2. C H A P T E R C H E C K L I S T
When you have completed your study of this chapter, you will be able to
Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome. 1
Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome. 2

3. EXTERNALITIES IN OUR DAILY LIVES
An externality is a cost or a benefit that arises from:
Production that falls on someone other than the producer
Consumption that falls on someone other than the consumer
Negative externality
A production or consumption activity that creates an external cost.
Positive externality
A production or consumption activity that creates an external benefit.

4. EXTERNALITIES IN OUR DAILY LIVES
Four types of externalities
Negative production externalities
Positive production externalities
Negative consumption externalities
Positive consumption externalities

5. EXTERNALITIES IN OUR DAILY LIVES
Negative Production Externalities
Pollution is the major example of this type of externality.
Others are noise and congestion.
Positive Production Externalities
Example: Orchards provide positive production externalities to honey producers, who in turn provide positive production externalities to orchards.

6. EXTERNALITIES IN OUR DAILY LIVES
Negative Consumption Externalities
Smoking tobacco in a confined space
Noisy parties
Positive Consumption Externalities
A flu vaccination
Restoration of an historic building
Education and research

7. 9.1 NEGATIVE EXTERNALITIES
Private Costs and Social Costs
Marginal private cost
The cost of producing an additional unit of a good or service that is borne by the producer of that good or service.
Marginal external cost
The cost of producing an additional unit of a good or service that falls on people other than the producer.

8. 9.1 NEGATIVE EXTERNALITIES
Marginal social cost
The marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. It is the sum of marginal private cost and marginal external cost.
MSC = MC + Marginal external cost

9. 9.1 NEGATIVE EXTERNALITIES
Figure 9.1 shows the relationship between cost and output.
When output is 4,000 tons of chemicals per month:
1. Marginal private
cost is $100 a ton.
2. Marginal external
cost is $125 a ton.
3. Marginal social cost is $225 a ton.

10. 9.1 NEGATIVE EXTERNALITIES
Production and Pollution: How Much?
When an industry is unregulated, the amount of pollution it creates depends on the market equilibrium price and quantity of the good produced.
If the industry creates external costs, the market equilibrium is inefficient. Too much of the good is produced.

11. 9.1 NEGATIVE EXTERNALITIES
Figure 9.2 shows inefficiency with an external cost.
1. Market equilibrium at a price of $100 a ton and 4,000 tons a month is inefficient.
2. Marginal social cost exceeds ...
3. Marginal benefit.

12. 9.1 NEGATIVE EXTERNALITIES
4. The efficient quantity is 2,000 tons a month, where marginal social cost equals marginal benefit.
5. The gray triangle shows the dead-weight loss created by the pollution externality.

13. 9.1 NEGATIVE EXTERNALITIES
Property Rights
Property rights
Legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.

14. 9.1 NEGATIVE EXTERNALITIES
Figure 9.3 shows how property rights achieve an efficient outcome.
1. With property rights, the MC curve that excludes pollution costs shows only part of the producers’ marginal cost.

15. 9.1 NEGATIVE EXTERNALITIES
2. The marginal private cost curve includes the cost of pollution, and the supply curve is S = MC.

16. 9.1 NEGATIVE EXTERNALITIES
3. Market equilibrium is at a price of $150 a ton and a quantity of 2,000 tons a month and is efficient because…
4. Marginal social cost equals marginal benefit.

17. 9.1 NEGATIVE EXTERNALITIES
The Coase Theorem
Coase theorem
The proposition that if property rights exist, only a small number of parties are involved, and transactions costs are low, then private transactions are efficient and the outcome is not affected by who is assigned the property right.
Transactions costs
The opportunity costs of conducting a transaction.

18. 9.1 NEGATIVE EXTERNALITIES
Application of the Coase Theorem
If factories own homes and river, people pay lower rent the greater the amount of pollution.
If homeowners own the river, factories must pay homeowners for pollution, and the more they pollute, the more they pay.
Regardless of who owns the river, so long as someone owns it, the factories bear the cost of pollution, and the quantity of production and pollution are efficient.

19. 9.1 NEGATIVE EXTERNALITIES
Government Actions in the Face of External Costs
The three main methods that governments can use to achieve a more efficient allocation of resources in the presence of external costs are:
Emission charges
Marketable permits
Taxes

20. 9.1 NEGATIVE EXTERNALITIES
Figure 9.4 shows the effects of a pollution tax.
1. A pollution tax is imposed that is equal to the marginal external cost of pollution.

21. 9.1 NEGATIVE EXTERNALITIES
The supply curve becomes the marginal private cost curve, MC, plus the tax—the curve labeled
S = MC + tax.

22. 9.1 NEGATIVE EXTERNALITIES
2. Market equilibrium is at a price of $150 a ton and a quantity
of 2,000 tons a month and is efficient because…
3. Marginal social cost equals marginal benefit.

23. 9.1 NEGATIVE EXTERNALITIES
4. The government collects tax revenue shown by the purple rectangle.

24. 9.2 POSITIVE EXTERNALITIES
Private Benefits and Social Benefits
Marginal private benefit
The benefit of an additional unit of a good or service that the consumer of that good or service receives.
Marginal external benefit
The benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.

25. 9.2 POSITIVE EXTERNALITIES
Marginal social benefit
The marginal benefit enjoyed by society—by the consumers of a good or service and by everyone else who benefits from it. It is the sum of marginal private benefit and marginal external benefit.
MSB = MB + Marginal external benefit

26. 9.2 POSITIVE EXTERNALITIES
Figure 9.5 shows an external benefit.
When 15 million students
attend college:
1. Marginal private benefit is $10,000 per student.
2. Marginal external benefit is $15,000 per student.
3. Marginal social benefit is $25,000 per student.

27. 9.2 POSITIVE EXTERNALITIES
Figure 9.6 shows inefficiency with an external benefit.
1. Market equilibrium is at a tuition of $15,000 a year and 7.5 million students and is inefficient
because …
2. Marginal social benefit exceeds …
3. Marginal cost.

28. 9.2 POSITIVE EXTERNALITIES
4. The efficient quantity is 15 million students.
5. The gray triangle shows the deadweight loss created by the external benefits of college education.

29. 9.2 POSITIVE EXTERNALITIES
Government Actions In the Face of External Benefits
Four devices that governments can use to achieve a more efficient allocation of resources in the presence of external benefits:
Public provision
Private subsidies
Vouchers
Patents and copyrights

30. 9.2 POSITIVE EXTERNALITIES
Public provision
The production of a good or service by a public authority that receives the bulk of its revenue from the government.
Subsidy
A payment that the government makes to private producers that depends on the level of output.
Voucher
A token that the government provides to households that can be used to buy specified goods or services.

31. 9.2 POSITIVE EXTERNALITIES
Figure 9.7(a) shows how public provision can achieve an efficient outcome.
1. Marginal social benefit equals marginal cost with 15 million students enrolled in college.
2. The efficient quantity.
3. Tuition is set at $10,000 per year.
4. The taxpayers cover the remaining $15,000 of marginal cost per student.

32. 9.2 POSITIVE EXTERNALITIES
Figure 9.7(b) shows how a subsidy can achieve an efficient outcome.
The efficient number of
students is 15 million.
1. A $15,000 per student subsidy shifts the supply curve to S = MC – subsidy.
2. The equilibrium price is $10,000.

33. 9.2 POSITIVE EXTERNALITIES
3. The market equilibrium is efficient with 15 million students enrolled in college.
4. Marginal social benefit equals marginal cost.

34. 9.2 POSITIVE EXTERNALITIES
Figure 9.8 shows how vouchers can achieve an efficient outcome.
The demand curve is D = MSB because…
1. With vouchers, buyers are willing to pay MB plus the value of the voucher.

35. 9.2 POSITIVE EXTERNALITIES
2. Market equilibrium is efficient with 15 million students enrolled in college.
3. Price, marginal social benefit, and marginal cost are equal.
4. Tuition equals the dollar price of $10,000 plus the value of the voucher.

36. 9.2 POSITIVE EXTERNALITIES
Intellectual property rights
The property rights of the creators of knowledge and other discoveries.
Patent or copyright
A government-sanctioned exclusive right granted to the inventor of a good, service, or productive process to produce, use, and sell the invention for a given number of years.