1. Externalities and Public Policy
Chapter 3
Externalities and Public Policy

2. Externalities
Externalities are costs or benefits of market transactions not reflected in prices.
Negative externalities are costs to third parties.
Positive externalities are benefits to third parties .

3. Externalities and Efficiency
The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. These occur when market transactions for a good produce negative externalities.

4. Social Costs
MSC = MPC + MEC

5. Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency
Price, Benefit, and Cost (Dollars)
Tons of Paper Per Year (Millions)
D = MSB
S = MPC
MPC + MEC = MSC
110 G
105
4.5 B 10 5
100 A

6. Implications of Figure 3.1
Market equilibrium occurs where
MPC = MSB
Efficiency Requires that
MSC = MPC + MEC = MSB

7. Positive externalities
The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production or consumption of a good. These occur when the market for a good creates positive externalities.

8. Social Benefit
MSB = MPB + MEB

9. Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency
Price, Benefit, and Cost (Dollars)
Inoculations Per
Year (Millions) Z 45
MPB + MEB = MSB
S = MSC
MPB V 30 12 U 25 10 H 10

10. Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output
Price, Benefit, and Cost (Dollars)
Inoculations per Year (Millions)
MPBi + MEB = MSB 16
S = MSC F 30
S' = MSC' B 12 A 25 10
MPBi C 20

11. Internalization of Externalities
An externality can be internalized under policies that force market participants to account for the costs of benefits of their actions.

12. Corrective Taxes to Negative Externalities
Setting a tax equal to the MEC will internalize a negative externality.

13. Figure 3.4 A Corrective Tax
S’ = MPC + T = MSC
Price, Benefit, and Cost (Dollars)
Tons of Paper Per Year (Millions)
D = MSB
S = MPC
110
Net Gains in
Well-Being G
105 95
4.5
Tax Revenue = Total
External Costs B T
100 5 A

14. Results of a Corrective Tax
Price rises.
The tax revenue is sufficient to pay costs to third parties.
Socially optimal levels of production are achieved.

15. Using a Corrective Tax The greenhouse effect and a “Carbon Tax”
The greenhouse effect is caused by burning carbon-based fuels. A carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels.
It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.

16. Theory of the Second Best
When one condition for an optimum is violated, then maintaining the others will not guarantee a second-best solution.

17. A Polluting Monopolist
Chapter 2 showed that monopoly creates a loss to society. This chapter shows that a negative externality causes a loss as well.
The losses do not necessarily add to one another. In fact, they can cancel each other out.

18. Figure 3.5 A Second Best Efficient Solution
MPC + MEC = MSC
D = MSB
MPC
Price
Output per Year MR F M Q P A C Q* B

19. Corrective Subsidies
Setting a subsidy equal to MEB will internalize a positive externality.

20. Figure 3.6 A Corrective Subsidy
Price, Benefit, and Cost (Dollars)
Inoculations per Year (Millions)
D' = MPBi +
$20
= MSB 45 Z
D = MPBi
S = MSC 30 12 V R
Subsidy Payments 25 10 U Y 10 X

21. Property Rights and Internalization of Externalities
Externalities arise because some resource users’ property rights are not considered in the marketplace by buyers or sellers of products.
Governments can give businesses the right to emit wastes in the air and water or it can give individuals the right to clean air and water.

22. Coase's Theorem
By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.

23. The Significance of Coase’s Theorem
The efficient mix of output will result simply as a consequence of the establishment of exchangeable property rights.
It makes no difference which party is assigned the right to use a resource.
If the transactions costs of exchanging the rights are zero, the efficient mix of outputs among competing uses of the resource will emerge.

24. Figure 3.7 Coase’s TheoremB A
Price of Beef (Dollars)
Price of Wheat (Dollars)
Wheat Output per Year
Beef Output per Year
MCW*
MPCB + MEC = MSC
QW*
QB*
MCW
MPCB
QW1
QB1 PW PB

25. Limitations of Coase’s Theorem
Transactions costs are not zero in many situations.
However you allocate the property rights, the distribution of income is affected.

26. Applying Coase's Theorem
The Clean Air Act of 1990 allows for the sale of the "right to pollute." Firms face a tradeoff when they pollute. If they pollute, they forgo the right to sell their emission permits to others.
In markets for electricity, Clean Air Act has motivated firms to shift to natural gas and away from coal as a means of producing electricity.

27. Figure 3.8 Pollution Rights and Emissions
Price and Marginal Social Benefit
Tons of Annual Emissions
and Number of Pollution Rights
D = MSB of
Emitting Wastes
100,000
S = Supply of Pollution Rights
$20
75,000

28. Figure 3.9 The Efficient Amount of Pollution Abatement
Marginal Social Cost and Benefit
Percent Reduction in Waste Emitted per Year
100
MSB
MSC E A*

29. Recycling
Recycling may be a less efficient and more polluting use of labor, land and capital than simple land fill disposal because:
Collecting waste for recycling costs three times as much as collecting it for disposal.
Rural land is inexpensive.
Recycling paper creates more water pollution and does not “save” trees; it simply reduces the number that are planted.

30. Regulatory Solutions
Instead of using market forces to force firms to internalize externalities, we can use emission standards and apply these to all market players.

31. Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions
Firm A
Cost and Benefit (Dollars)
Firm B
QB1
QA1
Tons of Emissions per Year
MSB A B G H QR
MEC = MSC 10 C F
QA*
QB*
DQRB
DQRA

32. Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions
Firm C
Tons of Emissions per Year
Firm D
Cost and Benefit (Dollars)
MSB
MEC = MSC 20 X
QC* S Y Z R QR
MEC = MSC T
QD*
DQRD
DQRC

33. Markets for Pollution Rights
The Clean Air Act of 1990 allowed firms the right to trade Sulfur Dioxide emissions allowances.
The market for the allowances began in 1991.
Firms must have the allowances to emit Sulfur Dioxide.
Firms increasing production can buy permits or use pollution controls to keep their total emissions constant.
Firms that reduce their emissions can sell their allowances to others.

34. Sulfur Dioxide Emission Prices

35. Global Externalities
CFC’s
Deforestation
Global Warming

36. Costs and Benefits to the EPA
The EPA estimates that annual compliance costs could be in the range of $225 billion per year.
The EPA estimated in 1990 that the benefits of the Clean Air Act were nearly 50 times the costs.
Ninety percent of the benefits are estimated to come from laws pertaining to power plants and factories.