EXTERNALITIES

BY:
ELEANOR P. GAROY
FME 323 (PUBLIC FINANCE)
2ND SEMESTER, AY 2022-2023
DEFINITION
• Market mechanism guarantees that, through competition, welfare
effects are transmitted via changes in market prices.
• The allocation of resources is Pareto efficient, bringing all individuals
to behave such that: MRSxy = MRTxy.
• The behavior of some people affects the welfare of others assuming
no market failure.
• As long as the effects are transmitted via prices, markets are
efficient.
DEFINITION
• When the activity of one entity (person or firm) directly affects the
welfare of another in a way that is not reflected in the market price,
the effect is called an externality (because one entity direct affects
the welfare of another entity that is “external” to the market).
• Unlike effects that are transmitted through market prices,
externalities affect economic efficiency negatively.
DEFINITION
• Example: suburban-urban migration
 Suppose large numbers of people who live in the suburb decide
they want to move to an urban setting?
 Urban property owners are better off so are the merchants in the
urban area
 Urban tenants already in the city are worse off so are suburban
merchants.
DEFINITION
• Example: suburban-urban migration
This is NOT a real externality; it is sometimes called pecuniary
externalities:
 when the effects of the actions of one economic entity on the
other are transmitted through changes in the market price
 effects of increases or decreases in the price of a good on existing
customers as a result of changes in the demand or supply of a
good
THE NATURE OF EXTERNALITIES
• An Illustration:
 Bart operates a factory that dumps its garbage into a river nobody
owns. Lisa makers her living by fishing from the water.
 Bart’s activities imposes costs on Lisa that are not reflected in
market prices, so the harm done to Lisa is not incorporated into
Bart’s market decision.
 The production of Bart: inputs are used including water, which is
considered scarce with alternative uses (e.g., used for fishing by
Lisa).
THE NATURE OF EXTERNALITIES
• An Illustration:
 If water is used efficiently then Bart should pay a price that reflects
the water’s value as a scarce resource that has alternative uses.
 Since Bart pays 0 price using the river as a dumping ground, the
result is that too much garbage being dumped into the river.
 If no one owns the river, there is not market for its use and everyone
can use it for free. And if someone owned the river, people would
have to pay for its use, and no externality would materialize.
 Externality is a consequence of the failure or inability to establish
property rights.
THE NATURE OF EXTERNALITIES
• An Illustration:
 What if Lisa owns the river?
- She could charge Bart a fee for polluting that reflected the
damage done to her catch.
- Bart would take these charges into account when making his
production decisions and would no longer use the water
inefficiently.
THE NATURE OF EXTERNALITIES
• An Illustration:
 What if Bart owns the river?
- He could make money by charging Lisa for the privilege of
fishing in it.
- The amount of money that Lisa would be willing to pay Bart
for the right to fish in the river would depend on the amount
of pollution present.
- Hence, Bart would have an incentive not to pollute excessively.
Otherwise, he could not make as much money from Lisa.
THE NATURE OF EXTERNALITIES
• Takeaway:
 As long as some owns a resource, and the market of the resource
in question exists and behave competitively, the price reflects the
resource’s value for alternative uses, and the resource is therefore
used efficiently.
 In other words, externalities are costs or benefits of market
transactions not reflected in prices.
 In contrast, resources owned in common (common goods, or
simply, commons) are abused because no one has an incentive to
economize in their use.
OTHER CHARACTERISTICS OF
EXTERNALITIES
 Externalities can be produced by consumers as well as firms.
Example: Consider the person who smokes a cigar in a crowded room,
reducing the utility of others by depleting the common resource of fresh air.
 Externalities are reciprocal in nature.
 Externalities can be positive, furthermore, it can be positive to some while
negative to others.
 Public goods can be viewed as a special kind of externality.
 When the positive externality had its full effect felt by every person in the
economy, the externality is a pure public good.
 Sometimes the boundary of the two is not clear.
The Nature of Externalities – Graphical
Analysis • Bart-Lisa example (graph: Bart’s use of a common
property to produce an output)
• MB – shows the marginal benefit to Bart of each
level of output, assumed to decline as output
increases.
• MPC – marginal private cost – reflects payments
made by Bart for inputs; increases with output
• By-product of Bart’s production: pollution, making
Lisa worse off.
• Pollution increases as the factory’s output increases
(assuming fixed amount of pollution per unit of
output).
• MD – marginal damage – damage inflicted on Lisa by
the pollution; upward sloping because as Lisa is
subjected to additional pollution, she becomes
worse off
The Nature of Externalities – Graphical
Analysis
• Bart’s profit maximization goal is achieved when: MB
≥ MC, i.e., MB ≥ MPC; produces up to Q1, where MPC
intersects MB (MPC = MB)
• From society’s point of view: production should
occur as long as MB to society exceeds MC to society.
• Marginal cost to society:
1. value of Inputs purchased by Bart is reflected in
MPC
2. damage done to Lisa is reflected in MC
3. MSC = MPC + MD
• Efficiency from a social point of view requires
production of only those units of output for which
MB > MSC; output should be Q*.
• MB = demand
• MB = 100 – 2Q
• MPC = 4Q
• To derive the MSC = MPC + MD
4Q = 100 – 2Q
6Q = 100
Q = 100/6
With externality
• MD = 2Q
• MB = 100 – 2Q
• MPC = 4Q
• To derive the MSC = MPC + MD
MSC = 4Q + 2Q = 6Q
• To derive the socially efficient output:
Equate MSC and MB: 6Q = 100 – 2Q
Q = 100/8
The Nature of Externalities – Graphical
Analysis
Implications:
1. When externalities exist, private markets do not produce
the socially efficient output level. When a good
generates a negative externality, a free market produces
more than the efficient output.
2. The model not only shows that efficiency would be
enhanced by a move from Q1 to Q*, but it also provides a
way to measure the benefits of doing so.
Figure:
• Output cut from Q1 to Q*: Bart loses profits.
• Loss in profit: area dcg
• Lisa become better off because Bart’s output falls, so
do the damages for her fishery.
• Each unit decline in Bart’s output, Lisa gains an
amount equal to the MD associated with that unit of
output.
The Nature of Externalities – Graphical
Analysis
Implications:
Figure:
• Lisa’s gain: area cdhg = area abfe
• Area cdhg = area under the MD curve between Q* and
Q1, abfe.
• If output were reduced from Q1 to Q*, Bart would lose
area dcg and Lisa would gain area cdhg.
• Provided that society views a dollar to Bart as
equivalent to a dollar to Lisa, then moving from Q1 to
Q* yields a net gain to society equal to the difference
between cdhg and dcg, which is dhg.
3. Zero pollution is NOT socially desirable.
- Finding the right amount of pollution requires trading
off its benefits and costs, and the optimum generally
occurs at some positive level.
The Nature of Externalities – Graphical
Analysis
Implications:
3. Zero pollution is NOT socially desirable.
- Given that all production is non-zero
pollution production, requiring pollution to
be set at 0 is equivalent to banning all
production, an inefficient solution.
The Nature of Externalities
It is difficult to identify and to value the effect of an externality like
pollution:
1. What activities produce pollutants?
• The types and quantities of pollution associated with various
production processes are hard to identify.
2. Which pollutants do harm?
• It is difficult to determine which pollutants cause harm and by
how much.
The Nature of Externalities
It is difficult to identify and to value the effect of an externality like
pollution:
3. What is the value of the damage done?
• It is a hard to calculate the dollar value of the damage. Pollution is
generally not bought and sold in explicit markets. The use of a
willingness-to-pay measure can be questioned. People may be
ignorant about the effects of an externality and underestimate
the value of reducing it.

The inefficient allocation caused by an externality can be avoided. An

efficient output can be achieved by both private and public responses.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Cause of inefficiencies associated with externalities: absence of
property rights.
• When property rights are assigned, individuals respond to the
externality by bargaining with each other.
• Illustration:
- Property rights to the river: assigned to Bart.
- It is costless for Lisa and Bart to bargain with each other.
- It is possible for the two parties to strike a bargain that results in
output being reduced from Q1?
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Illustration:
- Bargaining process:
 Bart would be willing to not produce a given unit of output
receiving payment > (MB – MPC) (where MB – MPC is the
incremental gain from producing that unit)
 Lisa would be WTP Bart as long as: payment < MD
 Lisa’s WTP Bart > cost to Bart of not producing, the
opportunity for a bargain exists: MD > (MB – MPC)
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Illustration: (1) Bart is assigned property rights
- At Q1, MB – MPC = 0 while MD is positive;
hence, MD > (MB – MPC) and there is scope for
a bargain.
- At every output to the right of Q*: the payment
Lisa would be willing to make excess MB - MPC.
- To the left of Q*, the amount of money Bart
would demand to reduce his output would
exceed what Lisa would be willing to pay. Hence,
Lisa pays Bart to reduce output just to Q*, the
efficient level.
- The total payment will be at least dcg, the
amount Bart loses by decreasing output to Q*
and no greater than cdhg
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Illustration: (1) Bart is assigned property
rights
- The total payment will be at least dcg,
the amount Bart loses by decreasing
output to Q* and no greater than cdhg,
the amount that Lisa gains by having
Bart decrease output to Q*.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Illustration: (2) Lisa is assigned property
rights to the river
- Lisa’s permission is gained before Bart
can produce any output.
- Bargaining process:
 Bart paying Lisa’s consent to pollute.
 Lisa is WTA some pollution as long as
payment she receives from Bart for
each unit of Bart’s output exceeds
the MD caused by that output to her
Lisa’s enterprise.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Illustration: (2) Lisa is assigned property
rights to the river
- Bargaining process:
 Bart finds it worthwhile to pay for the
privilege of producing as long as the
amount is less than the value of MB –
MPC for that unit of output.
 1st unit of Q that Bart produces, his
marginal profit (MB – MPC) far
exceeds the MD to Lisa, so there is
ample room to bargain and allow
Bart to produce this unit.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Illustration: (2) Lisa is assigned property
rights to the river
- Bargaining process:
 As long as (MB – MPC) > MD for each
additional unit of production, they
have every incentive to reach an
agreement whereby Lisa sells Bart
the right to produce at Q*.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Two important assumptions in the
preceding analysis
1. The costs to the parties of bargaining
are low.
2. The owners of resources can identify
the source of damages to their property
and legally prevent damages.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Implication of the Coase Theorem:
- Coase Theorem: Provided that
transaction costs are negligible, an
efficient solution to an externality
problem is achieved as long as someone
is assigned property rights, independent
of who is assigned those rights.
- Implies that once property rights are
established, government is not required
to deal with externalities (Coase, 1960).
- But Coase theorem (& the two
assumptions) do not always hold.
PRIVATE RESPONSES: BARGAINING
AND THE COASE THEOREM
• Relevance of Coase Theorem
- Most relevant for cases in which only a
few parties are involved and the sources
of the externality are well defined.
- Even when these conditions hold, the
assignment of property rights is relevant
from the point of view of income
distribution.
PRIVATE RESPONSES: MERGERS
• One way to deal with externality is to “internalize” it by combining the
involved parties.
• Illustration: (Bart-Lisa scenario)
- If Bart took into account the damages he imposed on Lisa’s fishery,
then a net gain would be possible.
- If Bart and Lisa coordinated their activities, then the profit of the joint
enterprise would be higher than the sum of their individual profits
when they don’t coordinate.
- The market provides a strong incentive for the firms to merge – Lisa
can buy the factory, Bart can buy the fishery, or some third party can
buy them both.
PRIVATE RESPONSES: MERGERS
• Illustration: (Bart-Lisa scenario)
- Once the two firms merge, the externality is internalized – it is taken
into account by the party that generates the externality.
- If Bart purchased the fishery, he would willingly produce less output
than before, because, at the margin, doing so would increase the
profits of his fishery subsidiary more than it decreased the profits from
his factory subsidiary.
- The external effects would not exist, and the market would not be
inefficient.
- The outsider observer would not even characterize the situation as an
“externality” because all decisions would be made within a single firm.
PRIVATE RESPONSES: SOCIAL
CONVENTIONS
• Social conventions – are attempts to force people to take into account
the externalities they generate.
- “Do unto others as you would have others do unto you.”
- “Before you undertake some activity, take into account its external
marginal benefits and costs.”
- ”If a person desires to open a shop in the courtyard, his neighbor
may stop him because he will be kept awake by the noise of people
going in and out of the shop.”
• Moral precepts induce people to empathize with others, and hence internalize
the externalities their behavior may create. And these precepts correct for the
absence of missing markets.
PUBLIC RESPONSES: TAXES
• Pigouvian tax – a tax levied on each unit of a polluter’s output in an
amount just equal to the MD it inflicts at the efficient level of output.
- In Bart-Lisa scenario:
 Bart produces inefficiently because the prices he pays for inputs
are below social costs. Because his input prices are too low, the
price of his output is too low.
 A natural solution, suggested by A. C. Pigou, a British economist
in the 1930s, is to levy a tax on the polluter that makes up for
the fact the some of his inputs are priced too low.
PUBLIC RESPONSES: TAXES
• Pigouvian tax Analysis
- MD at the efficient output Q* -
distance cd – this is the Pigouvian
tax (MSC – MPC = MD)
- How does Bart react to the
imposition of a tax of cd dollars per
unit?
- The tax raises Bart’s effective MC.
- For each unit produced, Bart has to
make payments both to the
suppliers of his inputs (MPC) and to
the tax collected (cd)
PUBLIC RESPONSES: TAXES
• Pigouvian tax Analysis
- Bart’s new MC curve (schedule): =
MPC + cd (shifts MPC up by the
value of cd)
- Profit maximization requires that
Bart produce where MB = MC: the
intersection of MB and MPC + cd, at
the efficient output Q*.
- In effect, the tax forces Bart to take
into account the costs of the
externality that he generates and
induces him to produce efficiently.
PUBLIC RESPONSES: TAXES
• Pigouvian tax Analysis
- The tax generates revenue of cd
dollars for each of the id units
produced (id = 0Q*)
Tax revenue = cd x id or the area of
the rectangle ijcd (pink-shaded area)
- But tax revenue should not be seen
as something to compensate Lisa,
who is still being hurt by Bart’s
activities.
PUBLIC RESPONSES: SUBSIDIES
• Pigouvian subsidy – A Pigouvian subsidy for each unit not produced
shifts up the private marginal cost curve by the amount of the per-unit
subsidy and induces production at the efficient level of output.
- Assuming a fixed number of polluting firms, the efficient level of
production can be obtained by paying the polluter not to pollute.
- A subsidy works like a tax (thus, subsidies are taxes in reverse).
- A subsidy for not polluting is simply another method of raising the
polluter’s effective production cost.
PUBLIC RESPONSES: SUBSIDIES
• Pigouvian subsidy analysis
- Suppose the government announces
that it will pay Bart a subsidy of cd for
each unit of output below Q1 he does
not produce.
- What will Bart do?
- Bart’s MB at output level Q1 is the
distance between MB and horizontal
axis, ge.
- The MC of producing at Q1 is the sum
of the amount Bart pays for his inputs
and the subsidy of cd that he forgoes
by producing.
PUBLIC RESPONSES: SUBSIDIES
• Pigouvian subsidy analysis
- The perceived MC schedule is MPC
+ cd. At output Q1, this is distance
ek (= eg + gk)
- But ek > MB, ge. As long as the MC
> MB at Q1, it is not sensible for
Bart to produce this last unit of
output.
- Instead, he should forgo its
production and accept the subsidy.
- Similarly, Bart does not produce
any output in excess of Q*.
PUBLIC RESPONSES: SUBSIDIES
• Pigouvian subsidy analysis
- All output levels to the right of Q*,
the sum of the MPC and the
subsidy > MB.
- All outputs to the left of Q*, it is
worthwhile for Bart to produce
even though he has to give up the
subsidy. For these output levels,
the total opportunity cost, MPC +
cd, is less than the MB. Hence, the
subsidy induces Bart to produce
just to Q*, the efficient output.
PUBLIC RESPONSES: SUBSIDIES
• Pigouvian subsidy analysis
- Distributional consequences of the
tax and subsidy schemes differ.
- Instead of paying the tax of ijcd,
Bart receives a payment equal to
the number of units of forgone
production, ch, times the subsidy
per unit, cd, which equals
rectangle dfhc.
PUBLIC RESPONSES: SUBSIDIES
• Pigouvian subsidy analysis
- Problems of implementation:
1. Subsidy leads to higher profits,
so in the long run, more firms
may be induced to locate along
the river. Subsidy may cause so
many new firms to relocate on
the river that total population
actually increases.
2. Subsidies may be ethically
undesirable.
PUBLIC RESPONSES: EMISSIONS
FEES
• The market for pollution reduction
- Horizontal axis: Bart’s annual level
of pollution reduction
- MSB – shows the marginal social
benefit to Lisa of each unit of
pollution Bart reduces. In other
words, MSB shows the fall in Lisa’s
costs for each unit of reduction in
Bart’s pollution.
- MSB is downward sloping, reflecting
our assumption that Lisa becomes
worse off at an increasing rate for
each additional unit of pollution.
PUBLIC RESPONSES:EMISSIONS
FEES
• The market for pollution reduction
- MC – shows the MC to Bart for
reducing each unit of pollution.
- Bart’s costs for reducing pollution
can stem from reducing output,
shifting to cleaner inputs, or
installing a new technology to
control pollution
- MC is upward sloping suggesting
that the cost to Bart of reducing
pollution increases at an increasing
rate.
PUBLIC RESPONSES:EMISSIONS
FEES
• The market for pollution reduction
- MC – shows the MC to Bart for
reducing each unit of pollution.
- Bart’s costs for reducing pollution
can stem from reducing output,
shifting to cleaner inputs, or
installing a new technology to
control pollution
- MC is upward sloping suggesting
that the cost to Bart of reducing
pollution increases at an increasing
rate.
PUBLIC RESPONSES:EMISSIONS
FEES
• The market for pollution reduction
- If Coasian bargaining does not occur
and the government does not
intervene, Bart has no incentive to
reduce pollution and will be at point
O.
- Efficient outcome is where Bart’s MC
of cutting pollution equals the MB to
Lisa of the pollution reduction, e*.
- At any point to the left of e*, the
benefit of further pollution
reduction outweighs the cost, so
more reduction improves efficiency.
PUBLIC RESPONSES: EMISSIONS
FEES
• The market for pollution reduction
- At any point to the right of e*, the
benefit of the last unit of pollution
reduced is not worth the cost of
doing so, so less reduction improves
efficiency.
- What can government do to attain
e*, the efficient amount of pollution
reduction?
1. Emissions fees
2. Cap-and-trade
3. Command-and-control regulation
PUBLIC RESPONSES: EMISSIONS
FEES
• Emission fee
- Works the same way as tax; the only
difference is that in this case a tax is
levied on each unit of pollution rather
than on each unit of output.
- With no emissions reduction, Bart is at
point O.
- Assume that the government levies
emissions fee that charges f* for each
unit of pollution.
- f* - marginal social benefit of pollution
reduction at the efficient level of e*.
PUBLIC RESPONSES: EMISSIONS
FEES
• Emission fee
- How does Bart respond?
- Bart incurs a cost of MC for each unit
he reduces emissions.
- With emissions fee in place, his tax bill
goes down by f* for each unit of
pollution he cuts.
- If the amount he saves in taxes per unit
exceeds the cost of reducing pollution
by another unit, Bart pollutes less.
f* > MC: Bart reduces pollution.
This holds at all points to the left of e*
PUBLIC RESPONSES: EMISSIONS
FEES
• Emission fee
Bart will cut back on polluting until
the efficient point.
Pollution is not reduced beyond e*
because the MC > his reduction in
taxes.
- This example shows that the
government can achieve the desired
amount of pollution reduction with
an emissions fee.
POSITIVE EXTERNALITIES
• Emission fee
Bart will cut back on polluting until the efficient point.
Pollution is not reduced beyond e* because the MC > his
reduction in taxes.
- This example shows that the government can achieve the desired
amount of pollution reduction with an emissions fee.
NUMERICAL EXAMPLE
• Emission fee
• MB = demand
• MB = 100 – 2Q
• MPC = 4Q
• To derive the
4Q = 100 – 2Q
6Q = 100
Q = 100/6