1. Externalities
A cost or benefit to a third party who is not involved in the transaction between producer and consumer
External cost is also known as “negative externality”
External benefit is also known as “positive externality”

2. Examples of External Costs & Benefits
External Benefits
Production
dumping toxic waste destroys habitats
-overfishing depletes fish stocks
-burning coal adds to global warming
-location of firm in high unemp. area increases local standards of living
-new transport built for industry encourages greater tourism
Consumption
-excess alcohol intake at pub causes vandalism
-increased car use leads to delays and lost work
-improving one’s garden adds value to a neighbour’s property
-higher education improves prospects for the next generation
** you only need to be able to discuss external costs from production and external benefits from consumption**

3. Private Costs & Social Costs
Producers are only concerned with “private costs” so this is all they take into account when deciding their quantity of output
Consumers are only concerned with “private benefit” so this is all they take into account when deciding their quantity of consumption
Social Cost = private cost + external cost
Social benefit = private benefit + external benefit

4. External Costs MSC Cost MPC=S Quantity
Externality
Quantity
If the negative externality were included in the “cost”, MPC would shift to MSC by the vertical amount of the negative externality. S would decrease.

5. External Benefits Cost MSB MPB=D Quantity
Externality
MSB
MPB=D
Quantity
If the positive externality were included in the “demand”, MPB would shift to MSB by the vertical amount of the positive externality. D would increase.

6. Market Optimum vs. Socially Optimum Output
Free market equilibrium is where marginal private cost = marginal private benefit (MPC=MPB)
Socially optimum equilibrium is where marginal social cost = marginal social benefit (MSC = MSB)

7. Market Optimum vs. Socially Optimum Output
MSC
Cost
MPC=S
P socially optimum
P free mkt
MPB=MSB=D Q
socially optimum Q
free
mkt
Quantity
Where there are external costs, the free market will overproduce and underprice.

8. Market Optimum vs. Socially Optimum Output
Cost
MPC=MSC=S
P socially optimum
P free mkt
MSB
MPB=D Q
free
mkt Q
socially optimum
Quantity
Where there are external benefits, the free market will underconsume & underprice.

9. Welfare Loss Q Q Cost WELFARE LOSS MPC=MSC=S P socially optimum
P free mkt
MSB
MPB=D Q
free
mkt Q
socially optimum
Quantity
- loss to society from not producing at the socially optimum output and price = area between the two curves from the free market output to the socially optimum output

10. Remedies for External Costs & Demerit Goods
Direct Controls
Tradable Permits
Extending Property Rights
Taxes
Subsidies of Alternatives

11. Direct Controls
Restriction or prohibition of production or consumption of a good
Eg. smoking ban in public places, using cannabis is illegal, production of refrigerators using ozone-depleting chemicals is forbidden, restrictions on pollution levels
A full ban is rational when MSC > MPB at all levels

12. Restriction of Output Q Q MSC Cost MPC=S1 MPC=S P socially optimum
P free mkt
MPB=MSB=D Q
socially optimum Q
free
mkt
Quantity

13. Pros/Cons of Direct Controls
Advantages
Disadvantages
Clear limits are defined
Major offenders may be shut down (either by restriction or prohibition)
-expensive to monitor
-extra admin costs to firms
-difficult to assess the correct monetary impact of the externality (S may shift too far or not far enough)
-may lead to gov’t failure if resources end up being allocated incorrectly

14. Tradable Permits
Gov’t sets quantitative limit (quota) on the amount of an externality allowed in an industry
Each firm is allocated permits to produce their share of the externality
Firms who want to produce less than their permits allow can sell their permits to another firm who wants to produce more – everyone gets what they want
The total in the industry remains the same

15. Advantages of Tradable Permits
externality controlled by the price mechanism as producers decide how much they are willing to pay to continue producing the externality
permits can be ↓ over time to gradually phase out the externality (↓supply of permits →↑price of the externality → ↓quantity produced
encourages firms to invest in going “cleaner” with revenue from selling permits
firms producing the externality pay for it, (“internalising the externality”)

16. Disadvantages of Tradable Permits
↑ production and admin costs for firms
↓ pressure for offenders to clean up their act (just buy more permits!) – gives impression it’s okay
Valuation of the correct value & quantity of permits with respect to the true social cost is difficult
May lead to fraud/bribery/bullying by big polluting firms

17. Extending Property Rights
Gov’t allocates ownership to people/organisations for certain resources (eg. air, river, sea, etc.)
Often externalities arise due to lack of property rights (nobody owns the sea so no one minds if we dump this waste!)
Once someone owns the resource, they can sue anyone who damages it

18. Pros/Cons of Extending Property Rights
Advantages
Disadvantages
-enforcement is moved away from gov’t to private individuals & courts
-firms pay to change their production method or pay when they get sued – either way “internalising the externality”
-may be difficult to extend property rights in all cases (eg. which fisherman owns which piece of the sea)
-difficult to trace the source of externalities where there are multiple offenders
-may be imbalance of power between ‘big’ polluters and ‘little’ individuals

19. Taxes
Indirect tax imposed on offending firms to charge them for their externality (internalise the externality)
MSC
Cost
MPC=S1
consumer pays
tax
MPC=S
P so
P fm
producer pays
MPB=MSB=D Q
socially optimum Q
free
mkt
Quantity

20. Pros/Cons of Taxes Advantages Disadvantages
-the offenders pay for the externality – not the 3rd party
-monetary incentive for producers or consumers of good to ↓ externality
-↑tax revenue can be used to clean up or compensate sufferers
-elastic goods may see significant reduction in demand
-difficult to measure the exact value of the externality – ie. to set the correct tax
-↑ production costs for firms
-firms may relocate to less taxed countries
-inelastic goods may not see a significant decrease in demand

21. Subsidies of Alternatives
Provided to encourage production and consumption of a more socially beneficial alternative
Eg. subsidies for construction of gas-fired power stations, subsidies for public transport, subsidies for nicorette? S
Price
Quantity S1 P P1 D Q Q1

22. Pros & Cons of Subsidies
Advantages
Disadvantages
-should ↓ use of good with negative externality or demerit good
-increase consumer surplus (shifting S outward)
-expensive for gov’t
-firms may become inefficient if relying on subsidies
-may be difficult to make people shift if demand for the demerit good is inelastic (not price sensitive)