UNIT 5

Externalities

UNIT 5 OUTLINE
5.1 Externalities I: Types

5.2 Externalities: II
Analysis
5.3 Solutions: Public and
Private

MICROECONOMICS
Prepared by:
Dr. Alfonso Bárcena
5.1 Externalities I: Types

• When a market doesn’t operate efficiently it is called market failure

• The effect of a market exchange on a third party who is outside or
”external” to the exchange is called an externality
• Example: an outdoor country music concert happens a half-mile away from
your home and you can hear the music from your backyard
• Because externalities that occur in market transactions affect other
parties beyond those involved, are sometimes called spillovers
• Externalities can be negative or positive
• If you hate country music then the listening to it would be a negative
externality and vice versa if you love country music it would be a
positive externality

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Negative externalities
• Externalities that are costs to some other people are called negative
externalities
• These are uncompensated costs that are imposed upon individuals who are
not directly involved in the production or consumption of goods
• The act of producing or consuming goods sometimes generates costs to
those who are not compensated for these costs, such as in
• Automobile exhaust
• Cigarette smoking
• Alcohol drinking
• Pollution, noise, trafic jams are typical negative externatilities from
everyday life

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Positive externalities
• Externatilities that are benefits to some other people are called
positive externalities
• These are unpaid benefits that are received by individuals who are
not directly involved in the production or consumption of goods
• The act of producing or consuming goods sometimes generates
benefits to those who have not paid for these benefits, such as
• Immunizations
• Restored historic buildings
• Education
• Scientific and technological research
• Scientific progress is a positive externality

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Negative externalities and market inefficiency
• Negative externalities lead to market failure
• Negative externalities can occur when production or consumption
lead markets to produce larger quantities than are socially desirable
• We can distinguish between production and consumption
externalities
• Production externalities: social costs of production become greater
than the private costs to producers (i.e. alumunium smelting pollutes
rivers)
• Consumption externalities: social value is smaller than private value to
consumers (i.e. drinking causes trafic accidents )

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Negative externalities in production

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Negative externalities in consumption

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Social versus private
• The slides above distinguished between social and private value as
well as social and private cost
• This is a very important distinction for economics that needs to be
well understood
• Without externalities, in a competitive market equilibrium, social
value is equal to private value and social cost is equal to private cost
• The value of consumption to the individual is equal to its value to
society
• The cost of production to the individual is equal to its cost to society
• Externalities break this equality even for competitive markets

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Negative externalities in
production and consumption
• The optimal level of output for society is determined at the
intersection of the social-demand curve and the social-cost curve
• Optimum price makes optimum output possible
• Negative externality prevents the formation of optimum price and
output in market equilibrium
• Market equilibrium price is below optimum price
• Market equilibrium quantity is above optimum quantity
• Price no longer reflects either the social costs of production or the
social value of the good or service in question

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Attainment of the optimal output
• How can we move this market to optimum equilibrium where social
and private costs and values are equal?
• Internalising an externality involves altering incentives so that people
take into account the external effects of their actions
• The government may intervene to internalise an externality by
imposing a tax on the producer in order to reduce the equilibrium
quantity to the socially desirable quantity
• In other words, the move towards optimum requires an increase in
the market price which can happen through a government
intervention

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Positive externalities and market
inefficiency
• Positive externalities in production or consumption lead to market
failure
• For production, the social costs of production are less than the private
cost to producers (i.e. techno-logical research spillovers)
• For consumption, the social value to is bigger than private value (i.e.
education makes better citizens)
• Again, positive externalities imply a non-optimum market equilibrium
• Market equlibrium price is above optimum price
• Market equilibrium quantity is below optimum quantity

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Positive externalities in production
Price
of Robot Value of Supply (private cost)
technology
Social cost
spillover

Equilibrium

Optimum

Demand
(private value)

0 Quantity
QMARKET QOPTIMUM of Robots
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Positive externalities in consumption

Price of
Education
Value of
Supply
education
(private cost=social cost)

Optimum

Equilibrium

Demand
(Social value)

Demand
(private value)
0 QMARKET Quantity of
QOPTIMUM
Education
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 Attainment of the optimal output
• How can we move this market to optimum equilibrium where social
and private costs and values are equal to one another?
• The government can internalise positive externality by subsidising
production
• A subsidy means paying the producer to produce more than the
equilibrium quantity so that the socially desirable quantity is supplied
• Again an intervention in the market price by the government is
required to attain optimum output and price
• Many cases for government subsidies (arts, museums, parks, etc)
rests on this argument

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5.2 Externalities II: Analysis
Positive Externalities in Public Health Programs
• The standard of living in the last several centuries has changed because people
are living longer
• The rise in life expectancy seems to stem from three primary factors:
1. Systems for providing clean water and disposing for human waste helped to
prevent the transmission of many diseases
2. Changes in public behavior (washing hands, precautions with tobacco and
smoking)
3. Medicine advancements (immunizations, penicillin, antibiotics)
• These advances in public health have all been closely linked to positive
externalities and public goods

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Negative Externalities: Pollution
• A negative externality exists when the cost to society of a economic agent’s
action is greater than the cost to the agent
• The problem of pollution arises for every economy in the world
• Every country needs to strike some balance between production and
environmental quality
• Traditionally, policies for environmental protection have focused on
governmental limits on how much of each pollutant can be emitted
• Economists have suggested a range of more flexible, market-oriented policies
that reduce pollution at a lower cost

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The Economics of Pollution
• Over the past 50 years population in the U.S. has increased by one-third and the
U.S. economy has doubled.
• Despite the gradual reduction in emissions from fossil fuels, many important
environmental issues remain
• There are still high levels of air and water pollution
• Other issues include:
• Hazardous waste disposal
• Destruction of wetlands and other wildlife habitat
• Impact on human health from pollution

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Pollution as a Negative Externality
• Pollution is a negative externality
• The social costs include the private costs of the
production incurred by the company and the
external costs of pollution that are passed on to
society
• In a market with no antipollution restrictions,
firms can dispose of certain wastes absolutely
free

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Regulating Pollution
• In the 60s and 70s the U.S. began passing laws comprehensive
environmental laws specifying how much pollution could be emitted
out of a smokestack or a drainpipe
• This law also imposed penalties if that limit was exceeded
• Some laws required the installation of certain equipment
• These laws fall under the category of effluent standards
• Effluent standards require that firms increase their costs by installing anti-
pollution equipment
• Firms are thus required to take the social costs of pollution into account

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Tradable Permits

• Examples
• SO2 (acid rain)
• CO 2 (global warming)
• Permit allows each firm to emit a certain amount of pollutants
• Total number of permits issued equals emission limit for the region
each year
• Firms that are better at reducing emissions sell permits to firms that
are worse at it.

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Effluent Changes
• An effluent (or pollution) charge is a tax imposed on the quantity of
pollution that a firm emits
• Under an effluent charge system, firms are allowed to pollute, as long
as they pay the charge for every unit of pollution
• A pollution charge gives a profit-maximizing firm an incentive to figure
out ways to reduce its emissions
• A pollution charge gives a profit-maximizing firm an incentive to figure out ways
to reduce its emissions

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Tradable Permits

• Examples
• SO2 (acid rain)
• CO 2 (global warming)
• Permit allows each firm to emit a certain amount of pollutants
• Total number of permits issued equals emission limit for the region
each year
• Firms that are better at reducing emissions sell permits to firms that
are worse at it.

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Marketable Permits
Table 1. How Marketable Permits Work

– Firm Alpha Firm Beta Firm Gamma Firm Delta

Current emissions—
permits distributed 200 tons 400 tons 600 tons 0 tons
free for this amount
How much pollution
will these permits 100 tons 200 tons 300 tons 0 tons
allow in one year?
Actual emissions one
150 tons 200 tons 200 tons 50 tons
year in the future
Buys
Buyer or seller of Doesn’t buy or Sells permits for Buys permits for
permits for
marketable permit? sell permits 100 tons 50 tons
50 tons
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The economics of smoking

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 5.3 Solutions: Public and Private
Government policy toward externalities
• We can now summarise how the government may attempt to internalise
the externalities, either though
• Imposing a tax on goods in the case of negative externalities
• Giving a subsidy to goods in the case of positive externalities
• This is easy to say but faces major difficulties in real life due to several
reasons
• Measuring correctly negative or positive externalities is not a very easy task
• Obviously, producers facing negative externalities will try to resist taxes
while those with positive externalities will demand unjustified subsidies

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Private solutions to externalities

• What is the reaction of economists to externalities?

• Many economists are scared of the consequences of government
intervention even to correct externalities
• They try to find ways that make government action unneccessary to the
problem of externalities
• Private solutions which work without government intervention may include
• Moral codes and social sanctions
• Charitable volontary organizations
• Integrating different types of businesses
• Contracting between parties
• Let us now review the theory that lies behind private solutions to
externalities

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Case study. Fight against the obesity.

• A potential health externality that has recently attracted significant

attention is obesity.
• Why obesity is the negative externality?
• Higher public health expenditures
• Shorten life expectancy
• Lower life quality

• How can we prevent it?

• Tax?
• Penalties?
• Healthy food?

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Case study. How to reduce youth smoking rate?

• Generally we do not want people to smoke.

• Smokers usually start to smoke before 18 years old.
• How can we prevent it?
• Tax?
• Prohibition?
• Propaganda?

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