Module-14
Externalities:
impacts on a third party
TEACHER’S GUIDE
P. 417Defined
P. 422Content standards
P. 423Materials
P. 423Procedure
P. 434Closure
P. 434Assessment
P. 437Overheads
Visuals N
Visuals for overhead projector.
Copy to transparent paper for overhead.
P. 438NVisual-1: Externality defined
P. 439NVisual-2: Marginal external cost
P. 440NVisual-3: Musical notes
P. 441NVisual-4A: The paper river
P. 442NVisual-4B: The paper river
P. 443NVisual-5A: External benefits
P. 444NVisual-5B: External benefits
Lessons 2
Copy and handout to students.
P. 446 2Lesson-II: Rancher and Hunter
P. 448 2Lesson assessment
Externalities
Impacts on a third party
Module-14
Teacher
DEFINED
M
any actions we take impact non-consentive parties around us.
People whistle as they walk down the street, ladies may wear
perfume, dogs run in the park—all with some costs and benefits that
impact non-consenting parties. These are externalities and they surround
us. Most often, the costs and benefits are so negligible we pay little
attention to them. Some externalities, however, have large impacts on
individuals and society.
Often when an action is taken, an outside party is involuntarily
impacted by that action. That impact may be in the form of a cost, a
cigarette being smoked in the classroom, for example, or a benefit,
a beautiful garden planted across the street. An externality is a cost
or benefit from an economic activity that impacts a non-consenting
party. An externality is a cost or benefit that is not internalized, or
recognized, by the acting agent.
Consider a paper mill up-wind from a housing development. The
sludge from a paper mill may contain pathogenic bacteria that have a
vile stench. The economic activity of producing the paper may create
an external cost on neighbors through the emission of the unpleasant
smell. The smell is an external cost called a negative externality (or an
external diseconomy).
Alternatively, the fact that many U.S. citizens are vaccinated and
lots of people get a flu shot each year makes it less likely that an epidemic will occur or that you yourself will contract the flu, even if you
have not been vaccinated. This is an example of an external benefit or
a positive externality (also called an external economy).
Such externalities occur when property rights are not well specified and perhaps they cannot be. Think about Module-13: Property
rights and questions that were asked about who owns the rights to the
air and water. When property rights are not well specified for the air,
it is unclear whether or not a paper mill has the right to emit a stench
into it. Without outside intervention to either better define the ownership rights, provide incentive, or regulate air quality, the mill will not
consider the full cost of the smell or pollutant on society. As a result,
emissions from the mill will likely be more than the socially desired
amount. The mill does not pay for the burden the stench imposes on
others and, hence, does not internalize the cost of it. In order for markets
alone to bring about the most efficient outcome, the economic agent,
in this case decision makers of the mill, must realize all the costs and
benefits of the action.
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In terms of supply and demand, the producer is not factoring in all
of the costs when making decisions. The producer’s supply curve does
not include the costs of the harm from the pollution. If all costs were
factored in, including the cost of the pollution on society, the supply
curve would be to the left of the firm’s supply curve by the amount of
the harm done per unit produced. The harm per unit is the marginal
external cost.
At a given quantity the difference between the original supply,
known as the private supply curve, and the new supply including the
social cost of pollution is called the marginal external cost. It is the additional cost on society to produce an additional unit of the product.
The new supply curve, also called the social supply curve, is the sum
of the original (private) supply and the cost of the pollution. NVisual-2:
Marginal external cost, also shown below, shows the original private
supply and the adjusted social supply curve. The vertical distance between the two is the marginal external cost.
External benefits, like external costs, occur when property rights are
ill-specified. Think about the individual that benefits from the beautiful
Paper Pr oduction
Paper production
from
a paper
mill
fr om
a Paper
M ill
Ss
Price per unit of paper
Price per
Unit of
Paper
Sp
Marginal
External
Cost
}
Ps
Pp
Q s Qp
D
# of Units
of Paper
Number of units of paper
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garden across the street. When a beautiful garden is planted there are
beneficiaries that pay nothing to enjoy the view. In addition, it is likely
that the owner of the garden pays little heed to the desires of each of
these other beneficiaries. In general, the garden planter thinks of the
personal benefits of the garden when planting without much consideration for the additional social benefits. Nonetheless, society would
prefer more beautiful gardens to meet the desire of all those enjoying
the view, but the gardeners do not internalize all of the benefits.
External benefits are often in the form of what economists call public goods. Contrary to the name, public goods need not be provided by
the public sector. The economic definition of a public good is a good
or service that is non-rival and non-excludable. As non-rival, more than
one individual can consume the same units of the good. The consumption by one person does not diminish what is available to others. Many
people can look at a view without impacting another’s value of the view.
Alternatively, when one person consumes a rival good, less is available
for others to consume. Consumption of a fish, for example, reduces the
number of fish available for others. When a good is non-excludable,
National defense
National Defense
Price per unit of National defense
Price per
Unit of
National
Defense
S
Ps
}
Marginal
External
Benefit
Pp
Qp
Dp
Ds
Qs
# of Units
of National
Number of units of National
defense
Defense
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it is difficult or costly to prevent people from benefitting from its availability or to force payment from others; the good is accessible to all. A
beautiful landscape, clean air, clean water, and biodiversity are a few
public goods.
From a supply and demand perspective, when there is a public benefit
or a public good, society generally demands more than the quantity supplied. This difference between the supplier demand and social demand
exists because the supplier is satisfying only the demand the supplier will
benefit from with no incentive to provide for the demand of free riders.
Recall, as a public good it is difficult to exclude everyone that benefits.
Free riders take advantage of contributions by others. Which can lead to
less supply than society desires.
The realized or private demand curve is something less than the actual demand. If all of society’s desires were included, the social demand
curve would sit to the right of the private demand as shown in NVisual-3:
Marginal external benefit. At a given quantity, the difference between the
private demand and social demand is the marginal external benefit.
When externalities exist (excluding pecuniary externalities as noted
at the end of this section) markets alone may not result in the efficient
level of production. For markets to function properly all costs and benefits must be realized by the acting agents. When external costs exist,
the acting agent does not internalize all the costs of production and
will over-allocate resources producing more than the efficient level.
When external benefits exist the acting agent does not realize all the
benefits and will under-allocate resource use, producing less than the
efficient level.
How can we overcome the problem of negative externalities? There
are several theories that provide potential solutions to address the problem of externalities, none of which are perfect in all cases, but each of
which is useful under certain circumstances. One possibility as proposed by Pigou (Puh-go), an economist of the mid-twentieth century,
is to tax producers in the amount of the marginal external cost. This
would force producers to realize the full costs of production, shifting the private supply curve to the left where the social supply curve
lies. It may sound simple but it is a technical challenge; what is the
marginal external cost and how can it be calculated? The knowledge
of the marginal external cost rests in bits and pieces with each individual impacted by the externality. It is often an unknown value that
cannot be easily determined. The Pigouvian solution may effectively
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estimate the social supply when few parties are impacted. Otherwise
the Pigouvian tax is likely to be a politically determined figure that
may or may not reflect the actual costs to society.
Recall, the externality is the result of poorly specified property
rights. Better defining the property rights can help eliminate the externality. This too may be no simple task. How do you define property
rights to the air and enforce them? As explained by Ronald Coase (a
1991 Nobel Laureate in economics), if property rights can be defined
and bargaining is allowed in a zero transaction cost world (remember,
transaction costs are the costs of negotiation between buyer and seller
and here would include the cost of defining the rights) the parties affected would simply negotiate to reach the most efficient solution. If
the polluter owned the air and there was only one person down-wind
that was affected, the impacted individual would offer to pay the polluter what clean air was worth to them. If the offer was greater than the
cost to clean up the air or more than the production of the good was
worth, the polluter would clean the air. If it was more costly to clean
the air or the product was valued more highly, then the polluter would
turn down the offer and continue to produce and pollute. Either way,
the air is being used for its highest value. Similarly, if the down-wind
party owned the air, the polluter would offer the party what it was
worth to pollute the air. If the clean air was worth more to the downwind party, the air would remain clean. If the air was worth more to
the polluter, the down-wind party would accept the payment in compensation for the dirty air. Regardless of who was given the property
rights, the highest value would prevail.
Finally there is the regulatory approach. A governing agency can decide what the appropriate quantity is and regulate it. Again, without market information about the efficient quantity, the government determined
amount is unlikely to reflect the actual costs and benefits. The government’s solution may place more burden on society than the externality.
Above and Beyond: Another type of externality you may encounter,
a pecuniary externality, does not pose the same kinds of problems. Not
a standard part of the externality curriculum, it is an important concept
for addressing possible questions. A pecuniary externality occurs when
the external effect is the result of a change in prices. Imagine yourself
as an artist that buys beads to make bracelets to sell. Another bracelet
artist moves into the area and increases the demand for beads causing
the price of beads to rise. The increased price of beads is an external
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cost to you: A pecuniary externality. This diseconomy does not impose
the same problems on society because the higher bead price is a market
signal of the scarcity of beads. The price adjustment is internalized by
the acting agents. Hereafter pecuniary externalities will be ignored in
this module.
CONCEPTS
1.
2.
3.
4.
5.
6.
7.
8.
Efficiency
External cost, negative externality (external diseconomy)
External benefit, positive externality (external economy)
Public good
Non-rival
Non-excludable
Free rider
Transaction costs
OBJECTIVES
1. Understand the meaning of efficiency.
2. Understand the meaning of externality.
3. Know the difference between an external cost and an external
benefit.
4. Understand the meaning of a public good.
CONTENT STANDARDS
National Content Standards in Economics
1. (Standard 2) Effective decision making requires comparing the
additional costs of alternatives with the additional benefits.
2. (Standard 8) Prices send signals and provide incentives to buyers
and sellers.
3. (Standard 16) There is an economic role for government to play in
a market economy whenever the benefits of a government policy
outweigh its costs.
4. (Standard 17) Costs of government policies sometimes exceed
benefits.
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Montana Social Studies Content (Standard 5)
1. (Benchmark 1) Identify and explain basic economic concepts.
2. (Benchmark 2) Use basic economic concepts to explain current and
historical events.
3. (Benchmark 3) Understand the social costs and benefits to society of
allocating goods and services through private and public sectors.
TIME REQUIRED
3-4 class periods
MATERIALS
Overhead projector
Transparency pen
Visuals for overhead projector: Copy to transparency.
The Lorax by Dr. Suess
Pencils with erasers for half the class
1 sheet of 8 ½ x 11 paper cut into 10 rectangles each for every 2 students
(cut in half long, then each length cut into 5 equal rectangles of
4.25” x 2.2”)
NVisual-1: Externality defined
NVisual-2: Marginal external cost
NVisual-3: Musical notes
NVisual-4A: The paper river
NVisual-4B: The paper river
NVisual-5A: External benefits
NVisual-5B: External benefits
Lesson worksheets: Copy for each student:.
2Lesson-II: Rancher and Hunter
2Lesson assessment
PROCEDURE
1. Review the principles discussed in Module 13: Property rights. Have
students reiterate the defining factors of well-specified property rights;
definable, defendable, transferrable, and exclusive. Remind them of
the importance of property rights and the incentives provided. Touch
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again on the idea that with well specified property rights owners are
accountable for any harm done to others.
2. LQuestion: Referring to The Lorax by Dr. Seuss, ask students if
any individual, firm, or entrepreneur would pollute the air like the
Onceler did, harming the Swamee-Swans? You can also relate the
Humming-Fish.
Answer: Discuss with students the fact that all of us pollute the air
every day. If we ride in a car or on a bus we pollute the air directly. Even
riding a bicycle is an indirect source of pollution in the manufacturing
process of the bicycle.
LQuestion: Are we bad people because we pollute?
Answer: We each weigh the costs and benefits of our actions,
including our decisions to pollute. The cost of not polluting would
mean giving up nearly everything we have.
Again, talk about student actions and how those actions may cause
pollution. We all pollute both directly and indirectly. All animals
pollute. It is said that the emissions from cows produce more
greenhouse gases than the vehicles on our roads. Pollution is emitted
from the production process of the products that we use and the
food that we eat. Our computers and iPods use energy and energy
emits pollutants. It’s hard to avoid. Discuss some of the alternatives
if students were to try and reduce pollution. We could drive less,
conserve energy, and consume fewer products.
3. Now focus specifically on air pollution.
LQuestion: Who owns the air?
Answer: Property rights to the air are not-well specified. While each
one of us pollutes the air when we drive, none of us realize the full
cost of that action. We are not forced to compensate each other for
our auto emissions.
LQuestion: How many students would drive or ride in a vehicle
as often if the tail pipe was routed into the interior of the car?
Answer: Forced to realize the full costs of the pollution, most
students wouldn’t drive very long or would clean it up. Similarly, if
we dumped garbage onto a neighbor’s land, we would be expected
to remove the garbage or compensate the neighbor for the damage
done. This can be enforced through our laws, particularly the
common law.
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(Depending on your goals and class level, you may wish to further
explore the common law. A great treatise of the common law is
presented in a 1998, PERC Policy Series (no.13) The Common
Law: How it Protects the Environment by Roger Meiners and Bruce
Yandle. It can be found online at www.perc.org/perc.php?subsection
= 6andid = 653)
4. Display NVisual-1: Externality defined. Introduce the concept of
external costs (negative externalities) and external benefits (positive
externalities). Many actions we take have external effects, some more
significant than others. Refer back to the Onceler in module 13and
our own polluting activities, these are external costs. Our decisions
to pollute are made because the benefits outweigh the costs that we
realize. Because the property rights to air are not well defined, we
do not internalize the full costs of our actions. We are not forced to
pay for the full cost of our polluting activities. The result is an overallocation of resources toward the activity. If we internalized the full
costs of our pollution, we would reduce our polluting activities.
5. Discuss the idea of external costs and air pollution from a factory with
regard to supply and demand. Producers realize their private costs of
production. The supply curve does not incorporate the external cost
of pollution that is being spewed onto society. Display NVisual-2:
Marginal external cost. The private supply curve sits to the right of
the social supply curve. The private supply curve factors in the actual
costs that are borne by the private producer. The difference between
the private supply and the social supply is the cost of harm done
to society as a result of the pollution emissions. At a given quantity
that difference is the marginal external cost. It is the additional cost
or burden to society for producing an additional unit of the good or
service. The shift is parallel because it is assumed that the marginal
or additional external cost is the same for each unit produced in this
example.
Point out that the equilibrium quantity decreases from the
private to the socially optimal supply. When external costs exist,
costs that are not incorporated into the production decisions, there
is an over-allocation of resources. More is produced than is socially
efficient.
Ultimately the polluter should pay. Forcing the firm to incorporate
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the added costs of pollution does two things to help reach efficiency.
First, by forcing the private supply curve to shift to the left and meet
the social supply curve, the equilibrium quantity is reduced to the
socially efficient level. Second, when the supply curve shifts to the
left, price increases sending the proper signal to consumers about
the true cost of production. The difficulty lies in determining the
actual cost of the pollution to society.
6. 2Lesson I: Musical notes. Display NVisual-3: Musical notes. Explain
the following scenario to students. Alice and Barry are neighbors.
They live in a cheap duplex with little sound barrier between their
units. Alice is a rock and roll wanna-be and plays the drums. She
likes really loud music and gives drum lessons for $5 per night. At
that low rate she has students every night. Barry likes quiet.
LQuestion: Who has the right to the desired noise level?
Answer: Without well specified rights it is unknown whether Alice
has the right to make noise or if Barry has the right to quiet. Once the
rights are defined the two can negotiate. If the rights are defined and
the two can negotiate the most efficient solution will result regardless
of who owns the right to the noise.
It has already been stated that Alice can earn $5 per night making
noise. Let’s assume this is also her nightly value for the ability to
play and teach drumming.
i. Assume for a moment that Barry values quiet at $2 per night
(middle of NVisual-3: Musical notes). It doesn’t matter whether
Alice or Barry owns the right to noise. Either way they will
negotiate to allow Alice to play her music. If Barry owns the
right to quiet Alice is willing to compensate him more than his
value for quiet. Alice will pay up to $5 per night. Barry only
values the quiet up to $2 per night. If Alice owned the right to
the noise, again she would continue to play her music. Barry
would offer her up to $2 to stop playing but Alice has a higher
value to make music. She will continue to play. Notice that the
income distribution does change when ownership changes. But
either way, the highest valued use, making music, will be the
end result.
ii.Now assume instead that Barry values quiet at $7 per night
(bottom of NVisual-3: Musical notes). Again, regardless of
who owns the right to the sound, the most efficient outcome
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will result. In this case, quiet will be the result. If Barry owns
the right to the sound, Alice will not be willing to pay him
enough to allow for her noise. If Alice owns the right, Barry will
pay her up to $7 to be quiet. It will only take $5 for Alice to
stop playing her music. Again, the income will be distributed
differently depending upon ownership of the right to noise, but
the end result will be the same. It will be quiet.
This idea is known as the Coase Theorem. If property rights
are well specified, transactions costs are zero (the costs of
negotiation), and the right to negotiate exists, the outcome will
be efficient.
7. 2Lesson-II: The Paper River. The Paper River is an exercise designed
by Gail Hoyt, Patricia Ryan, and Robert Houston, that can help
students explore methods to solve the problem of external costs.
(For additional information visit http://www.indiana.edu/~econed/
pdffiles/spring99/Hoyt.pdf)
a.Split the class into half. Each half of the class will represent
a firm. Firm-A on the right will produce math problems and
firm-B on the left will produce paper airplanes. You must have
an even number of students in each group. If there is an uneven
number of student have one student help as your assistant.
b.Have students clear their desks. Provide each student in firm-A
with a pencil and 5 very small sheets of paper (1.5”x 3” or one
letter size sheet of paper cut into 20 pieces). Firm A students
are going to solve math problems. Using only the pencil and
paper provided, each firm-A student will have 2 minutes to
solve as many of the 10 problems as possible. The first set
of problems are available in NVisual-4A: Paper river math
problems. Offer a tradeable reward for each correct answer
such as 1 bonus point or 1 piece of candy for each problem
solved correctly. Once students understand what is expected
set your timer, post the questions on the board or overhead and
let firm-A students go to work.
c.While firm-A students are working, prepare firm-B students
for their task. They, too, will have 2 minutes to complete their
task and will be given a similar reward. Firm-B students will
be making paper airplanes with the small sheets of paper.
Demonstrate the type of airplane you would like to see or have
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an assistant teach firm-B students the specific plane you would
like them to fold.
d.When the 2 minutes for firm-A are exhausted, have them
stop solving problems. Post the correct answers to the math
problems on the board or overhead. Hand a record sheet from
Lesson I to each student and have them record the correct
number of problems they were able to solve.
e.Each member of firm-A will now give their five sheets of paper,
the pencil, and the record sheet to a member of firm-B. Remind
firm-B that their job is to fold paper airplanes that fly. Now tell
them that they must make their airplanes with clean sheets
of paper. Firm-B must erase any marks on the paper before
making airplanes. Tell them of their reward. This should be
similar to the reward for firm-A, such as a bonus point or piece
of candy for each airplane they fold. They will have 2 minutes
to produce paper airplanes. Set your timer and let the folding
begin.
f. After 2 minutes stop the production process and make sure the
airplanes can fly. Have firm-B members record the number of
functional airplanes they produced on the record sheet.
g.Discuss the production process of each firm.
LQuestion: Did firm-A consider the full costs of their actions?
Answer: No. They did not consider the cost of writing on the
paper (polluting). This was a cost to firm-B.
LQuestion: How does firm-B feel about the costs imposed on
them?
Answer: Answers will vary
LQuestion: Is this a problem that occurs in the real world?
Answer: Yes. Many producers pollute the air and water
without realizing or internalizing the costs of the pollution.
h.Similar to the discussion in Module-13: Property rights,
polluters don’t have to realize the full costs of their activities
when property rights are not well specified. Think of the
paper as a river. Firm A is polluting the paper river without
consideration of the costs inflicted on firm-B. Display
NVisual-5: Paper river. Discuss the idea that without specified
property rights it is difficult to solve the pollution problem. It is
unknown whether A has the right to pollute or B has the right
to clean water.
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It is often difficult for students to accept the idea that
someone may have the right to pollute. In this case refer back
to 2Lesson-I: Musical notes, and remind them that the value
to pollute may be greater than the value of clean (noise is a
form of sound pollution).
LQuestion: Who owns the paper?
Answer: Ownership of the resource was not defined.
i. Have firms A and B discuss options for their production
process. Have them discuss possible solutions to the pollution
problem and write them on the board.
i. What could be changed to encourage A to consider all the
costs of their production process?
ii. How much did firm-A pay for the paper?
iii. Does the lack of a private cost for the use of the paper
influence how firm-A uses the paper?
iv. Should firm-A pay for their use of the paper river? How
much should they pay?
v. Should firm-B pay for their use of the paper river? How
much should they pay?
vi. Allow firms A and B to negotiate a deal using their reward
points for compensation. Let the students determine the
appropriate scheme and compensation.
vii. Students should assign property rights (though perhaps
not advertently) to firm-A or B. For example, firm-A must
pay one or two points for each piece of paper written on
to compensate B for the cost to clean it. Or perhaps rights
will be assigned to firm-A and firm-B will have to pay to
get clean sheets from firm-A.
j. Once the firms have agreed on a compensation scheme, run
the experiment again.
i. First, make certain each student understands the
negotiation. Discuss it or write it on the board.
ii. Pick up all small pieces of paper remaining from round
one. Have firm-B return the record sheet and pencils to the
original firm-A member from which it came. Give 5 new
sheets of paper to firm-A producers. Post new problems
on the board and give firm-A 2 minutes to solve their
problems. When the time is complete, post the correct
answers and have firm-A students record their scores.
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iii.Have firm-A students transfer their record sheets, pencils,
and paper to the same firm-B partner from the previous
round. Give firm-B 2 minutes to produce paper airplanes.
When finished, have firm-B students record their scores. Be
certain that they include the compensation scheme on the
record sheet.
k.Discuss the implications of the experiment and the
negotiations.
LQuestion: What was the original problem?
Answer: Steer students to discuss the property rights of the
paper. Who owned the paper? De facto rights may come back
to you for providing the paper at no cost to firm-A.
LQuestion: How did the students solve the problem? What
were the options discussed?
Answer: To whom did they assign property rights? Which firm
was forced to compensate?
LQuestion: Were there transaction costs?
Answer: Sometimes transactions costs are too high to
allow for effective negotiations. Were you required to act as a
government mediator?
l. Refer back to NVisual-5: Paper river. Bring the discussion into
the real world and think about how an upstream firm may
pollute a river if there are no costs to them for doing so.
LQuestion: Would they continue to pollute the river if they
owned it?
Answer: If the benefit from polluting exceeded potential
benefits from keeping it clean or cleaning it up. In the history
of the United States, firms were given the right to pollute some
water ways. Initially, pollution dissolved into the water and
had little impact on other water users. Additionally, the historic
value of clean water was often less than the value to use it for
production which provided goods, jobs, and income.
8. Externalities also come in the form of benefits. Display NVisual6a: External benefits. Discuss with students, that like external costs,
external benefits occur when property rights are ill-specified. Talk
about the garden or the view that none of the students helped plant
or pay for but each may enjoy looking at it. Have them think about
their payment or donation to help provide that view. Make them
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realize that they have not compensated anyone for providing the
view (unless it is government-owned in which case they may have
paid through taxes). Those enjoying the view without paying are
free riders. They are enjoying the benefits, the ride, without paying
for it. Now place them on the view provider or gardener’s side.
Even though many additional people benefit from the beauty of the
garden, the gardener thinks of the personal benefits of the garden
when planting without much consideration of the additional social
benefits. Nonetheless, society would prefer more beautiful gardens
to meet the desire of all those enjoying the view but the planters
do not internalize all of the gains. As a result, we may not have as
many gardens as society would really like to see. Let’s put this a little
closer to home for the students.
LQuestion: Ask students if any of them listen to the radio. Have
any of them paid for their listening pleasure?
LQuestion: Some radio stations like NPR (National Public Radio)
are funded through donations. Do any students listen to NPR?
LQuestion: Have any donated to the station?
Answer: Students that have not paid but continue to listen to the
radio are free riders.
LQuestion: Why can they continue to listen? Why do radio stations
continue to play music even though listeners do not pay?
Answer: There are enough donations to NPR to keep the station
running. Many other radio stations are funded through advertising.
This allows free riders to continue to receive the public good.
9. External benefits are often in the form of what economists call public
goods. Contrary to the name, it is not necessary that public goods are
provided by the public sector. The economic definition of a public
good is a good or service that is non-rival and non-excludable.
a.As non-rival, more than one individual can consume the same
units of the commodity. The consumption by one person does
not diminish what is available to others. Many people can look
at a view without impacting another’s value of the view. Many
people can listen to the radio without impacting the listening
pleasure of other listeners. Display NVisual-6a: External
benefits to show the definition of a non-rival good.
b.Alternatively, when one person consumes a rival good, there is
less available for others to consume. My consumption of a fish,
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for example, reduces the number of fish available for others.
c.When a good is non-excludable it is difficult or costly to
prevent people from benefitting from its availability; the good is
accessible to all. A beautiful landscape, clean air, clean water,
and biodiversity are a few public goods that many people
can benefit from and it is difficult to exclude anyone from
the benefits of their provision. The provision of radio stations
is another public good that is non-rival and non-excludable.
NVisual-6a: External benefits also provides a definition for
when a good is non-excludable.
10.From a supply and demand perspective, when there is a public
benefit or a public good, society generally wants more than what is
being provided. The provider only realizes the private demand. They
realize the demand from which they receive the benefits. Recall, as
a public good it is difficult to exclude non-payers. The inefficiency
results because people can become free riders, they do not have
to pay for the good to benefit from it. Free riders take advantage of
contributions by others. The lower incentive to contribute (benefits
can be realized free of charge) can lead to a lower quantity supplied
than society would like to see. The realized or private demand curve
is something less than the actual demand. If all of society’s desires
were included the social demand curve would sit to the right of the
private demand as shown in NVisual-3: Marginal external benefit.
At a given quantity, the difference between the private demand and
social demand is the marginal external benefit.
11.2Lesson-II: The rancher and the hunter. (Adaptation from lesson
created by Dave Buschena) Split the class into two, half will be cattle
ranchers and the other half will be elk hunters. Display NVisual-7:
Ranchers and hunters and handout the lesson to students. Remind
students of Module-2 and the Production possibilities frontier
where veggie eatin’ Val and meat eatin’ Max made trade-offs in
their production between raising cattle and growing vegetables. It
is assumed here that the range will be used only for forage for cattle
and elk.
i. Explain to ranchers that they depend on cattle for their income.
The more cattle they produce, the more income they receive
to purchase the goods and services they desire. This is the only
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income available to them. Have them determine where along
the production possibilities frontier they would like to produce.
ii.Explain to the hunters that their income comes from a different
activity. Their role in this game is that they like to hunt. When
more habitat is provided for elk, the quality of hunting is
better. Have hunters determine where along the Production
possibilities frontier they would like to see cattle production.
iii.Using NVisual-6: Ranchers and hunters, call on ranchers to
get a feel for the average point in which ranchers would like to
produce. This should be somewhere around point A or B where
ranchers produce a lot of cattle and little elk habitat. Discuss
why ranchers would not want to provide a large amount of elk
habitat. For each acre of elk habitat provided, ranchers lose
some income from cattle production. Some ranchers may also
be elk hunters and be willing to give up some cattle production
for the production of some elk habitat.
iv.Now, call on hunters and get a feel for where they would like
to see production of cattle and elk habitat on the production
possibilities frontier. They should be closer to point D. Talk
about why hunters would prefer to see the production of more
forage for elk.
v. Tease out some answers for the differences in production
preferences between ranchers and hunters.
LQuestion: Why do hunters want more elk habitat than
ranchers want to provide?
LQuestion: Who pays for the provision of elk forage?
LQuestion: Who benefits from the provision of elk forage?
LQuestion: Is it difficult to force hunters to pay for the
provisions of elk forage?
LQuestion: What if there is public access to hunt on lands
adjacent to the ranch?
LQuestion: What if there is no hunting access nearby other
than on the ranch?
LQuestion: Does it matter what kind of hunting access exists
nearby?
vi.Partner the class, one hunter and one rancher together. Have
them answer the questions on the lesson and discuss the
options for negotiation.
vii. Discuss student answers to the lesson in class. Emphasize that
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it is not a necessary condition that a public good be provided
by the public sector. A public good is one that is non-rival
and non-excludable. Like a radio station and the provision
of habitat, markets can provide for some public goods.
How efficient the market quantity is will depend upon the
commodity and the property rights.
CLOSURE
Lesson review
1. LQuestion: What is an externality?
Answer: An externality is a cost or benefit not realized by consumer
or producer during economic activity. An externality affects a third
or nonconsenting party.
2. LQuestion: Is the market outcome efficient when externalities
exist? When an external benefit exists markets may under allocate
resources.
Answer: Not usually. When an external cost exists the market will
over-allocate resources. Society would like all costs to be realized
during production. An external cost, pollution for example, may not
be realized and internalized by the producer. As a result, markets
alone will produce too much. The private marginal cost curve then
sits to the right of the socially desired marginal cost curve.
Answer: Society would like to see more produced than markets may
provide. This is often the case for public goods that are non-rival and
non-excludable. Because free riders exist, all marginal benefits may
not be realized. The marginal social benefit curve may sit to the right
of the marginal private benefit that is realized by the market place.
ASSESSMENT
Multiple-choice questions
1. LQuestion: All people that pollute are bad.
a.This is true. If people care about themselves and the world,
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they will not pollute.
b.This is true. The costs of pollution are always greater than any
potential benefits.
c.This is false. Pollution is the result of economic activity and
costs and benefits of pollution are irrelevant.
d.This is false. Sometimes the additional benefit of an economic
activity is greater than the additional cost of the pollution
caused by it.
2. LQuestion: When do markets under-allocate resources for the
production of a good or service?
a.When no externalities exist, all costs and benefits are realized
in the production process.
b.When the cost of pollution from production is not included in
the decision process.
c.When an external cost exists.
d.When an external benefit exists.
3. LQuestion: When do markets over-allocate resources for the
production of a good or service?
a. When no externalities exist, all costs and benefits are realized
in the production process.
b. When the cost of pollution from production is not included in
the decision process.
c. When a public good is being produced.
d. When an external benefit exists.
4. LQuestion: Why don’t farmers produce more forage for elk and
other wildlife?
a. Because they don’t realize the full benefits.
b. Because they don’t realize the full costs.
c. Because they don’t believe increased forage for wildlife has any
benefits.
d. Because they have the comparative advantage.
5. LQuestion: Do public goods have to be provided by the public
sector?
a. Yes. That is the definition of a public good.
b. Yes. The private sector will never provide the efficient quantity
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of a public good.
c. No. Public goods can be provided by the private sector.
d. No. Public goods are goods that are rival and excludable.
Answers:
1.
2.
3.
4.
5.
d
d
b
a
c
Discussion/Essay Questions
1. LQuestion: Is the market outcome efficient when externalities exist?
Explain.
Answer: Not usually. Externalities are costs or benefits that are
not realized in the decision making process of an economic activity.
When there are external costs, like pollution, the producer is not
realizing the full costs of production. The producer is not realizing
the cost of the pollution to other members of society. The producer
is likely to produce more than the socially efficient level.
External benefits, like a good view, are benefits received from an
outside party from some economic activity. The producer does not
realize the additional benefits, hence may not produce as much as
society desires. This often occurs for public goods; goods that are
non-rival and non-excludable, such as radio stations.
2. LQuestion: Do we need government intervention to address all
externalities?
Answer: No. Externalities surround us. People singing or wearing
perfume may be considered an external cost by some and an external
benefit by others. Many externalities are so trivial that the benefits
of trying to achieve the efficient quantity are less than the costs.
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O ve r he ad
visuals
Externalities
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Module-14
Visual
Impacts on a third party
Visual-1: Externality defined
Smoke from a cigarette,
pollution from a factory
A beautiful view,
national defense
Externality: A cost
or benefit from an
economic activity
that impacts a nonconsenting party. an
externality is a cost
or benefit that is
not internalized by
acting agent.
N444
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Visual
Visual-2: Marginal External Cost
Paper Production
from a Paper Mill
Price per unit of paper
Price per
Unit of
Paper
S
P
p
D
Q
p
# of Units
of Paper
Number of units of paper
Paper Pr oduction
Paper production
from
a paper
mill
fr om
a Paper
M ill
Ss
Price per
Unit of
Paper
Price per unit of paper
Paper production from a paper mill
Sp
Marginal
External
Cost
}
Ps
Pp
Q s Qp
D
# of Units
of Paper
Number of units of paper
N445
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Visual
Visual-3: Musical Notes
a rock-n-roll
wannabe can earn
$5.00 per night
giving drum lessons.
likes it QUIet
playing music at $5.00 per night
quiet
playing music at $5.00 per night
quiet at $7.00 per night
N446
at $2.00 per night
Externalities
Impacts on a third party
Module-14
Visual
Answer
Questions
Visual-4A: The Paper river
321
x
34
765
x
29
543
x
56
924
x
64
976
x
78
793
x
87
289
x
64
642
x
56
368
x
63
379
x
33
321
x
34
4182
765
x
29
22185
543
x
56
30408
924
x
64
59136
976
x
78
76128
793
x
87
68991
289
x
64
18496
642
x
56
35952
368
x
63
23184
379
x
33
12507
N447
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Impacts on a third party
Module-14
Visual
Answer
Questions
Visual-4B: The Paper river
123
x
34
567
x
29
345
x
56
429
x
64
679
x
78
397
x
87
982
x
64
246
x
56
863
x
63
973
x
33
123
x
34
4182
567
x
29
16443
345
x
56
19320
429
x
64
27456
679
x
78
52962
397
x
87
34539
982
x
64
62848
246
x
56
13776
863
x
63
54369
973
x
33
32109
N448
Externalities
Impacts on a third party
Module-14
Visual
Visual-5: External Benefits
When an economic action provides an additional
benefit that is not realized by the provider.
National defense
Price per unit of National defense
National Defense
Price per
Unit of
National
Defense
S
Ps
}
Marginal
External
Benefit
Pp
Qp
Dp
Ds
Qs
# of Units
of National
Number of units of National
Defense defense
N449
Externalities
Module-14
Visual
Impacts on a third party
Visual-5: External Benefits
is a good or
service that is:
Non-rival:
When more than one individual can consume the
same units of a commodity and the consumption
by one person does not diminish what is available
to others.
non-excludable;
When a commodity is
difficult or costly
to prevent people
from benefitting
from availability,
the good is fully
accessible.
N450
Module-14
L e s son
w o r ks h ee ts
Externalities
Externalities
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Module-14
Lesson
LESSON II: Ranchers and Hunters
Rancher and hunter
You are a rancher/hunter. Given the production possibilities frontier below, at which point would
you prefer to produce? Explain.
Cattle
Production
Production Possibilities Frontier
B
A
C
D
Elk Forage
1. LQuestion: Why do hunters want to see more elk forage than ranchers?
452 2
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Lesson
LESSON II: Ranchers and Hunters
2. LQuestion: Who pays for the production of elk forage?
3. LQuestion: Who benefits from the production of elk forage?
4. LQuestion: Are the benefits from increased elk habitat excludable?
5. LQuestion: Does property ownership matter?
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Lesson
Lesson: Assessment
Multiple-choice questions
1. LQuestion: All people that pollute are bad.
a.This is true. If people care about themselves and the world, they will not pollute.
b.This is true. The costs of pollution are always greater than any potential benefits.
c.This is false. Pollution is the result of economic activity and costs and benefits of
pollution are irrelevant.
d.This is false. Sometimes the additional benefit of an economic activity is greater than the
additional cost of the pollution caused by it.
2. LQuestion: When do markets under-allocate resources for the production of a good or
service?
a.When no externalities exist, all costs and benefits are realized in the production
process.
b.When the cost of pollution from production is not included in the decision process.
c.When an external cost exists.
d.When an external benefit exists.
3. LQuestion: When do markets over-allocate resources for the production of a good or
service?
a. When no externalities exist, all costs and benefits are realized in the production process.
b. When the cost of pollution from production is not included in the decision process.
c. When a public good is being produced.
d. When an external benefit exists.
4. LQuestion: Why don’t farmers produce more forage for elk and other wildlife?
a. Because they don’t realize the full benefits.
b. Because they don’t realize the full costs.
c. Because they don’t believe increased forage for wildlife has any benefits.
d. Because they have the comparative advantage.
5. LQuestion: Do public goods have to be provided by the public sector?
a. Yes. That is the definition of a public good.
b. Yes. The private sector will never provide the efficient quantity of a public good.
c. No. Public goods can be provided by the private sector.
d. No. Public goods are goods that are rival and excludable.
454 2
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Module-14
Lesson
Lesson: Assessment
Discussion/essay questions
1. LQuestion: Is the market outcome efficient when externalities exist? Explain.
2. LQuestion: Do we need government intervention to address all externalities?
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NOTES
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