2. 10
Externalities
CHAPTER
Notes and teaching tips: 4, 8, 10, and 33.

3. 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
1 Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome.
2 Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome.

4. 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
A negative externality is a production or consumption activity that creates an external cost.
A positive externality is a production or consumption activity that creates an external benefit.
Launch your Chapter 10 lecture by asking your students if they have seen the movie Erin Brokovich. It’s a great (not necessarily in a review sense, but in an economic sense!) movie that shows how pollution creates external costs and how residents required Pacific Gas & Electricity (PG&E) to account for both private costs and external costs in the use of hexavalent chromium (chromium 6). PG&E used the chemical to clean its equipment. According to the movie, PG&E improperly discharged the chemical and polluted the ground and water, causing death and disease. The movie starts with PG&E recognizing there is a problem because it offers a homeowner $55,000 for his home and medical bills. The movie ends with this family receiving $5 million from PG&E. PG&E now claims that chromium 6 is not deadly if you drink it, only if you inhale it and that it presents no external costs. Still, PG&E settled the case for $330 million.

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

6. 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.

7. 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

8. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Private Costs and Social Costs
Marginal private cost is 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 is the cost of producing an additional unit of a good or service that falls on people other than the producer.
Students quite often are surprised that economists have a lot to say about pollution. Many students think that pollution is a topic handled only by scientists, technicians, and engineers working in the field. You can point out to your students that in truth economists have had a lot of influence in the nation’s pollution policies. So, if a student is considering a career in a pollution related field, he or she might also want to consider economics as a potential major.

9. 10.1 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.
Marginal social cost (MSC) is the sum of marginal private cost (MC) and marginal external cost.
MSC = MC + Marginal external cost

10. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.1 shows the relationship between cost and output.
When output is 4,000 tons of chemicals a month:
1. Marginal private
cost is $100 a ton.
Draw the supply (marginal cost) curve for a good, say electricity, that when produced creates pollution. Remind students that this curve represents the costs paid by the producers to produce one more unit of the good. Pick a point on the curve and say “To increase the production of electricity one more unit, the graph shows that the producer must incur a cost of $100 (or whatever price and quantity you have chosen). If I tell you that the utility is polluting the environment, do we as a society face a higher cost?” Most students will answer “yes” and you can plot a point higher on the graph at the same quantity. Do the same analysis for other production points and you now have a new supply curve, the marginal social cost (MSC) curve. Remind students that the distance between the curves is the added cost of the pollutants, which is the marginal external cost.
2. Marginal external
cost is $125 a ton.
3. Marginal social cost is $225 a ton.

12. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Production and Pollution: How Much?
When an industry is unregulated, the amount of pollution it creates depends on the market equilibrium price and the quantity of the good produced.
If the industry creates an external cost, the market equilibrium is inefficient. Too much of the good is produced.

13. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.2 shows inefficiency with an external cost.
1. The market is in equilibrium at a price of $100 a ton and 4,000 tons of chemical a month is inefficient.
2. Marginal social cost exceeds ...
3. Marginal benefit.

14. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
4. The efficient quantity is 2,000 tons of chemical, where marginal social cost equals marginal benefit.
5. The gray triangle shows the dead-weight loss created by the pollution externality.

16. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
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.

17. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.3 shows how property rights achieve an efficient outcome.
1. With property rights, the MC curve that excludes the cost of pollution shows only part of the producers’ marginal cost.

18. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
2. The marginal private cost curve includes the cost of pollution, and the supply curve is S = MC.

19. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
3. Market equilibrium is at a price of $150 a ton and a quantity of 2,000 tons of chemical a month and is efficient because…
4. Marginal social cost equals marginal benefit.

21. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
The Coase Theorem
Coase theorem is 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 are the opportunity costs of conducting a transaction.

22. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Application of the Coase Theorem
If factories own homes and river, the rent people willingly pay decreases as the amount of pollution increases.
If homeowners own the river, factories must pay homeowners for any 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.

23. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
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

24. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Emission Charges
Emission charges confront the producers with the external cost of pollution and provide an incentive to seek technologies that are less polluting.
To work out the emission charge that achieves efficiency, the regulator needs a lot of information about the industry, which is generally not available.

25. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Marketable Permits
A marketable permit assigns to each producer in an industry an emission limit.
Producers can buy and sell permits in the market.
Producers with a low marginal cost of reducing pollution will sell permits and producers with a high marginal cost of reducing pollution will buy.
Producers will buy and sell permits until their marginal cost of pollution equals the market price of a permit.

26. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Taxes
Figure 10.4 shows the effects of a pollution tax.
1. A pollution tax is imposed that is equal to the marginal external cost arising from pollution.

27. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
The supply curve becomes the marginal private cost curve, MC, plus the tax—the curve labeled S = MC + tax.
Because the tax equals the marginal external cost, the MSC curve becomes the supply curve.

28. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
2. Market equilibrium at a price of $150 a ton and 2,000 tons of chemical a month is efficient because…
3. Marginal social cost equals marginal benefit.

29. 10.1 NEGATIVE EXTERNALITIES: POLLUTION
4. The government collects tax revenue shown by the purple rectangle.

31. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Private Benefits and Social Benefits
Marginal private benefit is the benefit of an additional unit of a good or service that the consumer of that good or service receives.
Marginal external benefit is the benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.

32. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Marginal social benefit is the marginal benefit enjoyed by society—by the consumers of a good or service and by everyone else who benefits from it.
Marginal social benefit (MSB) is the sum of marginal private benefit (MB) and marginal external benefit.
MSB = MB + Marginal external benefit

33. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Figure 10.5 shows an external benefit.
When 15 million students
attend college:
1. Marginal private benefit is $10,000 per student.
To clarify the effects of the government’s options of using public provision, private subsidies, and vouchers to deal with external benefits, draw all three options as headings across the board at one time. Under each heading, start with identical demand and supply curves that result in underproduction. Add the MSB curve in each case. Start with the voucher case first because it is the simplest and show how the voucher increases demand so that it becomes the same as the MSB curve. You can then show how a subsidy shifts the supply curve creating the same outcome. Compare the value of the subsidy with the value of the voucher …it’s the same. Then draw the public provision case showing how the taxpayer pays the marginal external cost (the same amount in the two other cases) and produces the efficient amount. Review how each option produces the same outcome for the same “price” and that it’s just the process to the efficient outcome that differs.
2. Marginal external benefit is $15,000 per student.
3. Marginal social benefit is $25,000 per student.

35. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Figure 10.6 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.

36. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
4. The efficient number of students is 15 million.
5. The gray triangle shows the deadweight loss created because too few students enroll in college.

38. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
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

39. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Public provision is the production of a good or service by a public authority that receives the bulk of its revenue from the government.
A subsidy is a payment that the government makes to private producers to cover part of the costs of production.
A voucher is a token that the government provides to households that can be used to buy specified goods or services.

40. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Public provision
Figure 10.7(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 $10,000 per year.
4. The taxpayers cover the remaining $15,000 of marginal cost per student.

42. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Private Subsidies
Figure 10.7(b) shows
how a subsidy achieves an efficient outcome of 15 million students.
1. A $15,000 subsidy per student shifts the supply curve to
S = MC – subsidy.
2. The dollar price is $10,000 a student.

43. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
3. The market equilibrium is efficient with 15 million students enrolled in college.
4. Marginal social benefit equals marginal cost.

45. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Vouchers
Figure 10.8 shows how vouchers can achieve an efficient outcome.
The MSB curve becomes the demand curve because…
1. With vouchers, buyers are willing to pay MB plus the value of the voucher.

46. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
2. Market equilibrium is efficient with 15 million students enrolled.
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.

48. 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Intellectual property rights are the property rights of the creators of knowledge and other discoveries.
A patent or copyright is 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.