1. 10 Externalities P R I N C I P L E S O F F O U R T H E D I T I O N
This chapter is slightly below average in length, and, for most students, in difficulty. Most instructors cover it in two class sessions. The following chapter – “Public Goods and Common Resources” – is best covered immediately after this chapter, as both chapters involve similar concepts.
For variety, this PowerPoint presentation uses different examples from the textbook in its analysis of the welfare effects of externalities.
The fourth edition of the textbook includes a new “In the News” box with an excellent article on taxing gas to encourage conservation. Please encourage your students to check it out.

2. In this chapter, look for the answers to these questions:
What is an externality?
Why do externalities make market outcomes inefficient?
How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work?
What public policies aim to solve the problem of externalities?
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3. Introduction Recall one of the Ten Principles:
Markets are usually a good way to organize economic activity.
Lesson previously learned:
In the absence of market failures, the competitive market outcome is efficient, maximizes total surplus.
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4. Introduction One type of market failure: externalities.
Externality: the uncompensated impact of one person’s actions on the well-being of a bystander
Negative externality: the effect on bystanders is adverse
Positive externality: the effect on bystanders is beneficial
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5. Introduction
Self-interested buyers and sellers neglect the external effects of their actions, so the market outcome is not efficient.
Another basic principle :
Governments can sometimes improve market outcomes.
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6. Pollution: A Negative Externality
Example of negative externality: Air pollution from a factory.
The firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity.
How gov’t may improve the market outcome:
Impose a tax on the firm equal to the external cost of the pollution it generates
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7. Other Examples of Negative Externalities
the neighbor’s barking dog
late-night stereo blasting from the dorm room next to yours
noise pollution from construction projects
talking on cell phone while driving makes the roads less safe for others
health risk to others from second-hand smoke
If you would like to shorten/tighten your presentation of this chapter, you can verbally name these examples in class and omit the slide.
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8. Positive Externalities from Education
A more educated population benefits society:
lower crime rates: educated people have more opportunities, are less likely to rob and steal
better government: educated people make better-informed voters
People do not consider these external benefits when deciding how much education to “purchase”
Result: market eq’m quantity of education too low
How gov’t may improve the market outcome:
subsidize cost of education
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9. Other Examples of Positive Externalities
Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you.
R&D creates knowledge others can use.
Renovating your house increases neighboring property values.
Again, if you wish to tighten the presentation, omit this slide and, instead, give these examples verbally to your students.
Thank you for not contaminating the fruit supply!
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10. Recap of Welfare Economics1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
The market eq’m maximizes consumer + producer surplus.
Supply curve shows private cost, the costs directly incurred by sellers
$2.50 25
Demand curve shows private value, the value to buyers (the prices they are willing to pay)
For many students, the concepts are easier to learn in the context of a specific example with numerical values.
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11. Analysis of a Negative Externality1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
Social cost = private + external cost
external cost
Supply (private cost)
External cost
= value of the negative impact on bystanders
= $1 per gallon (value of harm from smog, greenhouse gases)
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12. Analysis of a Negative Externality1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
The socially optimal quantity is 20 gallons.
Social cost S
At any Q < 20,
value of additional gas exceeds social cost
At any Q > 20,
social cost of the last gallon is greater than its value
“At any Q < 20, value of additional gas exceeds social cost.”
For example, at Q = 10, the value to buyers of an additional gallon equals $4, while the social cost is only $2. Therefore, total surplus (society’s well-being) would increase with a larger quantity of gas.
“At any Q > 20, social cost of the last gallon is greater than its value.”
For example, at Q = 25 - the market equilibrium - the last gallon cost $3.50 (including the external cost) but the value of it to buyers was only $ Hence, total surplus would be higher if Q were lower.
Only at Q = 20 is society’s welfare maximized. D 25
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13. Analysis of a Negative Externality1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
Market eq’m (Q = 25)
is greater than
social optimum (Q = 20)
Social cost S
One solution: tax sellers $1/gallon,
would shift supply curve up $1. D 25
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14. “Internalizing the Externality”
Internalizing the externality: altering incentives so that people take account of the external effects of their actions
In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs.
When market participants must pay social costs, market eq’m = social optimum.
(Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)
The parenthetical remark at the bottom of the slide follows from a lesson in Chapter 6: tax incidence and the allocation of resources is the same whether a tax is imposed on buyers or sellers.
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15. Positive Externalities
In the presence of a positive externality, the social value of a good includes
private value – the direct value to buyers
external benefit – the value of the positive impact on bystanders
The socially optimal Q maximizes welfare:
At any lower Q, the social value of additional units exceeds their cost.
At any higher Q, the cost of the last unit exceeds its social value.
Since you have just walked students through the analysis of a negative externality, let’s see if they can do the analysis of a positive externality.
This slide provides the introductory information they will need to do the analysis. The following slide provides the exercise.
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16. A C T I V E L E A R N I N G 1: Analysis of a positive externality10 20 30 40 50 P Q $
The market for flu shots
External benefit = $10/shot
Draw the social value curve.
Find the socially optimal Q.
What policy would internalize this externality? S D 15

17. A C T I V E L E A R N I N G 1: Answers
Socially optimal Q = 25 shots
To internalize the externality, use subsidy = $10/shot. 10 20 30 40 50 P Q $
The market for flu shots
external benefit S 25
Social value = private value + external benefit D 16

18. Effects of Externalities: Summary
If negative externality
market quantity larger than socially desirable
If positive externality
market quantity smaller than socially desirable
To remedy the problem, “internalize the externality”
tax goods with negative externalities
subsidize goods with positive externalities
Effects of Externalities: Summary
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19. Private Solutions to Externalities
Types of private solutions:
moral codes and social sanctions, e.g., the “Golden Rule”
charities, e.g., the Sierra Club
contracts between market participants and the affected bystanders
The textbook gives a nice example of a contract in which a beekeeper and apple orchard manager each agree to boost production, as each producer’s activity confers an external benefit on the other.
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20. Private Solutions to Externalities
The Coase theorem: If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own.
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21. The Coase Theorem: An Example
Dick owns a dog named Spot.
Negative externality: Spot’s barking disturbs Jane, Dick’s neighbor.
The socially efficient outcome maximizes Dick’s + Jane’s well-being.
If Dick values having Spot more than Jane values peace & quiet, the dog should stay.
Coase theorem: The private market will reach the efficient outcome on its own…
See Spot bark.
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22. The Coase Theorem: An Example
CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800
Socially efficient outcome: Spot goes bye-bye.
Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off.
Private outcome = efficient outcome.
Both Jane and Dick are better off. (What about Spot? Doesn’t anyone care about Spot???)
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23. The Coase Theorem: An Example
CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800
Socially efficient outcome: See Spot stay.
Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays.
Private outcome = efficient outcome.
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24. The Coase Theorem: An Example
CASE 3: Jane has the legal right to peace & quiet. Benefit to Dick of having Spot = $800 Cost to Jane of Spot’s barking = $500
Socially efficient outcome: Dick keeps Spot.
Private outcome: Dick pays Jane $600 to put up with Spot’s barking.
Private outcome = efficient outcome.
The private market achieves the efficient outcome regardless of the initial distribution of rights.
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25. A C T I V E L E A R N I N G 2: Brainstorming
Collectively, the 1000 residents of Green Valley value swimming in Blue Lake at $100,000.
A nearby factory pollutes the lake water, and would have to pay $50,000 for non-polluting equipment.
A. Describe a Coase-like private solution.
B. Can you think of any reasons why this solution might not work in the real world?
Have students work together – in small groups, or as a class (with you as moderator). If working in groups, allow 5 minutes, then solicit responses from the class.
If you wish, insert a blank slide after this one and use it to type students’ responses as they share them.
Most students should find part A very straight-forward. A good Coasian solution would be for each of the 1000 residents to chip in $75, so the town can offer $75,000 to the factory to stop polluting.
The second part involves brainstorming: students try to come up with a list of reasons why it might be difficult to implement Coase-like solutions in the real world. Brainstorming engages students and is shown to increase learning outcomes and student satisfaction. And it provides a break from what otherwise would be a long stretch of lecture.
I have not provided a slide with answers. Instead, the following slide lists the reasons why private solutions don’t always work, and the “notes” section (what you’re reading right now) gives some examples of each in the context of this scenario. 24

26. Why Private Solutions Do Not Always Work
1. Transaction costs: The costs parties incur in the process of agreeing to and following through on a bargain.
These costs may make it impossible to reach a mutually beneficial agreement.
2. Stubbornness: Even if a beneficial agreement is possible, each party may hold out for a better deal.
3. Coordination problems: If # of parties is very large, coordinating them may be costly, difficult, or impossible.
An example for each bullet point in the context of the brainstorming activity on the previous slide:
1. Transactions costs: Suppose lawyers charge $60,000 to represent the two parties and draw up a contract that is enforceable in a court. Then it will be impossible for both parties to come to a mutually beneficial agreement, and the factory will continue polluting the lake.
2. Stubbornness: Suppose the town offers $55,000 to the factory. The factory would be better off taking this offer than nothing at all, but the factory may counter with a $95,000 price. Both parties hold out in hopes that the other will cede, but neither does. The factory keeps polluting, and the residents of Green Valley continue to be denied the joy of swimming in the lake.
3. Coordination problems: Getting all 1000 residents to agree to a specific offer will be difficult. Moreover, each resident has an incentive to free-ride off his neighbors.
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27. Public Policies Toward Externalities
Two approaches
Command-and-control policies regulate behavior directly. Examples:
limits on quantity of pollution emitted
requirements that firms adopt a particular technology to reduce emissions
Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own.
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28. Market-Based Policy #1: Corrective Taxes & Subsidies
Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality
Also called Pigouvian taxes after Arthur Pigou ( ).
The ideal corrective tax = external cost
For activities with positive externalities, ideal corrective subsidy = external benefit
Greg Mankiw’s blog ( has semi-regular posts on Pigou taxes, some of which are worth using in class (either as assigned or recommended reading or fodder for class discussion). On the main page, look under “A Few Timeless Posts” for “the Pigou Club Manifesto.”
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29. Market-Based Policy #1: Corrective Taxes & Subsidies
Example: Acme, US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO2 causes acid rain & other health issues.
Policy goal: reducing SO2 emissions 25%
Policy options
regulation: require each plant to cut emissions by 25%
corrective tax: Make each plant pay a tax on each ton of SO2 emissions. Set tax at level that achieves goal.
This example will be continued later to illustrate the gains from tradable pollution permits.
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30. Market-Based Policy #1: Corrective Taxes & Subsidies
Suppose cost of reducing emissions is lower for Acme than for US Electric.
Socially efficient outcome: Acme reduces emissions more than US Electric.
The corrective tax is a price on the right to pollute.
Like other prices, the tax allocates this “good” to the firms who value it most highly (US Electric).
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31. Market-Based Policy #1: Corrective Taxes & Subsidies
Under regulation, firms have no incentive to reduce emissions beyond the 25% target.
A tax on emissions gives firms incentive to continue reducing emissions as long as the cost of doing so is less than the tax.
If a cleaner technology becomes available, the tax gives firms an incentive to adopt it.
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32. Market-Based Policy #1: Corrective Taxes & Subsidies
Other taxes distort incentives and move economy away from the social optimum.
But corrective taxes enhance efficiency by aligning private with social incentives.
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33. Example of a Corrective Tax: The Gas Tax
The gas tax targets three negative externalities:
congestion the more you drive, the more you contribute to congestion
accidents larger vehicles cause more damage in an accident
pollution burning fossil fuels produces greenhouse gases
Greg Mankiw is a big advocate of raising the gas tax. See his blog for more information.
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34. A C T I V E L E A R N I N G 3: Discussion question
Policy goal: Reducing gasoline consumption
Two approaches:
A. Enact regulations requiring automakers to produce more fuel-efficient vehicles
B. Significantly raise the gas tax
This discussion question is inspired by a new “In the News” box in the fourth edition of the textbook, which contains a New York Times article entitled “A Fuel-Saving Proposal from Your Automaker: Tax the Gas.”
Key points:
1. If consumers demand gas-guzzling SUVs instead of fuel-efficient compact sedans, then forcing automakers to produce more of the latter will not be the best way to achieve the goal.
2. Raising the gas tax would shift consumer demand toward more fuel-efficient vehicles, and self-interested automakers would respond by producing more fuel-efficient vehicles.
3. The U.S. cannot impose mileage restrictions on foreign automakers. It can, however, restrict imports of foreign vehicles deemed inefficient. But this would risk WTO sanctions or retaliatory trade restrictions on goods produced in the U.S.
4. People who drive more than average are likely to prefer A to B. It might not be cost-effective for average Joes to organize, we could likely expect the trucking industry to lobby members of Congress to support option A and oppose option B.
5. Many environmentalists would likely support B, but would likely oppose the end of regulations on automakers.
Discuss the merits of each approach. Which do you think would achieve the goal at lower cost? Who do you think would support or oppose each approach? 33

35. Market-Based Policy #2: Tradable Pollution Permits
Recall: Acme, US Electric each emit 40 tons SO2, total of 80 tons.
Goal: reduce emissions 25% (to 60 tons/month)
Suppose cost of reducing emissions is $100/ton for Acme, $200/ton for US Electric.
If regulation requires each firm to reduce 10 tons,
cost to Acme: (10 tons) x ($100/ton) = $1,000
cost to USE: (10 tons) x ($200/ton) = $2,000
total cost of achieving goal = $3,000
The tradable pollution permits concept is more popularly called “cap-and-trade.”
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36. Market-Based Policy #2: Tradable Pollution Permits
Alternative:
issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons)
give 30 permits to each firm
establish market for trading permits
Each firm can choose among these options:
emit 30 tons of SO2, using all its permits
emit < 30 tons, sell unused permits
buy additional permits so it can emit > 30 tons
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37. Market-Based Policy #2: Tradable Pollution Permits
Suppose market price of permit = $150
One possible equilibrium:
Acme
spends $2,000 to cut emissions by 20 tons
has 10 unused permits, sells them for $1,500
net cost to Acme: $500
US Electric
emissions remain at 40 tons
buys 10 permits from Acme for $1,500
net cost to USE: $1,500
Total cost of achieving goal: $2,000
For our two-firm example, we merely assume the market price is $150 (and the slide shows, in fact, that both firms gain from trade at this price).
In practice, there are many firms buying and selling these permits, and the market price is established by supply and demand – as in any other free market.
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38. Market-Based Policy #2: Tradable Pollution Permits
A system of tradable pollution permits achieves goal at lower cost than regulation.
Firms with low cost of reducing pollution sell whatever permits they can.
Firms with high cost of reducing pollution buy permits.
Result: Pollution reduction is concentrated among those firms with lowest costs.
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39. Tradable Pollution Permits in the Real World
SO2 permits traded in the U.S. since 1995.
Nitrogen oxide permits traded in the northeastern U.S. since 1999.
Carbon emissions permits traded in Europe since January 1, 2005.
Nitrogen oxides increase ground-level ozone, which has adverse health effects.
For more information, see
For information about Europe’s new carbon emissions trading program, see the Financial Times article featured in this chapter’s new “In the News” box. You can also find lots of good articles on this program at the website of the Financial Times,
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40. Corrective Taxes vs. Tradable Pollution Permits
Like most demand curves, firms’ demand for the ability to pollute is a downward-sloping function of the “price” of polluting.
A corrective tax raises this price and thus reduces the quantity of pollution firms demand.
A tradable permits system restricts the supply of pollution rights, has the same effect as the tax.
When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely.
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41. Objections to the Economic Analysis of Pollution
Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment.
However, people face tradeoffs.
The value of clean air & water must be compared to their cost.
The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment.
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42. CHAPTER SUMMARY
An externality occurs when a market transaction affects a third party. If the transaction yields negative externalities (e.g., pollution), the market quantity exceeds the socially optimal quantity. If the externality is positive (e.g., technology spillovers), the market quantity falls short of the social optimum.
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43. CHAPTER SUMMARY
Sometimes, people can solve externalities on their own. The Coase theorem states that the private market can reach the socially optimal allocation of resources as long as people can bargain without cost. In practice, bargaining is often costly or difficult, and the Coase theorem does not apply.
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44. CHAPTER SUMMARY
The government can attempt to remedy the problem. It can internalize the externality using corrective taxes. It can issue permits to polluters and establish a market where permits can be traded. Such policies often protect the environment at a lower cost to society than direct regulation.
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