Externalities
Definition: An externality exists whenever consumers or firms do not account fully for all the
ramifications of their actions. The effect that is not accounted for is called the external effect.
Negative externalities: Situations in which the external effect damages others;
Positive externalities: Situations in which the external effect helps others.
Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources?
Pareto’s Query: Given the state of affairs in question, is it possible to make at least one
individual better off without hurting anyone else?
No
Yes


Is the state of affairs getting the most from
Is the state of affairs getting the most from
the economy’s resources? No.
the economy’s resources? Yes.

State of affairs inefficient.
Preview
Externalities cause inefficiency.
Remedies for Externalities
Fees (Taxes) or Bonuses (Subsidies)
Coase Approach (Private Solution)
Command and Control
Cap and Trade

State of affairs efficient.
Pollution and Efficiency
First, focus on the
chemical firm
Farmer’s Clean-up Costs = C  F
where C = Quantity of chemicals produced
F = quantity of food produced
Both industries are
PC = 1,000
PF = 800
perfectly competitive.
Question: Does 399 units of chemicals
maximize the chemical firm’s profit? Answer: No.
Chemical Firm
MC of Chemicals
1,200
MRC = PC = 1,000
MCC
1,000
MRC = 1,000
C = 399
800
C = 399

C = 400
600
400
200
C* = 400
Profit
MCC = 200 + 2C
= 200 + 2×399
= 200 + 798
MCC = 998
=
TR

TC
Up by
Up by
Up by
$1,000
$998
$2
Question: Does 400 units of MCC = 200 + 2C
chemicals maximize the
= 200 + 2×400
chemical firm’s profit?
= 200 + 800
Answer: Yes
C
MCC = 1,000
Pollution and Efficiency
Next, focus on the
farmer.
Clean-up Costs = C  F
where C = Quantity of chemicals produced
F = quantity of food produced
Both industries are
P = 1,000
PF = 800
perfectly competitive. C
C* = 400
Question: How much food will the farmer produce?
MRF = PF = 800
F* = 100
MC of Food
Farm
C = 800
C = 400
C=0
1,200
1,000
The farmer must clean up the water
before he can use it to irrigate his fields.
MRF = 800
800
Farmer’s Clean-up Costs = C  F
= 400  100
600
Farmer’s Clean-up Costs = $40,000
400
200
100
200
300
F
State of Affairs: Each firm maximizes its individual profit:
Farmer’s Clean-up Costs = C  F
= 400  100
Claim: This state of affairs is inefficient.
= $40,000
Chemical Firm: C* = 400 Farm: F* = 100
Question: How would the farmer and the
chemical firm be affected if the chemical
firm produced 1 fewer unit of chemicals;
that is, what if the chemical firm
produced 399 units rather than 400?
Claim: Farmer’s clean-up costs fall by $100.
Farmer’s Clean-up Costs = 399  100
= $39,900
Claim: Chemical firm profit falls by $2.
Review:
Chemical firm profit rises by $2 when
production rises from 399 to 400
Profit
C = 399

C = 400
Up by
$2
Chemical firm profit falls by $2 when
production falls from 400 to 399.
Question: Can you devise a special deal between the owner of the chemical firm and the farmer
that would make both better off?
State of
Affairs:
Each firm maximizes its profit: C=400
F=100
Farmer’s Clean-up Costs = 40,000
When chemical production falls from 400 to 399.
Chemical firm profit falls by $2.
Farmer’s clean-up costs fall by $100.
Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources?
Pareto’s Query: Given the state of affairs in question, is it possible to make at least one
individual better off without hurting anyone else?
No
Yes


Is the state of affairs getting the most from
Is the state of affairs getting the most from
the economy’s resources? No.
the economy’s resources? Yes.


State of affairs inefficient.
State of affairs efficient.
Chemical Firm
Special Deal: The farmer gives
the owner of the chemical firm Chemical Production
down by 1 unit
a “side payment” of $50 on the

condition that the owner of the
chemical firm reduces chemical Profit down by $2
production by 1 unit.
$48 ahead
Side payment
$50
Farmer
Clean up costs
down by $100
$50 ahead
Conclusion: The state of affairs in question results in an inefficient high level of chemical
production.
Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources?
Pareto’s Query: Given the state of affairs in question, is it possible to make at least one
individual better off without hurting anyone else?
Yes
No


Is the state of affairs getting the most does
Is the state of affairs getting the most does
not from the economy’s resources? No.
not from the economy’s resources? Yes.


State of affairs inefficient.
State of affairs efficient.
Intuition: When each firm maximizes its profit are decisions based on misleading or accurate
information?
Misleading information
Accurate information


Inefficiency results
Efficiency results
Question: Why does the market fail to operate efficiency in the presence of a negative
externality?
Social Costs of
Private Costs of
>
Chemical Production
Chemical Production


Costs that the chemical firm incurs
Costs that the chemical firm incurs.
plus
the costs the chemical firm imposes on
others, the farmer.
Difference: External Effect
Answer: The chemical firm does not fully account for all the costs it is imposing.
EPA Prohibits the Chemical Firm from Polluting
PC = 1,000
Claim: This state of affairs is inefficient.
PF = 800
C** = 0
MRF = PF = 800
Question: How would the chemical firm and
F** = 200
the farmer be affected if the chemical firm
Farm
were allowed to produce 1 unit of chemicals?
C = 800 C = 400
MC of Food
MR = P = 1,000
C
C=0
MCC = 200 + 2C
= 200 + 2×0
MCC = 200
Profit
C=0

C=1
C
Up by
$800
=
TR
C=0
1,200
1,000

Up by
$1,000
TC
800
Up by
$200
600
Chemical firm’s profit rises by $800
400
Farmer’s Clean-up Costs = C  F
= 1  200
=
$200
Farmer’s clean-up costs rise by $200.
200
Question: Can you devise a special deal to
make both better off?
MRF = 800
100
200
Farmer’s Clean-up Costs =
=
Farmer’s Clean-up Costs =
300
C
0
 F
 200
$0
F
State of Affairs: EPA prohibits pollution: C = 0
F = 200
Farmer’s Clean-up Costs = 0
When chemical production rises from 0 to 1
Chemical firm’s profit rises by $800
Farmer’s clean-up costs rise by $200
Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources?
Pareto’s Query: Given the state of affairs in question, is it possible to make at least one
individual better off without hurting anyone else?
No
Yes


Is the state of affairs getting the most from
Is the state of affairs getting the most from
the economy’s resources? No.
the economy’s resources? Yes.


State of affairs inefficient.
State of affairs efficient.
Special Deal: The owner of the chemical firm gives the farmer a “side payment” of $400 on the
condition that the owner of the chemical firm can increase chemical production by 1 unit.
Side payment
Farmer
Chemical Firm
$400
Chemical Production up
Clean up costs
by 1 unit
up by $200

$200 ahead
Profit up by $800
$400 ahead
Summary of Externalities
An externality is present whenever consumers or firms do not account for the full
ramifications of their actions. In such a situation, the markets fail because decisions are
based on erroneous information. A market failure occurs.
More specifically when one party does not account for all the costs of its actions, a negative
externality exists. In such a case,
An unfettered market when each firm independently maximizes its own profit results
in an inefficiently high level of production.
Complete elimination of the negative externality is typically inefficient also.
The challenge: Efficiency calls for something in the middle. How can we get there?
Remedies for Externalities
Fees (Taxes) or Bonuses (Subsidies)
Coase Approach (Private Solution)
Command and Control
Cap and Trade
Fees (Taxes) or Bonuses (Subsidies)
Question: Consider the chemical firm and
farm. What is the basic problem when each
maximize profit?
Answer: The chemical firm is not
accounting for all the ramifications of its
actions. It is not accounting for the fact
that when it produces chemicals it is
imposing a cost on the farmer.
Social Costs of
Chemical
Production
Chemical Firm
MC of Chemicals
MC
Social
1,200
1,000
800
Private Costs of
Chemical
Production
600
The government charges the owner of the
chemical firm a fee for each unit of pollution
the chemical firm dumps into the lake.
200
>
MCPrivate
External Effect:
Costs the chemical
firm imposes on
the farmer.
400
C
Question: What should the pollution fee equal? Answer: The cost of the external effect.
Intuition: Are decisions based on misleading or accurate information?
Misleading
Accurate

Inefficiency results

Efficiency results
Coase Approach
Bargaining and deal making are the central ideas behind the Coase approach.
When it is possible to strike a deal be struck and when it would be impossible to strike a deal?
Question: What must be true if two (or more) individuals voluntarily agree to a deal?
Answer: The deal must
make at least one individual better off.
and
make no individual worse off.
Question: What must be true if it is IMPOSSIBLE for two (or more) individuals to AGREE
voluntarily to a deal?
Answer: It must be impossible to find a way to
make at least one individual better off
and
make no individual worse off.
Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources?
Pareto’s Query: Given the state of affairs in question, is it possible to make at least one
individual better off without hurting anyone else?
Yes
No


Is the state of affairs getting the most does
Is the state of affairs getting the most does
not from the economy’s resources? No.
not from the economy’s resources? Yes.


State of affairs inefficient.
State of affairs efficient.
Coase Approach
Get the affected parties together.
Encourage them to bargain and
make deals.
Continue this bargaining and
deal making process until it is
impossible for the parties to
make any more deals.
Coase Theorem: When bargaining costs are negligible
Bargaining leads to efficiency.
Furthermore, the assignment of property rights:
does not affect the allocation of resources.
does affect the distribution of income.
Simple Illustration of the Coase Theorem: Mr. Smith, Ms. Jones, and a Wood Stove
Mr. Smith, who suffers from asthma, is getting a new neighbor; Ms. Jones is building a
house near Mr. Smith.
Ms. Jones is deciding how to heat her house and has narrowed the options to two:
electricity or wood.
Electricity would cost her $5,000 per year and wood $2,000 a year.
Ms. Jones does not suffer from any respiratory problems; consequently, the fact that
wood burning will pollute the atmosphere does not concern her.
Since Mr. Smith suffers from asthma, his lungs cannot tolerate the pollution produced by
wood burning stoves.
If the air were polluted by Ms. Jones’ wood smoke, he would have to install a
climate control system in his home which would filter the air.
Such a system costs $2,500 per year.
Heating Costs for Ms. Jones: Wood: $2,000 Electricity: $5000
A difference of $3,000
Cost of Mr. Smith’s
climate control system:
$2,500
Scenario #1: Ms. Jones has the right to pollute the air.
Ms. Jones
Mr. Smith
Would Ms. Jones
Heats with wood
Installs climate control system
choose, wood or
Spends $2,000 on heat
Spends $2,500 on the climate control system
electricity?
Question: Could Mr. Smith offer Ms. Jones a “side payment” to induce her to heat with
electricity? No
What is the largest side payment Mr. Smith would be willing to offer? $2,500
$3,000
What is the smallest side payment Ms. Jones would find acceptable?
Ms. Jones
Mr. Smith
Outcome:
Heats with wood
Installs climate control system
Spends $2,000 on heat
Spends $2,500 on the climate control system
Question: Does this outcome make economic sense from the perspective of society as a whole?
Provide Mr. Smith
From society’s perspective
Provide Ms. Jones
with clean air.
there are two goals:
with heat.
There are two ways to achieve the goals:
Ms. Jones heats
Ms. Jones heats with wood
with electricity
and Mr. Smith installs the climate control system


Jones costs = $5,000
Smith costs = $0
Jones costs = $2,000 Smith costs = $2,500
Costs to Society = $5,000
Costs to Society = $4,500