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

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Externalities, Economic Efficiency, and Market Failure

Definition and Types of Externalities

An externality is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. Externalities are often described as side-effects of economic activity.

Negative externality: Imposes costs on third parties (e.g., pollution from factories).
Positive externality: Confers benefits on third parties (e.g., medical research, education).

When externalities are present, market equilibrium does not achieve economic efficiency. Government intervention may be necessary to improve outcomes.

Private and Social Costs/Benefits

Private cost: Cost borne by the producer.
Social cost: Total cost to society, including both private and external costs.
Private benefit: Benefit received by the consumer.
Social benefit: Total benefit to society, including both private and external benefits.

Negative Externalities in Production

Negative externalities in production (e.g., pollution) cause the social cost to exceed the private cost, leading to overproduction at market equilibrium.

Graph showing marginal private cost, marginal social cost, and efficient equilibrium for electricity production Graph showing deadweight loss from negative externality in electricity market

Positive Externalities in Consumption

Positive externalities in consumption (e.g., education) cause the social benefit to exceed the private benefit, leading to underproduction at market equilibrium.

Graph showing positive externality in college education market

Market Failure and Deadweight Loss

Market failure occurs when the market does not produce the efficient quantity of a good or service. With negative externalities, there is overproduction; with positive externalities, there is underproduction. Both cases result in deadweight loss.

Property Rights and the Coase Theorem

Role of Property Rights

Externalities often arise due to incomplete or unenforced property rights. Clearly defined and enforceable property rights can help internalize externalities and restore efficiency.

Example: If a farmer owns a stream, they can prevent or charge for pollution by a paper mill, aligning private incentives with social welfare.

The Coase Theorem

The Coase theorem states that if property rights are well-defined and transaction costs are low, private parties can negotiate to solve the externality problem, regardless of who holds the rights.

Transactions costs: Costs incurred in making and enforcing agreements.
Requires full information and low transaction costs for efficient bargaining.

Government Policies to Address Externalities

Corrective Taxes and Subsidies (Pigovian Taxes/Subsidies)

Governments can use taxes and subsidies to correct externalities:

Tax on negative externalities: Shifts supply curve upward, reducing quantity to the efficient level.
Subsidy for positive externalities: Shifts demand curve upward, increasing quantity to the efficient level.

Graph showing tax shifting supply curve for negative externality Graph showing price and quantity changes with tax for negative externality Graph showing subsidy shifting demand curve for positive externality

Pigovian Taxes and Double Dividend

Pigovian tax: A tax designed to correct for the effects of a negative externality.
Can increase efficiency and generate revenue, potentially allowing reduction of other distortionary taxes.
Example: British Columbia's carbon tax, with revenue used to reduce income taxes.

Command-and-Control vs. Market-Based Approaches

Command-and-control: Government sets quantitative limits or requires specific technology (e.g., catalytic converters in cars).
Cap-and-trade (tradable emissions allowances): Government sets a cap on total emissions and allows firms to trade permits, achieving pollution reduction at lowest cost.

Global Environmental Policy and Carbon Emissions

Policies include Pigovian taxes, cap-and-trade, and command-and-control approaches.
Global coordination is necessary for effective climate change mitigation (e.g., Paris Climate Accords).
Carbon taxes are favored by many economists but face political resistance.

Four Categories of Goods

Rivalry and Excludability

Rivalry: One person's consumption reduces availability for others.
Excludability: Non-payers can be prevented from consuming the good.

	Excludable	Non-Excludable
Rival	Private goods	Common resources
Non-Rival	Quasi-public goods	Public goods

Efficient Provision and Market Failure

Markets efficiently provide private goods.
Public goods suffer from free-rider problem; common resources from overuse (tragedy of the commons).
Quasi-public goods may exclude too many people due to profit maximization.

Demand Curves for Private and Public Goods

Private goods: Market demand is the horizontal sum of individual demands.
Public goods: Market demand is the vertical sum of individual willingness to pay at each quantity.

Tragedy of the Commons

Common resources are overused because individuals ignore the external cost of their consumption. Solutions include community norms (for small groups) or legal restrictions (taxes, quotas, permits) for larger groups.

Key Formulas and Concepts

Marginal Social Cost (MSC):
Marginal Social Benefit (MSB):
Deadweight Loss: Area between MSC/MSB and market equilibrium where net benefits are lost due to inefficiency.