1. 15 Externalities Notes and teaching tips: 4, 24, 28, and 40.
CHAPTER
Externalities
Notes and teaching tips: 4, 24, 28, and 40.
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2. 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

3. 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?

4. 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.
No man (or woman) is an island. The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency:
Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, creating too much of the activity creating the externality to be produced.
Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, creating too little of the activity creating the externality to be produced.
There are some correcting policies that the government can use to increase efficiency, but some are more effective than others.

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

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

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

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

15. 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.

16. 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.

17. 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.

19. 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.

20. 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.

22. 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.

23. 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.

24. 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.
The role of property rights in the market. Explain that when the property rights are well defined, the owner of that right receives the social benefit and bears the social cost of using that resource. Property rights “internalize” the externality.

26. 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.

27. 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.

28. 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
The best government policies emulate, rather than replace, the market process. Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it.
Make the polluters discover (and bear) the social costs of pollution. In the case of cost externalities like pollution, the government can choose from three policies: emissions charges, pollution taxes, or marketable pollution permits. All three policies require the government to initially assess the social marginal costs and benefits form pollution activities to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.

29. 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.

30. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

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

40. 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
Let the consumers determine the composition of public good to be provided. In the case of benefit externalities like education, the government has three policy choices: public provision, private subsidy, or vouchers. All three policies require the government to initially assess the social marginal costs and benefits to find the optimal level of education to be consumed. However, only the public provision policy forces the government to continually assess what type of education should be provided in a dynamic world of ever-changing technology. The policies of private education subsidies or educational vouchers force the students to determine what types of education would be best, because they now face an opportunity cost for their decisions as to what school to attend. An informed and motivated clientele, armed with vouchers or subsidies to allocate across the different qualifying educational institutions, would drive the composition of educational opportunities supply by the different educational institutions.

41. 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.

43. 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.

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

46. 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.

48. 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.

49. THE END