Chapter 18
Externalities
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What will you learn in this chapter?
• How external costs and benefits affect tradeoffs.
• What effects externalities have on market
price, quantity, and surplus.
• What private solutions to externalities exist.
• How taxes, subsidies, quantity regulations, and
tradable allowances can be used to counteract
an externality.
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What are externalities?
• When individuals make calculated decisions, they
weigh the costs and benefits of the action.
– Private benefit that accrues directly to the decision
maker.
– Private cost that falls directly on an economic decision
maker.
• Sometimes other people are affected by our
decisions or have a stake in the outcomes.
– External cost describes a cost imposed without
compensation on someone other than the person
who caused it.
– External benefit describes a benefit that accrues
without compensation to someone other than the
person who caused it.
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1
External costs and benefits
• The total cost of a decision, the social cost, includes
both private costs and external costs.
• The total benefit of a decision, the social benefit,
includes both private benefits and external benefits.
• External costs and external benefits are collectively
referred to as externalities.
– Negative externality: external costs.
– Positive externality: external benefits.
• A network externality is the effect that an additional
user of a good or participant in an activity has on the
value of that good or activity for others.
– Can be positive or negative.
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Negative externality from the demand side
How can drivers be forced to consider external costs, and thus operate
on the social demand curve?
• The most straightforward option is to implement a gasoline tax.
Market with private costs only
Price ($/gal.)
Tax
Sprivate
Market with social costs
1. If drivers bear full social
costs, the social demand
curve is below the private
demand curve…
Price ($/gal.)
Sprivate
1
2. … and the equilibrium is
at a lower price and
quantity.
3
3
2.5
Dprivate
Dprivate
0
Dsocial
20
Quantity of gasoline (billions of gals.)
0
15 20
Quantity of gasoline (billions of gals.)
If drivers ignore the external cost of pollution, When drivers bear the full social cost, the
they only consider the private costs and
externality is eliminated and they drive less.
benefits of driving.
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Negative externality from the demand side
A tax increases surplus when a negative externality is
present in the market.
Surplus under a negative
externality
Price ($/gal.)
Surplus when a negative
externality is internalized
Price ($/gal.)
External cost
Consumer surplus
Sprivate
Producer surplus
A
Sprivate
3
1
2
X
2.5
C
B
Y
Dprivate
0
20
Quantity of gasoline (billions of gals.)
•
•
Under a negative externality, the surplus lost to
those outside the market due to the external
cost is subtracted from consumer and producer
surplus, C.
Area C is equal to $1 × 20B = $20B.
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•
•
•
Dprivate
Dsocial
15
Quantity of gasoline (billions of gals.)
If the externality is internalized, demand shifts
downward by the amount of the tax.
CS and PS in the market are both lower.
The external cost imposed on people is
eliminated.
6
2
Active Learning: Calculating the cost of
negative externalities
Suppose that a $1 per unit tax can mitigate a negative externality. Using the following graphs:
• Calculate total surplus in the presence of a negative externality.
• Calculate total surplus when the negative externality is internalized.
Surplus under a negative
externality
Price ($/gal.)
Price ($/gal.)
Consumer surplus
5
Sprivate
3
1
Sprivate
5
Producer surplus
A
2
Surplus when a negative
externality is internalized
External cost
X
2.5
C
Y
Dprivate
B
1
1
0
50
Quantity of gasoline (billions of gals.)
Dprivate
0
Dsocial
37.5
Quantity of gasoline (billions of gals.)
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Negative externality from the demand side
A negative externality always reduces surplus unless
it is internalized.
Price ($/gal.)
S
private
Surplus lost by
consumers and
producers.
Tax
Gain in total surplus
when externality is
internalized.
3
1
2.5
2
Surplus gained
by pollution
sufferers.
D
private
• When the negative externality is
internalized by imposing a tax, the
demand curve shifts downward.
– Smaller quantity sold.
• CS and PS is lost from imposing a
tax.
• Surplus is gained by others in
society when they receive surplus
from tax revenue.
• Surplus gain is yellow area.
D
social
0
15 20
Quantity of gasoline (billions of gals.)
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Negative externality from the supply side
How can drivers be forced to consider external costs, and thus operate
on the social supply curve?
• The most straightforward option is to implement a gasoline tax.
Market with private costs only
Price ($/gal.)
Sprivate
3.5
3
3
Dprivate
Tax
1
0
20
Quantity of gasoline (billions of gals.)
Market with social costs
1. If gasoline retailers bear
full social costs, the social
supply curve is above the
private supply curve…
Price ($/gal.)
Ssocial
Sprivate
2. … and the equilibrium is
at a higher price and
quantity.
Dprivate
0
15 20
Quantity of gasoline (billions of gals.)
If drivers ignore the external cost of pollution, When drivers bear the full social cost, the
they only consider the private costs and
externality is eliminated and they drive less.
benefits of driving.
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9
3
Negative externality from the supply side
A tax increases surplus when a negative externality is
present in the market.
Surplus under a negative
externality
Price ($/gal.)
Surplus when a negative
externality is internalized
External cost
Price ($/gal.)
Ssocial
Sprivate
Consumer surplus
4
Producer surplus
A
X
C
1
Sprivate
3
3.5
Y
B
Dprivate
Dprivate
0
20
Quantity of gasoline (billions of gals.)
•
•
Under a negative externality, the surplus lost to
those outside the market due to the external
cost is subtracted from consumer and producer
surplus, C.
This area equals $1 × 20B = $20B.
0
•
•
•
15
Quantity of gasoline (billions of gals.)
If the externality is internalized, supply shifts
upward by the amount of the tax.
CS and PS in the market are both lower.
The external cost imposed on people is
eliminated.
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Negative externality from the supply side
A negative externality always reduces surplus unless
it is internalized.
S
social
Price ($/gal.)
Tax
1
S
private
Surplus gained
by pollution
sufferers.
2
2.5
Gain in total surplus
when externality is
internalized.
3
Surplus lost by
consumers and
producers.
D
private
• When the negative externality is
internalized by imposing a tax, the
supply curve shifts upward.
– Smaller quantity sold.
• CS and PS is lost from imposing a
tax.
• Surplus is gained by others in
society when they receive surplus
from tax revenue.
• Surplus gain is yellow area.
0
15 20
Quantity of gasoline (billions of gals.)
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11
Positive externalities from the demand side
• A positive externality also pushes quantity away from the efficient
equilibrium level, reducing total surplus.
• Internalizing a positive externality, the market reaches an equilibrium with a
higher quantity based on social costs and benefits.
Price ($)
3,500
500
3,000
1. When homeowners capture
external benefits, the social
demand curve for house
paintings is above the private
demand curve, and …
Sprivate
2.… the equilibrium point
moves to a higher price
and quantity.
1,700
1,500
Dsocial
Dprivate
0
• Suppose a homeowner
painting a house provides
$500 in external benefit
to the neighborhood.
• If homeowners are able
to capture the external
benefits of painting a
house, demand shifts
upward.
– Larger quantity.
300 360
Quantity of houses painted
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4
Positive externalities from the demand side
The increase in total surplus can be calculated when
a positive externality is present.
Surplus when a positive externality is internalized
Surplus under a positive externality
Price ($)
3,500
Price ($)
3,500
Consumer surplus
Producer surplus
External benefit
3,000
A
3,000
X
Sprivate
2,000
C
Sprivate
1,700
1,500
B
Y
Dsocial
Dsocial
Dprivate
Dprivate
0
300
Quantity of houses painted
0
• Area C is the amount of surplus gained by
those outside the market and is added to
consumer and producer surplus.
• This surplus equals $500 × 800 = $150K.
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360
Quantity of houses painted
• Internalizing the externality
– CS and PS increase; external
benefits disappear
• TS = X + Y = $540,000
13
Active Learning: Calculating positive
externalities
Suppose a negative externality exists and a $250 per unit subsidy resolves it.
• Calculate total surplus in the presence of a positive externality.
• Calculate total surplus when the positive externality is internalized.
Surplus when a positive externality is internalized
Surplus under a positive externality
Price ($)
1,250
Price ($)
1,250
Consumer surplus
Producer surplus
External benefit
1,000
A
1,000
C
Sprivate
291
250
B
Y
Dsocial
Dprivate
100
0
X
Sprivate
500
200
Quantity of houses painted
100
0
Dsocial
Dprivate
256
Quantity of houses painted
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Positive externality from the demand side
A positive externality always reduces surplus unless
it is internalized.
Price ($)
3,500
Gained when
externality is
internalized.
3,000
Gained from
extra trades.
S private
2,000
1,500
D social
Lost when
externality is
internalized.
0
300 360
Quantity of houses painted
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D private
• When the positive
externality is internalized by
imposing a subsidy, the
demand curve shifts
upward.
– Larger quantity sold.
• CS and PS is lost from
internalizing externality.
• Surplus is gained by market
participants receiving a
subsidy from tax revenue.
• Surplus gain is green area.
15
5
Positive externality from the supply side
• A positive externality also pushes quantity away from the efficient
equilibrium level, reducing total surplus.
• A subsidy corrects this market inefficiency, increasing surplus.
Price ($)
Surplus under a positive
externality
$3000
A
$1500
Surplus under a positive
externality
$3000
Sprivate
$500
$1000
Price ($)
External benefit
Consumer surplus
Producer surplus
Sprivate
X
$1300
C
B
Dprivate
0
300
Quantity of houses painted
Under a positive externality, the surplus by those
outside the market is added to consumer and
producer surplus, Area C.
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Ssocial
Y
Dprivate
•
•
•
360
Quantity of houses painted
If the externality is internalized through a
subsidy, the supply curve shifts downward.
CS and PS in the market are both higher.
The external benefit is now internalized to only
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market participants.
Positive externality from the supply side
A positive externality always reduces surplus unless
it is internalized.
Price ($)
S
private
Lost when
externality is
internalized.
S
social
Gain in total surplus
when externality is
internalized.
$1500
$1000
$500
Gained when
D
externality is
private
internalized.
D
social
0
300 360
Quantity of houses painted
• When the positive externality is
internalized by imposing a subsidy,
the supply curve shifts downward.
– Larger quantity sold.
• CS and PS is lost from internalizing
externality.
• Surplus is gained by market
participants receiving a subsidy
from tax revenue.
• Surplus gain is green area.
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Dealing with externalities
• External costs and benefits can be diffuse,
complex, and hard to control.
• Solutions must ensure that individuals experience
costs and benefits that are equal in value to the
true social costs and benefits of their choices.
– This may require coordinating across millions of
people.
• The Coase theorem states that if there are zero
transaction costs to negotiate and agreements are
enforceable, then an efficient equilibrium through
private trades can be reached, even in the
presence of an externality.
• Often, these two assumptions do not hold true.
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Dealing with externalities
• Because of the cost and difficulty of coordinating
private solutions, people often turn to public
policy for solutions to externalities.
• A Pigovian tax counters the effects of a negative
externality.
• There are two main problems with this solution:
– Setting the tax at the right level.
– No guarantee that the government can or will do
anything to help people bearing the external cost.
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Dealing with externalities
As previously analyzed, a tax can move the market
equilibrium to the social optimal equilibrium.
(B) The effect of a Pigovian tax
(A) The effect of a negative externality
Price $/(gal.)
5
4
Price ($/gal.)
Under a negative externality,
demand is above the optimal
level.
S
3
2.5
5
4
A Pigovian tax can move the
demand curve back to the
optimal level.
S
3
2.5
Dprivate
Dprivate
1
0
Dsocial
15 20
Quantity of gasoline (billions of gals.)
• Under a negative externality, the demand
curve is above the optimal demand curve by
the amount of the external cost.
• This causes quantity to be higher than the
efficient level.
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1
Dsocial
0
15 20
Quantity of gasoline (billions of gals.)
• A Pigovian tax counteracts a negative
externality.
• If the tax is set equal to the value of the
external cost:
• The externality cost is canceled.
• Quantity goes to the efficient level.
20
Dealing with externalities
As previously analyzed, a subsidy can move the market
equilibrium to the socially optimal equilibrium.
Price ($)
3,500
500
1.A $500 subsidy creates a
new demand curve, above
the old one…
3,000
S
private
2. … if the subsidy exactly equals
the positive externality, equilibrium
occurs at the socially efficient
outcome.
1,700
1,500
Dsocial
D
private
0
300 360
• Suppose government
estimates that painting
houses creates $500 worth
of external benefits for
neighbors.
• If this subsidy exactly
equals the external benefit
of painting houses,
equilibrium occurs at the
socially efficient outcome.
– Increased efficiency does
not imply increased
fairness.
– Troublesome to quantify
the externality.
Quantity of houses painted
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7
Dealing with externalities
• One solution is to regulate quantity to be socially optimal.
• This does not make the market efficient if individuals make decisions
based on net benefit (marginal benefit – marginal cost = 0).
(B) Gasoline consumption under a tax
(A) Gasoline consumption under a quota
Net benefit to driver
Net benefit to driver
1. Quantity is
the same
2
2
Quota
1.33
1.2
1. Marginal
benefit equals
the tax level…
1.2
1
2. … but marginal
benefit is different.
Tax level
0.8
Prius
0
•
20
2. …and
quantity
varies
accordingly.
Range
Rover
0
60
Gallons of gasoline
Under a quota, both drivers buy 20 gallons
regardless of the difference in their net
marginal benefits.
10
Range
Rover
Prius
30
60
Gallons of gasoline
Under a $1 tax, both drivers buy different
amounts of gas.
Neither is left wanting to buy more.
Total gallons consumed remain 40.
•
•
•
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Dealing with externalities
• Total surplus is higher under the tax than under the quota.
• The quota brings the two drivers to the same combined
quantity of gas consumption as the tax does, but does it
inefficiently (smaller total surplus).
Surplus under a quota
Marginal benefit to driver
Surplus under a tax
Marginal benefit to driver
Ranger Rover surplus
2
2
Prius surplus
Quota
1.33
1.2
Tax revenue
34 + 20 = 54
15
34
40 + 1 + 15 = 56
1.2
1
1
Tax level
0.8
20
Prius
0
20
Range
Rover
60
Gallons of gasoline
At 20 gallon quota, total surplus is $54.
10
+
30 =
40
Prius
0
10
Range
Rover
30 40
60
Gallons of gasoline
Under a $1 tax, total surplus is $56.
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Dealing with externalities
• Using a quota to deal with externalities can be
extended by permitting the buying and selling
of quota allowances, a tradable allowance.
– Market quantity is socially optimal (efficient).
– Total surplus is maximized.
– Tradable allowance does not create any
government revenue, because no taxes are
imposed.
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8
Dealing with externalities
• Because of the difficulty of measuring externalities
directly, many policies target individual goods and
processes.
• The downside of targeting individual activities is that it
risks misaligning the incentives that consumers and
producers face with the goal of minimizing the
externality.
• A policy that directly taxes or subsidizes the
externalities encourages the development of
technology and processes.
– Consumers and producers have an incentive to find new
ways of doing things that don’t generate externalities.
– This allows them to avoid having to pay for a tax or the
rights to an allowance, aligning their incentives with the
end goal of the policy.
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Summary
• Any cost that is imposed without
compensation on someone other than the
person who caused it is an external cost.
• A benefit that accrues without compensation
to someone other than the person who caused
it is called an external benefit.
• External costs and benefits are collectively
referred to as externalities.
• The total cost of the decision, including any
externalities, is referred to as the social cost.
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Summary
• A negative externality causes the individuals
who bear only the private cost to demand or
supply an inefficiently high quantity at any
given price.
• A positive externality causes individuals who
enjoy only the private benefit to demand or
supply an inefficiently low quantity at any
given price.
• In the presence of externalities, markets fail to
maximize total surplus.
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9
Summary
• If agreements are enforceable and transaction
costs are small, the Coase theorem states that
individuals reach an efficient equilibrium
through private trades.
• A Pigovian tax counterbalances the effects of a
negative externality.
• A subsidy counterbalances the effect of a
positive externality.
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Summary
• Setting a quota to counteract inefficiently high
consumption due to a negative externality can
lower quantity to the socially optimal efficient
level, but it does not maximize surplus.
• A tradable allowance is a production or
consumption quota that can be bought and
sold.
– Efficient quantity.
– Total surplus is maximized.
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