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PART 1 - CHAPTER 2
EXTERNALITIES:
PROBLEMS AND SOLUTIONS

Introduction producers =sellers, suffer cost = K, L... + tax

non-market participants suffer from 'lost' bc of your production activities but they
 Externalities arise whenever the actions of one
party make another party worse or better off, yet may also receive 'benefits' - third person not pay anything
the first party neither bears the costs nor receives
the benefits of doing so. 4 types of externalities
 As we will see, this represents a market failure for
which government action could be appropriate and
improve welfare.

EXTERNALITY

1. EXTERNALITY THEORY

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tax/ subsidy - regulated choice of government

1. EXTERNALITY THEORY
 Externalities can either be negative or positive, and they can
also arise on the supply side (production externalities) or the
demand side (consumption externalities).
 A negative production externality is when a firm’s
production reduces the well-being of others who are not
compensated by the firm.
 A negative consumption externality is when an
individual’s consumption reduces the well-being of others
who are not compensated by the individual.
 The basic concepts in positive externalities mirror those in
negative externalities.

a, Economics of Negative Production Externalities most famous

 To understand the case of negative production

externalities, consider the following example:
 A profit-maximizing steel firm, as a by-product of its production,
dumps sludge into a river.
 The fishermen downstream are harmed by this activity, as the fish
die and their profits fall.
 This is a negative production externalities because:
 Fishermen downstream are adversely affected.
 And they are not compensated for this harm.
 Figure 2 illustrates each party’s incentives in this situation.

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SMC = PMC +
Price MD S=PMC
of steel TheThe
yellow
steeltriangle
firm setsis the
consumer
PMB=PMC andto producer
The
Thefind its firmoptimal
steel
socially overproduces
level of
privately
surplus
optimal
at Q 1profit
from. society’s
production is at
viewpoint.
Q2, the
p2 This maximizing
Theframework
marginal damageoutput,
does notQ1. of SMC and SMB.
intersection
curve
capture (MD)
therepresents
harm donethe to The red triangle is the
The social marginal cost deadweight
is loss from the
fishery’s
the fishery,
harm however.
per unit.
p1 the sum of PMC and MD, and private production level.
represents the cost to society.
MD

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 2 Negative Production Externalities

SMC = PMC +
Price MD S=PMC pink = welfare lost bc SMC > SMB
small triangle of steel
= maximum if government intervene -> policy - reduction in quantity form Q1 to Q2
SW at Q2 p2
- tax for producer - marginal tax (tax per unit) -> t = MEC(Q*) at social
p1 quantity
MD
gov intervene then damage of third person = 0 => FALSE
loss of 3rd person = MD at Q2
D = PMB = black area = delta change of total damage to 3rd person
SMB
Q1: before regulated
0 Q2 Q1 QSTEEL
Q1: unregulated with Q2: social quantity
externalities
Figure 2 Negative Production Externalities
green: loss of surplus of market participants

triangle yellow = SW at Q2
trapezoid yellow = SW at Q1
green = delta change = DWL of market participants

b, Negative Consumption Externalities

 We now move on to negative consumption smokers - non-smokers

externalities. Consider the following example:
 A person at a restaurant smokes cigarettes.
 That smoking has a negative effect on your enjoyment of
the restaurant meal.
 In this case, the consumption of a good reduces the
well-being of someone else.
 Figure 3 illustrates each party’s incentives in the no compensation from smokers to non-smokers
presence of a negative consumption externality.

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Price of S=PMC=SMC
cigarettes The The
yellow
smoker
triangle
sets
is the
surplus
PMB=PMC to thetosmokers
find his
privately
(and producers)
optimal quantity
at Q1.
The
ThisThe
MD of cigarettes,
framework
curve
social does Q
represents
marginal 1.benefit is
not
the
capture
nonsmoker’s
the the harmharm
difference done per
to PMB
between The red triangle is the
non-smokers,
pack of cigarettes.
however.
and MD.
p1 deadweight loss from the
The
The socially
smoker private
optimalproduction
consumeslevel of level.
too
manysmoking
cigarettes
is at
from
Q2,society’s
the MD
p2 intersection viewpoint.
of SMC and SMB.

D=PMB
SMB=PMB-MD

0 Q2 Q1 QCIGARETTES

Figure 3 Negative Consumption Externalities

no externalities of producers -> PMC = SMC

Price of D shift left -> negative ex but D shift right -> positive (PMB + MD)
S=PMC=SMC
cigarettes

p1

MD
maximump2
SW
at Q2 D=PMB
SMB=PMB-MD

0 Q2 Q1 QCIGARETTES

Figure 3 Negative Consumption Externalities

c, Positive Externalities

 Positive externalities can occur in production or

consumption.
 A positive production externality is when a firm’s
production increases the well-being of others, but the firm
is not compensated by those others.
 Research and development is a production externality.
 A positive consumption externality is when an
individual’s consumption increases the well-being of others,
but the individual is not compensated by those others.
 Nice landscaping could be a consumption externality.

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c, Positive Externalities

 Let’s consider positive production externalities.

Consider the following example:
 A policeman buys donuts near your home.
 As a consequence, the neighbors are safer because of the
policeman’s continued presence.
 In this case, the production of donuts increases the
well-being of the neighbors.
 Figure 4 illustrates each party’s incentives in the
presence of a positive production externality.

Price of S = PMC
donuts The
The donut
yellowshop
triangle
setsisPMB
the
=consumer
PMC to find anditsproducer
privately
optimalsurplus
profit at
maximizing
Q1.
This
The red triangle theoutput,
Theframework
external
is Q1.not
marginal
does
benefit
capture (EMB)
the
deadweight loss from the benefit
represents
to the The Thedonut
socially
shopoptimal
underproduces
level of
the
neighbors,
private productionneighbor’s
level. however.
benefit. donuts
fromissociety’s SMC
at Q2, the = PMC -
viewpoint.
intersection
p1
of SMC andEMB SMB.
EMB
p2
The social marginal cost
subtracts EMB fromDPMC.
= PMB =
SMB

0 Q1 Q2 QDONUTS

Figure 4 Positive Production Externalities

Price of S = PMC
donuts

SMC = PMC -
p1 EMB
EMB
p2

D = PMB =
SMB

0 Q1 Q2 QDONUTS

Figure 4 Positive Production Externalities

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Positive Externalities

 Finally, there can be positive consumption

externalities.
 A neighbor’s improved landscape is a good example
of this.
 The graphical analysis is similar to negative
consumption externalities, except that the SMB
curve shifts outward, not inward.

Positive Externalities

 The theory shows that when a negative externality

is present, the private market will produce too
much of the good, creating deadweight loss.
 When a positive externality is present, the private
market produces too little of the good, again
creating deadweight loss.

EXTERNALITY

2. THE COASE THEOREM

The Solution for Private sector

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The Solution for Private Sector pollution of industrial production

some would pollute w/out payment/compensation for 3rd person

if they use common resources.
 The Coase Theorem: When there are well-defined
property rights and costless bargaining, then
negotiations between the parties will bring about
the socially efficient level.
 Thus, the role of government intervention may be
very limited—that of simply enforcing property
rights.
need bargaining bw two parties

fishermen = owner of river -> quantity he wants is = 0

The Solution (Coase Theorem) At 0, unacceptable for firm

 Consider the Coase Theorem in the context of the

negative production externality example from
before.
 Give the fishermen property rights over the amount
of steel production.
 Figure 5 illustrates this scenario.

SMC = PMC +
Price This bargaining processMD will S = PMC
of steel continue until the socially
The gain to society is
The gain to society is this area,this area,
the efficient
difference
the difference level.
betweenbetween
(PMB(PMB - -
PMC)
PMC) andandMDMD for for
thethe
firstsecond
unit. unit.
p2
The
If the
reason
fisheryishad
because
property
any
rights,
steel itproduction
would initially
makesimpose
the
p1 zero
fishery
steelworse
production.
off.
MD

Thus,Thus,
While
ButitThere
While
there
is itthe
is is
possible
fishery
the
possible still
room
fishery
room
forsuffers
toforbargain.
the suffers
to
thebargain.
only
steelsteelthe
a The
firm modest
firm
toThe
same
steel
to steel
“bribe”“bribe”
amount
damage
firm
firm
the gets
theof
gets
fishery
as
fisherydamage.
a lot
from
a
inbit
ofinthe
less D = PMB
order
order surplus
surplus
to to produce
produce from
from
first
the
the the
the
unit.
first
second
firstnext
unit.
unit.unit.
unit. SMB

0 1 2 Q2 Q1 QSTEEL

Figure 5 Negative Production Externalities and Bargaining

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The Solution (Coase theorem)

 Through a process of bargaining, the steel firm will

bribe the fishery to arrive at Q2, the socially optimal
level.
 After that point, the MD exceeds (PMB - PMC), so
the steel firm cannot come up with a large enough
bribe to expand production further.

The Solution (Coase Theorem)

 Another implication of the Coase Theorem is that

the efficient solution does not depend on which
party is assigned the property rights, as long as
someone is assigned them.
 The direction in which the bribes go does depend
on the assignment, however.
 Now, let’s give the property rights to the steel firm
over the amount of steel production.
 Figure 6 illustrates this scenario.

SMC = PMC +
Price MD S = PMC
of steel
This bargaining process will
The Thegaingain
to society is this
is area, the
continue until thetosocially
society this area,
If the
Thissteel
levelfirm
difference of production
had property
between MD and MD (PMB -
thethe
difference
efficient
While level. firmbetween a and
p2 rights,
maximizes itWhile
PMC)would
thesteel
the
by
steel
initially
consumer
cutting
firm
suffers
choose
andsuffers
another unit.
(PMB-PMC)
only
larger
aQ modest
loss byprofits.
cutting back 1 unit.
producer . in loss
1surplus.
in profits.

p1

MD

The
Thus,The
Thus,
fishery
it is
fishery
itpossible
gets
is possible
gets
the for
same
a lot
the
forofthe
fishery
surplus
fishery
surplus
to
as“bribe”
to
cutting
from
“bribe”
the
cutting
back
the
steel
from
steel
back
firmfirm
D=PMB=SMB
to
steel
cutthe
production
back first
toanother
cut
unit.
back.
by unit.
one unit.

0 Q2 Q1 QSTEEL

Figure 6 Negative Production Externalities and Bargaining

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The Solution (Coase Theorem)

 Figure 6 shows that even though the bargaining

process is somewhat different, the socially efficient
quantity of Q2 is achieved.

Problems with Coasian Solutions assignment: who must compensate - the share of compensation bw
companies (>1 company pollute)
holdout: many co-owner of property rights -> create cost of
 There are several problems with the Coase negotiation = administrative cost -> no such 'costless' bargaining
Theorem, however. free-rider: contribute nothing but gain
 The assignment problem
 The holdout problem
 The free rider problem
 Transaction costs and negotiating problems

Problems with Coasian Solutions

 The “assignment problem” relates to two issues:

 It can be difficult to truly assign blame.
 It is hard to value the marginal damage in reality.

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Problems with Coasian Solutions

 The “holdout problem” arises when the property

rights in question are held by more than one party.
 The shared property rights give each party power over all
others.
 This could lead to a breakdown in negotiations.

Problems with Coasian Solutions

 The “free rider” problem is that when an

investment has a personal cost but a common
benefit, individuals will underinvest.
 For example, if the steel firm were assigned property
rights and you are the last (of many) fishermen to pay,
the bribe is larger than the marginal damage to you
personally.

Problems with Coasian Solutions

 Finally, it is hard to negotiate when there are large

numbers of individuals on one or both sides.

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Problems with Coasian Solutions

 In summary, the Coase Theorem is provocative, but

perhaps not terribly relevant to many of the most
pressing environmental problems.

EXTERNALITY

3. SOLUTIONS OF THE PUBLIC

SECTOR

3. PUBLIC-SECTOR SOLUTIONS FOR should return to the pov of Pigouvian taxation - Pigo subsidy
EXTERNALITIES
 Coasian solutions are insufficient to deal with large
scale externalities. Public policy makes use of three
types of remedies to address negative externalities:
 Corrective taxation
 Subsidies
 Regulation

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in case of negative externalities

- producer pay tax if it its production nega ex
a, Corrective Taxation - consumer pay tax if ----

per-unit of Q(social) -> t/unit = MD (MD is constant)

 The government can impose a “Pigouvian” tax
on the steel firm, which lower its output and normal situation t/unit = MD(Qs)
reduces deadweight loss.
 If the per-unit tax equals the marginal damage at new PMC = PMC + t => PMC move to the left
the socially optimal quantity, the firm will cut
back to that point.
 Figure 7 illustrates such a tax.

SMC=PMC+MD
Price S=PMC+tax
S=PMC
tax paid to the gov: T = t/unit * Qs
of steel
The socially optimal level of
production, Q2, then maximizes
p2 profits.
The steel firm initially produces
at QImposing
1, the intersection
Imposing aatax of PMC
taxequal
shifts to
thethe
PMC
MD
p1 shifts
curveand
the PMB.curve
upward
PMC and reduces
such that
steel
it equals
production.
SMC.

D = PMB =
SMB

0 Q2 Q1 QSTEEL
at Q2 only if tax = MD(Qs)
Figure 7 Pigouvian Tax

Corrective Taxation

 The Pigouvian tax essentially shifts the private

marginal cost.
 The firm cuts back output, which is a good thing
when there is a negative externality.

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Corrective Taxation

 The steel firm’s privately optimal production solves:

PMB  PMC  tax

 When the tax equals MD, this becomes:
PMB  PMC  MD  SMC
 But this last equation is simply the one used to
determine the efficient level of production.

b, Subsidies gov sub to one who create positive subsidies

 The government can impose a “Pigouvian” subsidy

on producers of positive externalities, which
increases its output.
 If the subsidy equals the external marginal benefit at
the socially optimal quantity, the firm will increase
production to that point.
 Figure 8 illustrates such a subsidy.

Price of S = PMC
donuts The donut shop initially
choosesProviding a subsidy equal
Q1, maximizing shifts
the
its to PMC
EMB curve
profits. shifts downward.
the PMC
curve downward to SMC.

The socially optimal level of

SMC=PMC-EMB
p1 donuts, Q2, is achieved by such
a subsidy.

p2

D = PMB =
SMB

0 Q1 Q2 QDONUTS

Figure 8 Pigouvian Subsidy

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Subsidies tax/ sub make price change

 The subsidy also shifts the private marginal cost.

 The firm cuts expand output, which is a good thing
when there is a positive externality.

Subsidies

 The donut shop’s production solves:

PMB  PMC  subsidy
 When the subsidy equals EMB, this becomes:

PMB  PMC  EMB  SMC

 But this last equation is simply the one used to
determine the efficient level of production.

c, Regulation

 Finally, the government can impose quantity

regulation, rather than relying on the price
mechanism.
 For example, return to the steel firm in Figure 9.

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SMC = PMC + MD quantity reduction refer to case of negative externalities

Price S = PMC
of steel
without regulation Q1=Qm
p2
The
Yet firm
the government
has an incentive
couldto
simply require
produce
it toQproduce
1. no apply Q-regulation (require firm not to produce more than Q2)
p1 more than Q2.

compare Pigo tax and Q-regulation -> which case better

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 9 Quantity Regulation

Regulation

 In an ideal world, Pigouvian taxation and quantity

regulation give identical policy outcomes.
 In practice, there are complications that may make
taxes a more effective means of addressing
externalities.

Recap of Externalities:
Problems and Solutions
 Externality theory
 Private-sector solutions
 Public-sector solutions

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NEXT CHAPTER…
 PUBLIC GOODS

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