Chapter 5: Externalities, Environmental Policy, and Public Goods – Study Notes

Externalities, Environmental Policy, and Public Goods

5.1 Externalities and Economic Efficiency

Externalities are unintended side effects of economic activities that affect third parties not directly involved in the transaction. They can be either positive or negative and have significant implications for economic efficiency.

• Externality: A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

• Negative Externality: Imposes costs on others (e.g., pollution).

• Positive Externality: Confers benefits on others (e.g., education).

Private cost is the cost borne by the producer, while social cost includes both private and external costs. When externalities are present, market equilibrium does not yield the socially optimal outcome.

• Market Failure: Occurs when the market fails to produce the efficient level of output due to externalities.

• Deadweight Loss: The loss of economic efficiency when the equilibrium outcome is not socially optimal.

Example: Pollution from electricity production increases social cost above private cost, leading to overproduction and deadweight loss.

Graphical Representation: The socially optimal output is where the marginal social cost equals the marginal benefit. Market equilibrium, based only on private costs, results in overproduction when there is a negative externality.

5.2 Private Solutions to Externalities: The Coase Theorem

Private bargaining can sometimes resolve externalities without government intervention, provided property rights are well-defined and transaction costs are low.

• Property Rights: The rights individuals or businesses have to the exclusive use of their property.

• Coase Theorem: If property rights are assigned and transaction costs are low, private parties can negotiate to correct externalities and achieve an efficient outcome.

• Transaction Costs: Costs incurred in the process of agreeing to and carrying out an exchange.

Example: If a farmer and a paper mill share a stream, assigning property rights allows them to negotiate an efficient outcome, regardless of who holds the rights.

Is Zero Pollution Efficient? Not necessarily. The optimal level of pollution is where the marginal benefit of pollution reduction equals the marginal cost.

Graphical Representation: The efficient amount of pollution reduction is where the marginal cost curve intersects the marginal benefit curve.

5.3 Government Policies to Deal with Externalities

When private solutions are not feasible, government intervention can help achieve economic efficiency.

• Pigovian Taxes: Taxes imposed to correct negative externalities by internalizing external costs.

• Subsidies: Payments to encourage activities with positive externalities.

• Command-and-Control Policies: Regulations that set quantitative limits or require specific technologies to reduce externalities.

• Tradable Emissions Allowances (Cap-and-Trade): Systems where firms can buy and sell permits to emit pollutants, achieving pollution reduction at the lowest cost.

Example: A tax equal to the external cost of pollution shifts the supply curve upward, reducing output to the efficient level. Subsidies can increase the production or consumption of goods with positive externalities, such as education.

Graphical Representation: Taxes and subsidies shift supply or demand curves to achieve the efficient equilibrium.

Policy Applications: Cigarettes and soda are often taxed due to negative health externalities. Cap-and-trade systems have been used to reduce sulfur dioxide emissions effectively.

5.4 Four Categories of Goods

Goods can be categorized based on rivalry and excludability, which affects how efficiently markets provide them.

• Rivalry: One person's consumption reduces the amount available for others.

• Excludability: Non-payers can be prevented from consuming the good.

	Excludable	Nonexcludable
Rival	Private Goods Examples: Big Macs, running shoes	Common Resources Examples: Tuna in the ocean, public pastureland
Nonrival	Quasi-Public Goods Examples: Cable TV	Public Goods Examples: National defense

Efficient Provision: Markets efficiently provide private goods but tend to underprovide public goods (due to free-riding) and overuse common resources (tragedy of the commons).

Graphical Representation: For private goods, market demand is the horizontal sum of individual demands. For public goods, it is the vertical sum of willingness to pay.

Tragedy of the Commons: Overconsumption of common resources due to lack of property rights. Solutions include community norms for small groups or legal restrictions (taxes, quotas, permits) for larger groups.

Key Formulas

• Marginal Social Cost (MSC): $MSC = MPC + MEC$ where $MPC$ is marginal private cost and $MEC$ is marginal external cost.

• Marginal Social Benefit (MSB): $MSB = MPB + MEB$ where $MPB$ is marginal private benefit and $MEB$ is marginal external benefit.

Summary Table: Categories of Goods

Type of Good	Rival?	Excludable?	Examples
Private Good	Yes	Yes	Food, clothing
Public Good	No	No	National defense, street lighting
Common Resource	Yes	No	Fish in the ocean, public parks
Quasi-Public Good	No	Yes	Cable TV, toll roads

Additional info: Efficient government policy often requires balancing economic incentives with administrative feasibility and political support. Global issues like climate change require international cooperation for effective solutions.