15 CHAPTER Externalities

After studying this chapter you will be able to Explain how externalities arise Explain why negative externalities lead to inefficient overproduction and how property rights, emission charges, marketable permits, and taxes can be used to achieve a more efficient outcome Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, vouchers, and patents can increase economic efficiency

Greener and Smarter Environmental issues are at the same time everybody’s problem and nobody’s problem. Human beings are learning more and more every day. But are we learning more at a fast enough pace? How can we ensure that we use resources efficiently in the face of externalities?

Externalities in Our Lives An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer. A negative externality imposes a cost and a positive externality creates a benefit.

Externalities in Our Lives The four types of externality are Negative production externalities Positive production externalities Negative consumption externalities Positive consumption externalities

Externalities in Our Lives Negative Production Externalities Negative production externalities are common. Some examples are noise from aircraft and trucks, polluted rivers and lakes, the destruction of animal habitat, and air pollution in major cities from auto exhaust.

Externalities in Our Lives Positive Production Externalities Positive production externalities are less common that negative externalities. Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit production gets an external benefit from the bees, which pollinate the fruit orchards and boost fruit output; and honey production gets an external benefit from the orchards.

Externalities in Our Lives Negative Consumption Externalities Negative consumption externalities are a common part of everyday life. Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.

Externalities in Our Lives Positive Consumption Externalities Positive consumption externalities are also common. When you get a flue vaccination, everyone you come into contact with benefits. When the owner of an historic building restores it, everyone who sees the building gets pleasure.

Negative Externalities: Pollution Pollution is an old problem and is faced by both rich industrial countries and poor developing countries. It is an economic problem that is coped with by balancing benefits and costs.

Negative Externalities: Pollution The Demand for a Pollution-Free Environment The demand for a pollution-free environment is expressed through the political process and this demand has increased for two reasons: Higher incomes: A high-quality environment is a “normal good,” the demand for which increases with income. Greater awareness: Greater knowledge about the causes of environmental problems raises understanding of environmental issues.

Negative Externalities: Pollution The Sources of Pollution Three sources of environmental pollution problems are Air pollution Water pollution Land pollution

Negative Externalities: Pollution Figure 15.1 shows some 20-year trends in air pollution in the United States.

Negative Externalities: Pollution Private Costs and Social Costs A private cost of production is a cost that is borne by the producer, and marginal private cost (MC) is the private cost of producing one more unit of a good or service. An external cost of production is a cost that is not borne by the producer but is borne by others. Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

Negative Externalities: Pollution Marginal social cost is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost. That is, MSC = MC + Marginal external cost. We express costs in dollars but must remember that the dollars represent the value of a forgone opportunity. Marginal private cost, marginal external cost, and marginal social cost increase with output.

Negative Externalities: Pollution Figure 15.2 illustrates the MC curve, the MSC curve, and marginal external cost as the vertical distance between the MC and MSC curves.

Negative Externalities: Pollution Production and Pollution: How Much? In the market for a good with an externality that is unregulated, the amount of pollution created depends on the equilibrium quantity of the good produced.

Negative Externalities: Pollution Figure 15.3 shows the equilibrium in an unregulated market with an external cost. The quantity produced is where marginal private cost equals marginal social benefit.

Negative Externalities: Pollution MSB is less than MSC in the market equilibrium, so the market equilibrium is inefficient. The efficient quantity is where marginal social cost equals marginal benefit. The competitive market overproduces and creates a deadweight loss.

Negative Externalities: Pollution Property Rights Externalities arise because of the absence of property rights. Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.

Negative Externalities: Pollution Figure 15.4 uses the example in Figure 15.3 to illustrate how the establishment of property rights achieves an efficient outcome. The polluter bears all the costs. The market equilibrium is efficient because MSC = MSB.

Negative Externalities: Pollution The Coase Theorem The Coase theorem is a proposition that if property rights exist, if only a small number of parties are involved, and if transactions costs (defined below) are low, then private transactions are efficient. There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights.

Negative Externalities: Pollution The Coase solution works only if transaction costs are low. Transactions costs are the cost of conducting a transaction. An example is the transactions costs of buying a home include fees for a realtor, a mortgage loan advisor, and legal assistance. When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality.

Negative Externalities: Pollution Government Actions in the Face of External Costs There are three main methods that the government uses to cope with external costs: Taxes Emission charges Marketable permits

Negative Externalities: Pollution Taxes The government can set a tax equal marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost, MC + tax = MSC. This tax is called Pigovian tax, in honor of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.

Negative Externalities: Pollution Figure 15.5 shows how a pollution tax equal to the marginal external cost can achieve an efficient outcome because MSC = MSB. The government collect a tax revenue.

Negative Externalities: Pollution Emissions Charges The government sets a price per unit of pollution, so that the more a firm pollutes, the higher are its emissions charges. For the emissions charge to induce the firm to generate the efficient level of pollution, the government would need a lot of information that is usually unavailable.

Negative Externalities: Pollution Marketable Permits Each firm is assigned a permitted amount of pollution per period and firms trade permits. The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome. This method was used successfully to decrease lead pollution in the United States.

Positive Externalities: Knowledge Knowledge comes from education and research and creates external benefits. Private Benefits and Social Benefits A private benefit is a benefit that the consumer of a good or service receives, and marginal private benefit (MB) is the private benefit from consuming one more unit of a good or service. An external benefit is a benefit that someone other than the consumer receives. Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy.

Positive Externalities: Knowledge Marginal social benefit is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else on whom the benefit falls. Marginal social benefit is the sum of marginal private benefit and marginal external benefit. That is: MSB = MB + Marginal external benefit.

Positive Externalities: Knowledge Figure 15.6 illustrates the marginal private benefit, marginal external benefit, and marginal social benefit. It identifies marginal external benefit as the vertical distance between the MB and MSB curves.

Positive Externalities: Knowledge Figure 15.7 shows how a private market underproduces an item that generates an external benefit and creates a deadweight loss.

Positive Externalities: Knowledge Government Action in the Face of External Benefits Four devices that the government can use to achieve a more efficient allocation of resources in the presence of external benefits are Public provision Private subsidies Vouchers Patents and copyrights

Positive Externalities: Knowledge Public Provision Under public provision, a public authority that receives payment from the government produces the good or service. Figure 15.8(a) shows how public provision can achieve an efficient outcome.

Positive Externalities: Knowledge Private Subsidies A subsidy is a payment by the government to private producers. If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced is efficient.

Positive Externalities: Knowledge Figure 15.8(b) shows how a subsidy can achieve an efficient outcome.

Positive Externalities: Knowledge Vouchers A voucher is a token that the government provides to households, which they can use to buy specified goods or services. Figure 15.9 shows how vouchers can achieve a more efficient outcome.

Positive Externalities: Knowledge Patents and Copyrights Intellectual property rights give the creator of knowledge the property right to the use of that knowledge. The legal device for establishing an intellectual property right is the patent or a copyright. A patent or copyright is a government-sanctioned exclusive right given to an inventor of a good, service or productive process to use to produce, use and sell the invention for a given number of years.

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