: Losses in Efficiency
From Differences in the Marginal Social Benefit of
Firm A
Emissions
Cost and Benefit (Dollars)

B
C MEC = MSC
10
A

DQRA MSB

QA* QA1
Tons of Emissions per Year
Firm B

F G MEC = MSC
10
H
DQRB MSB
0
QB* QR QB1
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 Figure 3.11 Losses in Efficiency From Emissions
Standards When MEC Differs Among Regions
Cost and Benefit (Dollars)

Firm C Firm D

X Y MEC = MSC MSB

20
Z S
R T MEC = MSC
DQRC MSB

QC* QR QR
QD* DQRD
Tons of Emissions per Year

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Markets for Pollution Rights
 The Clean Air Act of 1990 allowed firms the right
to trade Sulfur Dioxide emissions allowances.
 The market for the allowances began in 1991.
 Firms must have the allowances to emit Sulfur
Dioxide.
 Firms increasing production can buy permits or
use pollution controls to keep their total
emissions constant.
 Firms that reduce their emissions can sell their
allowances to others.

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Sulfur Dioxide Emission Prices

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Global Externalities
 CFC’s
 Deforestation
 Global Warming

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Costs and Benefits to the EPA
 The EPA estimates that annual compliance costs
could be in the range of $225 billion per year.
 The EPA estimated in 1990 that the benefits of
the Clean Air Act were nearly 50 times the costs.
 Ninety percent of the benefits are estimated to
come from laws pertaining to power plants and
factories.

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