I need a volunteer…
• You must be super awesome at
texting.
http://www.nytimes.com/interactive/2009/07/19/technology/20090719-driving-game.html?_r=0
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Externalities
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10
The Main Idea…
• Recall: Adam Smith’s “invisible hand”
• Markets allocate scarce resources with forces of S
& D; equilibrium typically maximizes market
welfare
• But market failures can still
happen.
• Outcome of free market differs from socially
optimal outcome
• Gov’t policies can sometimes improve things
• Video Clip: “Episode 31: Market Failures”
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EXTERNALITIES
• Externality = the uncompensated
impact of one person’s actions on
the well-being of a bystander
• For example, I played a terrible song
at the start of class. You were innocent
bystanders – you weren’t involved in
me buying the song off of iTunes, but
you still suffered the noise pollution.
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EXTERNALITIES
• When the impact on the bystander
is adverse, the externality is called
a negative externality
• Exhaust from cars
• Your neighbor’s barking dog
• Rebecca Black’s, “Friday”
• When the impact on the bystander
is beneficial, the externality is
called a positive externality
• Me getting a flu shot
• Education
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EXTERNALITIES CAUSE MARKET
INEFFICIENCY
• In either case, decision maker fails to
take into account the external effect of
his or her behavior.
• This causes markets to be inefficient, and
thus fail to maximize total surplus.
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Negative Externalities
• Externality imposes costs on bystanders
• Intersection of the demand curve and the socialcost curve determines optimal output level.
• Market quantity > Socially optimal level
• The market produces a larger quantity than is
socially desirable (overproduction)
• Social Cost > Private Cost
• Add graph to your notes
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Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
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© 2004
South-Western
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South-Western
Life on Dismal Lake 
• I need five brave volunteers…
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Quick Quiz 1: Are You Picking Up
What Was Put Down?
• The government taxes goods like alcohol,
tobacco, and gasoline – you may be familiar
with the term sin tax. Why do you think many
economists support these types of taxes?
Provide a brief written explanation along with a
graph to support your reasoning. For your
graph, pick one market to represent – alcohol,
tobacco, or gas.
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Positive Externality Example: Education
• Externality benefits the bystanders
• Intersection of the supply curve and the socialvalue curve determines the optimal output
level.
• Optimal Output Level > Equilibrium Quantity
• The market produces a smaller quantity than is
socially desirable (underproduction)
• Social Value > Private Value
• Add graph to your notes
• Video Clip: “Episode 32: Externalities”
Copyright © 2004 South-Western
Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
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South-Western
Copyright
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South-Western
Quick Quiz 2: Are You Picking Up
What Was Put Down?
• Give an example of positive externality.
Explain why market outcomes are inefficient in
the presence of this externality. Provide a
graphical representation and explain how the
government can remedy such a market failure.
• DON’T PEAK AT YOUR NOTES.
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Adjusting for Negative Externalities
• Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
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Addressing Externalities:
Two Types of Public Policy
• Command-and-Control Policies:
Regulate behavior directly
• Make certain behaviors illegal
• Environmental regulations; limit pollution
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Addressing Externalities: Two
Types of Public Policy
• Market-Based Policies: provide incentives so private
decision makers choose to solve problem on their own
• Policy 1:
• Corrective Taxes: used to counter effects of negative
externalities; ideal tax should equal external costs (a.k.a.
Pigovian Taxes)
• Subsidies: used to counter effects of positive externalities;
ideal subsidy should equal external benefit
• Policy 2:
• Tradable Pollution Permits: Firms allotted certain amount of
pollution per year; a free market for pollution rights develops as
firms can buy and sell unused “units” of pollution
• Add graphs to your notes
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Figure 4 The Equivalence of Pigovian Taxes and Pollution
Permits
(a) Pigovian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigovian
tax sets the
price of
pollution . . .
Demand for
pollution rights
0
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
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South-Western
Copyright
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South-Western
Figure 4 The Equivalence of Pigovian Taxes and Pollution
Permits
(b) Pollution Permits
Price of
Pollution
Supply of
pollution permits
P
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Q
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
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South-Western
Copyright
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South-Western
Quick Quiz #3
• A glue factory and a steel mill emit smoke
containing a chemical that is harmful if inhaled
in large amounts. Describe three ways the town
government may respond to this externality.
What are the pros and cons of each solution?
• Create a chart on poster paper that shows
the pros and cons of each strategy. Come to
a consensus on which would be best and be
prepared to defend your choice.
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Quick Quiz #4
• We know education is beneficial to society,
however, the cost of college is skyrocketing.
On poster paper, explain how the government
could address this problem and provide a
graphical analysis. Discuss potential opposition
to such plan(s).
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2002 FRQ
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2008 Form B FRQ
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PRIVATE SOLUTIONS TO
EXTERNALITIES
• Government action is not always needed to
solve the problem of externalities.
•
•
•
•
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting between parties
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The Coase Theorem
• The Coase Theorem is
a proposition that
private parties can
solve the problem of
externalities on their
own by bargaining
without cost over the
allocation of resources
• Example: Mrs. K’s
barking dog
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Private Solutions Don’t Always Work 
• Transaction costs can be so high that private
agreement is not possible
• The costs parties incur in the process of agreeing to
and following through on a bargain
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In Summary…
• Sometimes the “invisible hand” fails to take
into account the well-being of third parties –
when a transaction impacts a third party, it’s
called an externality
• Externalities can be positive or negative
• Those affected by externalities can sometimes
solve the problem privately (Coase Theorem)
• When private parties cannot adequately deal
with externalities, then the government steps in.
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Quick Quiz #4
• Come up with your own externality story.
Apply the Coase Theorem and provide a private
solution. Give a specific scenario where the
transaction costs may get in the way of the
private solution.
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