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.
This occurs when there is a
negative externality.
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Social Costs
MSC = MPC + MEC
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Price, Benefit, and Cost (Dollars)
Figure 3.1 Market Equilibrium, A Negative
Externality and Efficiency
MPC + MEC = MSC
110
105
100
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G
B
10
S = MPC
10
A
D = MSB
4.5 5
Tons of Paper Per Year (Millions)
Implications of Figure 3.1
 Market equilibrium occurs
where
MPC = MSB
 Efficiency Requires that
MSC = MPC + MEC = MSB
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Positive externalities
 The marginal external benefit is the
dollar value of the benefit to third
parties from an additional unit of
production of consumption of a
good. This occurs when there is a
positive externality.
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Social Benefit
MSB = MPB + MEB
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Price, Benefit, and Cost (Dollars)
Figure 3.2 Market Equilibrium, A Positive Externality
and Efficiency
45
Z
30
25
10
S = MSC
V
U
H
MPB + MEB = MSB
0
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10 12
Inoculations Per
Year (Millions)
Price, Benefit, and Cost (Dollars)
Figure 3.3 A Positive Externality for Which MEB
Declines With Annual Output
MPBi + MEB = MSB
F
30
A
25
S = MSC
B
S' = MSC'
C
20
MPBi
0
10 12
16
20
Inoculations per Year (Millions)
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Internalization of Externalities
 An externality can be
internalized if there is a
policy that causes 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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Price, Benefit, and Cost (Dollars)
Figure 3.4 A Corrective Tax
S’ = MPC + T = MSC
S = MPC
G
110
105
100
95
B
Tax Revenue = Total
External Costs
T
A
Net Gains in
Well-Being
D = MSB
4.5 5
Tons of Paper Per Year (Millions)
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Results of a Corrective Tax
 Socially optimal levels of
production are achieved.
 The tax revenue is sufficient
to pay costs to third parties.
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Using a Corrective Tax
 The greenhouse effect and a “Carbon
Tax”
 If it is accepted that 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 secondbest solution.
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A Polluting Monopolist
 In Chapter 2 it was shown that
monopoly created a loss to society. In
this chapter it was shown 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
Price
PM
B
C
D = MSB
MR
0
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QM Q*
Output per Year
Corrective Subsidies
 Setting a subsidy equal to
MEB will internalize a
positive externality
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Price, Benefit, and Cost (Dollars)
Figure 3.6 A Corrective Subsidy
Z
45
30
25
R
S = MSC
V
U
Subsidy Payments
10
Y
X
D' = MPB i+ $20 = MSB
D = MPB i
0
10 12
Inoculations per Year (Millions)
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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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Figure 3.7 Coase’s Theorem
B
MPCB + MEC = MSC
MPCB
PB
Q*B QB1
Beef Output per Year
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Price of Wheat (Dollars)
Price of Beef (Dollars)
A
MCW
MC*W
PW
QW1 Q*W
Wheat Output per Year
Limitations of Coase’s Theorem
 Transactions costs are not
zero in many situations.
 However you allocate the
property right, 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 the
emission permit to others.
 With electricity this has motivated firms
to shift to natural gas and away from
coal as a means of producing electricity.
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Price and Marginal Social Benefit
Figure 3.8 Pollution Rights and Emissions
S = Supply of Pollution Rights
D = MSB of
Emitting Wastes
$20
0
75,000 100,000
Tons of Annual Emissions
and Number of Pollution Rights
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Marginal Social Cost and Benefit
Figure 3.9 The Efficient Amount of Pollution
Abatement
MSC
E
MSB
A*
0
100
Percent Reduction in Wastes Emitted per Year
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Regulatory Solutions
 Instead of using market
forces to cause firms to
internalize externalities we
can use emission standards
and apply these to all.
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Figure 3.10 Regulating Emissions: Losses in Efficiency
From Differences in the Marginal Social Benefit of
Emissions
Cost and Benefit (Dollars)
Firm A
B
MEC = MSC
C
10
A
DQRA
MSB
Q*A
Firm B
10
QB1
Tons of Emissions per Year
F
MEC = MSC
G
H
DQRB
0
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Q*B
QR
MSB
QB1
Cost and Benefit (Dollars)
Figure 3.11 Losses in Efficiency From Emissions
Standards When MEC Differs Among Regions
Firm C
20
X
Y
Firm D
MEC = MSC
S
Z
DQRC
Q*C QR
MSB
R
T
QR
Q*D
Tons of Emissions per Year
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MEC = MSC
DQRD
Sulfur Dioxide Emission Prices
Allowance Price (Dollars)
250
200
150
100
50
0
8/1/94
8/1/95
8/1/95
8/1/95
8/1/95
8/1/95
Month/Year
Fieldston Publications Price Index
SOURCE: United States Environmental Protection Agency
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Cantor Fitzgerald Market Price Index
Global Externalities
 CFC’s
 Deforestation
 Global Warming
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