Chapter 16:
Externalities
McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia
Objectives
After studying this chapter, you will be able to:
§ Explain how externalities arise
§ Explain why negative externalities lead to overproduction
and how property rights, emission charges, marketable
permits, and taxes can be used to achieve a more efficient
outcome
§ Explain why positive externalities lead to underproduction
and how public provision, subsidies, vouchers, and patents
can achieve a more efficient outcome
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Greener and Smarter
§ Environmental issues are at the same time everybody’s
problem and nobody’s problem.
§ Human beings are learning more and more every day.
§ But are we learning more at a fast enough pace?
§ How can we ensure that we use resources efficiently in
the face of externalities?
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Externalities in Our Lives
§ An externality is a cost or benefit that arises from
production and falls on someone other than the producer,
or a cost or benefit that arises from consumption and falls
on someone other than the consumer.
§ A negative externality imposes an external cost and a
positive externality creates an external benefit.
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Externalities in Our Lives
§ The four possible types of externality are:
§ Negative production externalities
§ Positive production externalities
§ Negative consumption externalities
§ Positive consumption externalities
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Externalities in Our Lives
§ Negative Production Externalities
§ Negative production externalities are common.
§ Examples are noise from aircraft, logging and clearing of
forests, and pollution
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Externalities in Our Lives
§ Positive Production Externalities
§ Positive production externalities are less common than
negative externalities.
§ Example: a beekeeper locates beehives in an orangegrowing area
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Externalities in Our Lives
§ Negative Consumption Externalities
§ Negative consumption externalities are a common part of
everyday life.
§ Smoking in a confined space poses a health risk to others;
noisy parties or loud car stereos disturb others.
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Externalities in Our Lives
§ Positive Consumption Externalities
§ Positive consumption externalities are also common.
§ When you get a flu vaccination, everyone you come into
contact with benefits.
§ When the owner of an historic building restores it,
everyone who sees the building benefits.
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Negative Externalities:
Pollution
§ Pollution is an old problem and is faced by both rich
industrial countries and poor developing countries.
§ It is an economic problem that is coped with by balancing
benefits and costs.
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Negative Externalities:
Pollution
§ The Demand for a Pollution-Free Environment
§ The demand for a pollution-free environment is
expressed through the political process. This demand
has increased for two reasons:
§ Higher incomes: A high-quality environment is a
“normal good,” the demand for which increases with
income.
§ Greater awareness: greater knowledge about the causes
of environmental problems raise understanding of
environmental issues.
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Negative Externalities:
Pollution
§ The Sources of Pollution
§ Economic activity pollutes air, water, and land, and these
individual areas of pollution interact through the
ecosystem.
§ Air pollution
§ Emissions causing greenhouse gases are a tough
problem to tackle
§ Water pollution
§ Output of sewage treatment plants, the use of
herbicides, pesticides, and fertilisers
§ Land pollution
§ Toxic waste and ordinary household garbage
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Trends in Air Pollution
Figure 16.1
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Negative Externalities:
Pollution
§ Private Costs and Social Costs
§ A private cost of production is a cost that is borne by the
producer, and marginal private cost (MC) is the private
cost of producing one more unit of a good or service.
§ An external cost of production is a cost that is not borne
by the producer but is borne by others.
§ Marginal external cost is the cost of producing one
more unit of a good or service that falls on people other
than the producer.
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Negative Externalities:
Pollution
§ Private Costs and Social Costs
§ Marginal social cost (MSC) is the marginal cost
incurred by the entire society and is the sum of marginal
private cost and marginal external cost.
MSC = MC + Marginal external cost.
§ Marginal private cost, marginal external cost, and
marginal social cost increase with output.
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An External Cost
Figure 16.2
Cost ( dollars per tonne)
300
Marginal
Social cost
MSC
225
Marginal External
cost
150
MC
100
75
Marginal
Private cost
2
4
6
Quantity (thousands of tonnes per month)
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Negative Externalities:
Pollution
§ Production and Pollution: How Much?
§ In an unregulated market with an externality, the
pollution created depends on the market equilibrium
price and quantity of the good produced.
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Inefficiency with an External
Cost
Figure 16.3
Price and cost ( dollars per tonne)
300
Marginal
Social cost
MSC
225
Deadweight loss
Efficient
equilibrium
Inefficient
Market
equilibrium
150
S= MC
100
75
D=MSB
Efficient
quantity
Marginal
Social
Benefit
2
4
6
Quantity (thousands of tonnes per month)
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Negative Externalities:
Pollution
§ Property Rights
§ Externalities arise because of the absence of property
rights.
§ Property rights are legally established titles to the
ownership, use, and disposal of factors of production
and goods and services that are enforceable in the
courts.
§ Establishment of property rights achieves an efficient
outcome.
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Property Rights Achieve an
Efficient Outcome
Figure 16.4
Price and cost ( dollars per tonne)
300
Price equals
marginal social
cost and MSB
S = MC =MSC
225
Cost of pollution
Borne by polluter
Efficient market
equilibrium
MC excluding
pollution cost
150
100
75
D=MSB
2
4
6
Quantity (thousands of tonnes per month)
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Negative Externalities:
Pollution
§ The Coase Theorem
§ The Coase theorem is a proposition that if property
rights exist, if only a small number of parties are
involved, and if transactions costs (defined below) are
low, then private transactions are efficient.
§ There are no externalities because all parties take into
account the externalities involved. The outcome is
independent of who has the property rights.
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Negative Externalities:
Pollution
§ Transactions costs are the opportunity cost of
conducting a transaction.
§ Example: the transactions costs of buying a home include
fees for a real estate agent, and the legal cost associated
with the transfer.
§ When a large number of people are involved and
transactions costs are high, the Coase solution is not
available
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Negative Externalities:
Pollution
§ Government Actions in the Face of External Costs
§ There are three main methods that the government uses to
cope with external costs:
§ Taxes
§ Emission charges
§ Licences and marketable permits
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Negative Externalities:
Pollution
§ Taxes
§ The government can set a tax equal to the marginal
external cost.
§ The effect of such a tax is to make marginal private cost
plus the tax equal to marginal social cost:
MC + Tax = MSC.
§ This tax is called Pigovian Tax, in honour of the British
economist Arthur Cecil Pigou, who first proposed
dealing with externalities in this fashion.
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A Pollution Tax
Figure 16.5
Price and cost ( dollars per tonne)
300
Marginal social
cost and MSB
S = MC + tax = MSC
225
Pollution tax
Efficient market
equilibrium
150
MC
88
75
D=MSB
Tax
revenue
2
4
6
Quantity (thousands of tonnes per month)
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Negative Externalities:
Pollution
§ Emissions Charges
§ The government sets a price per unit of pollution, so
that the more a firm pollutes, the higher are its
emissions charges.
§ For the emissions charge to induce the firm to generate
the efficient level of pollution, the government would
need a lot of information that is usually unavailable.
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Negative Externalities:
Pollution
§ Marketable Permits
§ Each firm is assigned a permitted amount of pollution per
time period, and firms trade permits.
§ The market price of a permit confronts polluters with the
social marginal cost of their actions and leads to an
efficient outcome.
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Positive Externalities:
Knowledge
§ Private Benefits and Social Benefits
§ A private benefit is a benefit that the consumer of a good
or service receives. Marginal private benefit (MB) is the
private benefit from consuming one more unit of a good
or service.
§ An external benefit is a benefit that someone other than
the consumer receives. Marginal external benefit is the
benefit from consuming one more unit of a good or
service that people other than the consumer enjoy.
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Positive Externalities:
Knowledge
§ Marginal social benefit is the marginal benefit enjoyed
by the entire society and is the sum of marginal private
benefit and marginal external benefit. That is:
§ MSB = MB + Marginal external benefit.
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An External Benefit
Figure 16.6
Price (thousands of dollars per
student per year)
40
Marginal
Social benefit
30
25
Marginal
External
benefit
20
MSB
10
0
Marginal
Private
benefit
50
100
MB
150
200
300
Quantity (thousands of students per year)
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Inefficiency With an External
Benefit
Figure 16.7
Price (thousands of dollars per
student per year)
40
38
30
Deadweight
loss
S=MSC
Marginal
Social
benefit
25
20
15
MSB
10
Marginal
Social cost
0
50
Inefficient
Market
equilibrium
D=MB
Efficient quantity
100
150
200
300
Quantity (thousands of students per year)
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Positive Externalities:
Knowledge
§ Government Action in the Face of External Benefits
§ There are four main methods that the government uses to
cope with external benefits:
§ Public provision
§ Private subsidies
§ Vouchers
§ Patents and copyrights
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Positive Externalities:
Knowledge
§ Public Provision
§ Under public provision, a public authority that receives
its revenue from the government produces the good or
service.
§ Education services produced by the public universities
and schools are examples of public provision
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Public Provision to Achieve an
Efficient Outcome
Figure 16.8(a)
Price and costs (thousands of
dollars per student per year)
40
38
30
S=MSC
Efficient
market
equilibrium
MSB = MSC
25
Paid by taxpayer
20
15
MSB
10
D=MB
Tuition
Efficient quantity
0
50
100
150
200
300
Quantity (thousands of students per year)
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Positive Externalities:
Knowledge
§ Private Subsidies
§ A subsidy is a payment by the government to private
producers. The government can induce private decision
makers to consider external benefits by making the
subsidy depend on the level of output
§ If the government pays the producer an amount equal to
the marginal external benefit for each unit produced, the
quantity produced increases to that at which marginal
cost equals marginal social benefit—an efficient
outcome.
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Private Subsidy to Achieve an
Efficient Outcome
Figure 16.8(b)
Price and costs (thousands of
dollars per student per year)
40
38
30
S=MSC
Efficient
market
equilibrium
S=MSC-subsidy
MSB = MSC
25
Subsidy of $15,000 per student
20
15
MSB
10
D=MB
Dollar price
Efficient quantity
0
50
100
150
200
300
Quantity (thousands of students per year)
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Positive Externalities:
Knowledge
§ Vouchers
§ A voucher is a token that the government provides to
households, which can be used to buy specified goods
or services.
§ A school voucher allows parents to choose the school
their children will attend and to use the voucher to pay
part of the cost. The school cashes the voucher to pay
its bills.
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Vouchers Achieve Efficiency
Figure 16.9
Price and costs (thousands of
dollars per student per year)
40
38
30
S=MSC
Efficient
market
equilibrium
MSB = MSC
25
Value of voucher
20
15
MSB
10
D=MB
Dollar price
0
50
100
150
200
300
Quantity (thousands of students per year)
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Positive Externalities:
Knowledge
§ Patents and Copyrights
§ Knowledge is productive and generates external benefits
and public policies are required to ensure an efficient
level of effort.
§ Intellectual property rights give the creator of
knowledge the property right to the use of that
knowledge.
§ The legal device for granting intellectual property rights
are through patent or copyright.
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END
CHAPTER 16
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