Chapter 10: Externalities – Market Failure and Public Policy

Externalities

Introduction to Externalities

Externalities are a central concept in economics, representing a form of market failure where the actions of individuals or firms have unintended side effects on third parties. These effects are not reflected in market prices, leading to inefficient market outcomes.

• Externality: A situation where a transaction between a buyer and a seller directly affects a third party who is not compensated for that effect.

• Negative externality: The impact on the bystander is adverse (e.g., pollution).

• Positive externality: The impact on the bystander is beneficial (e.g., education, vaccination).

Market Inefficiency Due to Externalities

Why Market Outcomes Are Inefficient

In the presence of externalities, market equilibrium does not maximize total welfare because buyers and sellers do not consider the external effects of their actions.

• Market equilibrium is not efficient when externalities exist.

• Government intervention can sometimes improve market outcomes by correcting these inefficiencies.

Examples of Externalities

Negative Externalities

• Air or water pollution from a factory

• Your neighbor's late-night party

• Talking on the phone in the library

• Noise from construction projects

• Second-hand smoke

• Texting while driving or walking

Positive Externalities

• Being vaccinated against contagious diseases

• Research into new technologies

• People going to college

• Restored historic buildings

• Owning a fire extinguisher

Welfare Economics and Externalities

Market Equilibrium Without Externalities

• The supply curve shows the private cost (costs directly incurred by sellers).

• The demand curve shows the private value (value to buyers, or the prices they are willing to pay).

• The market equilibrium maximizes consumer and producer surplus.

The Social Cost with Negative Externalities

• With negative externalities, the social cost includes:

  • Private cost (supply curve; direct cost to sellers)

  • External cost (costs to bystanders harmed)

• The social-cost curve lies above the supply curve and incorporates external costs imposed on society.

Formula:

$\text{Social Cost} = \text{Private Cost} + \text{External Cost}$

Graphical Analysis of Negative Externalities

• Market equilibrium quantity is greater than the socially optimal quantity.

• Example: In the market for paper, if the external cost is $60 per ton, the social-cost curve is $60 above the supply curve.

• The socially optimal quantity is where the demand curve (private value) intersects the social-cost curve.

The Social Benefit with Positive Externalities

• With positive externalities, the social value of a good includes:

  • Private value (direct value to buyers; demand curve)

  • External benefit (value of the positive impact on bystanders)

Formula:

$\text{Social Value} = \text{Private Value} + \text{External Benefit}$

• Market equilibrium quantity is less than the socially optimal quantity.

• Example: In the market for flu shots, if the external benefit is $10 per shot, the social-value curve is $10 above the demand curve.

Internalizing the Externality

Definition and Mechanisms

Internalizing the externality means altering incentives so that people take into account the external effects of their actions.

• For negative externalities: impose a tax equal to the external cost (e.g., $60/ton tax on paper producers).

• For positive externalities: provide a subsidy equal to the external benefit (e.g., $10 subsidy for flu shots).

• If market participants pay social costs or receive social benefits, market equilibrium moves to the social optimum.

Public Policies Toward Externalities

1. Command-and-Control Policies (Regulation)

• Regulate behavior directly by requiring or forbidding certain actions.

• Examples: Dictate a maximum level of pollution, require firms to adopt specific technologies to reduce emissions.

2. Market-Based Policies

• Provide incentives for private decision makers to solve the problem on their own.

• Two main types:

  1. Corrective taxes and subsidies

  2. Tradable pollution permits

Corrective Taxes and Subsidies

• Tax activities with negative externalities (ideal corrective tax = external cost).

• Subsidize activities with positive externalities (ideal corrective subsidy = external benefit).

Corrective Taxes (Pigovian Taxes)

• Align private incentives with society’s interests.

• Induce private decision makers to take into account the social costs of a negative externality.

• Should equal the external cost.

• Increase total surplus and do not create deadweight loss.

• Raise revenue for the government.

Corrective Taxes vs. Regulations

• A pollution tax lowers the overall cost of abatement:

  • Firms with low abatement costs reduce pollution more to reduce their tax burden.

  • Firms with high abatement costs reduce pollution less and pay the tax.

  • Regulation requiring all firms to reduce pollution by the same amount is generally not cost-effective.

  • Pollution taxes provide incentives for firms to adopt better technology to further reduce pollution.

Case Study: Gasoline Taxes

• Gas taxes can be viewed as corrective taxes targeting three negative externalities:

  • Congestion: More driving increases traffic congestion.

  • Accidents: Larger vehicles cause more damage in accidents.

  • Pollution: Cars cause smog and contribute to climate change.

Carbon Taxes

• Economists widely agree that a tax on the carbon content of fuels is an efficient way to reduce carbon dioxide emissions.

• Such taxes are generally less expensive and more effective than regulatory policies.

Tradable Pollution Permits

• Firms with low costs of reducing pollution do so and sell their unused permits.

• Firms with high costs of reducing pollution buy permits.

• Pollution reduction is concentrated among firms with the lowest costs, reducing pollution at a lower cost than regulation.

• The initial allocation of permits does not affect economic efficiency.

Policy	How it works	Best when...
Corrective Taxes	Firms pay a tax per unit of pollution emitted	We know the exact cost of pollution
Pollution Permits	Firms buy/sell rights to pollute up to a fixed total amount	We know the optimal quantity of pollution

Active Learning Example: Reducing Pollution

Policy Option	Tiana's Paper Mill	Jordan's Tire Factory	Total Cost
Regulation (each must cut 30 tons)	30 x $100 = $3,000	30 x $200 = $6,000	$9,000
Tradable Permits (Tiana sells 30 permits to Jordan at $150 each)	Must clean 60 tons: 60 x $100 = $6,000 Revenue from selling permits: 30 x $150 = $4,500 Net cost: $1,500	Buys 30 permits: 30 x $150 = $4,500	$6,000

Additional info: Tradable permits achieve the pollution reduction goal at a lower total cost than regulation.

Pollution Permits vs. Corrective Taxes

• Both allow firms to pay for the "right to pollute" (either by paying a tax or buying permits).

• Corrective taxes are easier if the cost of pollution is known; permits are easier if the optimal quantity is known.

Objections and Trade-Offs

• Some object to allowing pollution for a fee, but eliminating all pollution is impossible.

• The value of environmental measures must be compared with their opportunity cost.

Private Solutions to Externalities

Types of Private Solutions

• Moral codes and social sanctions (e.g., no littering)

• Charities (e.g., donations to environmental causes)

• Mergers (e.g., apple orchard and beekeeper)

• Negotiation of contracts between interested parties

The Coase Theorem

• If private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

• The efficient outcome is achieved regardless of the initial distribution of rights.

Examples:

• If the benefit to the party causing the externality is less than the cost to the affected party, compensation can lead to an efficient outcome (e.g., Zeina pays Taio to stop playing piano).

• If the benefit is greater, the activity continues, possibly with compensation (e.g., Taio pays Zeina to tolerate the piano playing).

Why Private Solutions Do Not Always Work

• High transaction costs: Costs incurred in the process of bargaining and enforcing agreements.

• Stubbornness: Parties may refuse to negotiate or compromise.

• Coordination problems: Large numbers of affected parties make negotiation difficult.

Chapter Summary

• Externalities occur when a transaction affects a third party.

• Negative externalities lead to overproduction; positive externalities lead to underproduction.

• Government can address externalities through regulation, corrective taxes, and tradable permits.

• Private solutions are possible but may be hindered by transaction costs and coordination problems.