Download The Study of Economics

THIRD EDITION
ECONOMICS
and
MICROECONOMICS
Paul Krugman | Robin Wells
Chapter 16
Externalities
WHAT YOU
WILL LEARN
IN THIS
CHAPTER
• What externalities are and why they can
lead to inefficiency and government
intervention in a market
• The difference between negative,
positive, and network externalities
• The importance of the Coase theorem,
which explains how private individuals
can sometimes solve externalities
• Why some government policies to deal
with externalities—such as emissions
taxes, tradable permits, or Pigouvian
subsidies—are efficient, but others—like
environmental standards—are
inefficient
The Economics of Pollution
• Pollution is a bad thing.
 Yet most pollution is a side effect of activities that provide us
with good things.
 Our air is polluted by power plants that generate the
electricity that lights our cities, and our rivers are damaged by
fertilizer runoff from farms that grow our food.
• Pollution is a side effect of useful activities, so the optimal
quantity of pollution isn’t zero.
• Then, how much pollution should a society have? What are
the costs and benefits of pollution?
Costs and Benefits of Pollution
• The marginal social cost of pollution is the additional cost
imposed on society as a whole by an additional unit of
pollution.
• The marginal social benefit of pollution is the additional gain
to society as a whole from an additional unit of pollution.
• The socially optimal quantity of pollution is the quantity of
pollution that society would choose if all the costs and
benefits of pollution were fully accounted for.
The Socially Optimal Quantity of Pollution
Marginal social
cost, marginal
social benefit
Marginal social cost,
MSC, of pollution
Socially
optimal point
O
$200
Marginal social benefit,
MSB, of pollution
0
Q
OPT
Socially optimal
quantity of pollution
Quantity of
pollution
emissions (tons)
Pollution: An External Cost
• An external cost is an uncompensated cost that an individual
or firm imposes on others.
• An external benefit is a benefit that an individual or firm
confers on others without receiving compensation.
Pollution: An External Cost
• Pollution is an example of an external cost, or negative
externality; in contrast, some activities can give rise to
external benefits, or positive externalities.
• External costs and benefits are known as externalities.
• Left to itself, a market economy will typically generate too
much pollution because polluters have no incentive to take
into account the costs they impose on others.
A Market Economy Produces Too Much Pollution
Marginal social
cost, marginal
social benefit
MSC of pollution
Marginal
social cost $400
at QMKT
The market
outcome is
inefficient:
marginal
social cost
of pollution
exceeds
marginal
social
benefit
300
Optimal
Pigouvian tax
on pollution
O
200
100
Marginal
social
benefit at
QMKT
0
MSB of pollution
Q
OPT
Socially optimal
quantity of pollution
Q
H
Q
MKT
Market-determined
quantity of pollution
Quantity of pollution
emissions
(tons)
FOR INQUIRING MINDS
TALKING, TEXTING, AND DRIVING
• Traffic safety experts take the risks posed by driving while
using a cell phone very seriously: A recent study found a sixfold increase in accidents caused by driving while distracted.
 And using hands-free, voice-activated phones to make a call
doesn’t seem to help much because the main danger is
distraction.
• Why not leave the decision up to the driver?
 Because the risk posed by driving while using a cell phone isn’t
just a risk to the driver; it’s also a safety risk to others—to a
driver’s passengers, pedestrians, and people in other cars.
FOR INQUIRING MINDS
TALKING, TEXTING, AND DRIVING
• Even if you decide that the benefit to you of using your cell
phone while driving is worth the cost, you aren’t taking into
account the cost to other people.
 Driving while using a cell phone, in other words, generates a
serious negative externality.
Private Solutions to Externalities
• In an influential 1960 article, the economist Ronald Coase
pointed out that, in an ideal world, the private sector could
indeed deal with all externalities.
• According to the Coase theorem, even in the presence of
externalities, an economy can always reach an efficient
solution provided that the transaction costs—the costs to
individuals of making a deal—are sufficiently low.
• The costs of making a deal are known as transaction costs.
Private Solutions to Externalities
• The implication of Coase’s analysis is that externalities need
not lead to inefficiency because individuals have an incentive
to find a way to make mutually beneficial deals that lead
them to take externalities into account when making
decisions.
• When individuals do take externalities into account,
economists say that they internalize the externality.
• Why can’t individuals always internalize externalities?
• Transaction costs prevent individuals from making efficient
deals.
Private Solutions to Externalities
Examples of transaction costs include the following:
• The costs of communication among the interested
parties—costs that may be very high if many people are
involved.
• The costs of making legally binding agreements that may
be high if doing so requires the employment of
expensive legal services.
• Costly delays involved in bargaining—even if there is a
potentially beneficial deal, both sides may hold out in an
effort to extract more favorable terms, leading to
increased effort and forgone utility.
ECONOMICS IN ACTION
Thank You for Not Smoking
• Second-hand smoke is an example of a negative externality.
But how important is it?
• A paper published in 1993 in the Journal of Economic
Perspectives found that valuing the health costs of
cigarettes depends on whether you count the costs
imposed on members of smokers’ families.
• If you don’t, the external costs of second-hand smoke have
been estimated at about only $0.19 per pack smoked.
ECONOMICS IN ACTION
Thank You for Not Smoking
• A 2005 study raised this estimate to $0.52 per pack
smoked. If you include effects on smokers’ families, the
number rises considerably.
• If you include the effects of smoking by pregnant women
on their unborn children’s future health, the cost is
immense: $4.80 per pack.
Policies Toward Pollution
 Environmental standards are rules that protect the
environment by specifying actions by producers and
consumers. Generally such standards are inefficient because
they are inflexible.
 An emissions tax is a tax that depends on the amount of
pollution a firm produces.
 Tradable emissions permits are licenses to emit limited
quantities of pollutants that can be bought and sold by
polluters.
 Taxes designed to reduce external costs are known as
Pigouvian taxes.
GLOBAL COMPARISON
Economic Growth and Greenhouse Gases in Six Countries
A more meaningful way to compare pollution across countries is to measure
emissions per $1 million of a country’s GDP, as shown in panel (b). On this basis, the
United States, Canada, India, and Australia are now “green” countries, but China
and Uzbekistan are not. What explains the reversal once GDP is accounted for? The
answer: both economics and government behavior.
GLOBAL COMPARISON
• First, there is the issue of economics.
 Countries that are poor and have begun to industrialize, such
as China and Uzbekistan, often view money spent to reduce
pollution as better spent on other things.
 From their perspective, they are still too poor to afford an
environment as clean as wealthy advanced countries.
 They claim that to impose a wealthy country’s environmental
standards on them would jeopardize their economic growth.
GLOBAL COMPARISON
• Second, there is the issue of government behavior—or
more precisely, whether a government possesses the tools
necessary to effectively control pollution.
 China is a good illustration of this problem.
 The Chinese government lacks sufficient regulatory power to
enforce its own environmental rules, promote energy
conservation, or encourage pollution reduction.
• To produce $1 of GDP, China spends three times the world
average on energy—far more than Indonesia, for example,
which is also a poor country.
 The case of China illustrates just how important government
intervention is in improving society’s welfare in the presence
of externalities.
Environmental Standards versus Emissions Taxes
(a) Environmental Standard
Marginal
benefit to
individual
polluter
$600 MBB
300
MB
A
150
0
Environmental
standards
forces both
plants to cut
emission by
half
(b) Emissions Taxes
Marginal
benefit to
individual
polluter
$600 MBB
S
B
MB
A
200
S
A
300
T
A
T
B
200
400
Emissions
tax
600
Without
government
action, each
plant emits 600
tons
Quantity of
pollution
emissions
(tons)
0
Plant A has a lower
marginal benefit of
pollution and reduces
emissions by 400 tons
600
Quantity of
pollution
emissions
(tons)
Plant B has a higher
marginal benefit of
pollution and reduces
emissions by only 200
tons
Policies Toward Pollution
• When the quantity of pollution emitted can be directly
observed and controlled, environmental goals can be
achieved efficiently in two ways: emissions taxes and
tradable emissions permits.
• These methods are efficient because they are flexible,
allocating more pollution reduction to those who can do it
more cheaply.
• An emissions tax is a form of Pigouvian tax, a tax designed to
reduce external costs.
• The optimal Pigouvian tax is equal to the marginal social cost
of pollution at the socially optimal quantity of pollution.
Production, Consumption, and Externalities
• When there are external costs, the marginal social cost of a
good or activity exceeds the industry’s marginal cost of
producing the good.
• In the absence of government intervention, the industry
typically produces too much of the good.
• The socially optimal quantity can be achieved by an optimal
Pigouvian tax, equal to the marginal external cost, or by a
system of tradable production permits.
Positive Externalities and Consumption
(a) Positive Externality
(b) Optimal Pigouvian Subsidy
Price, marginal social
benefit of flu shot
Price of flu shot
Marginal
external
benefit
PMSB
POPT
PMKT
S
S
Price to
producers
after subsidy
O
EMKT
MSB of
flu shots
D
QMKT QOPT
Optimal
Pigouvian
subsidy
O
EMKT
Price to
consumers
after subsidy
Quantity of
flu shots
D
QMKT QOPT
Quantity of
flu shots
Private versus Social Benefits
• The marginal social benefit of a good or activity is equal to
the marginal benefit that accrues to consumers, plus its
marginal external benefit.
Private versus Social Benefits
• A Pigouvian subsidy is a payment designed to encourage
activities that yield external benefits.
• A technology spillover is an external benefit that results
when knowledge spreads among individuals and firms.
 The socially optimal quantity can be achieved by an optimal
Pigouvian subsidy equal to the marginal external benefit.
• An industrial policy is a policy that supports industries
believed to yield positive externalities.
Private versus Social Costs
• The marginal social cost of a good or activity is equal to the
marginal cost of production, plus its marginal external cost.
Negative Externalities and Production
Price,
marginal
(a) Negative Externality
social cost
of livestock
(b) Optimal Pigouvian Tax
Price of
livestock
MSC of
livestock
Marginal
external
cost
PMSC
S
Price to
consumers
after tax
S
POPT
PMKT
Optimal
Pigouvian
Tax
EMKT
D
QOPT QMKT
Quantity of
livestock
EMKT
Price to
producers
after tax
D
QOPT QMKT
Quantity of
livestock
ECONOMICS IN ACTION
The Impeccable Economic Logic of Early Childhood
Intervention Programs
• One problem facing any society is how to break what
researchers call the “cycle of poverty.”
• Children who grow up with disadvantaged socioeconomic
backgrounds are far more likely to also be poor adults.
• A 2006 study found that high-quality early childhood
programs focused on education and health care lead to
significant advantages for kids.
ECONOMICS IN ACTION
The Impeccable Economic Logic of Early Childhood
Intervention Programs
• Children in programs were less likely to engage in destructive
behaviors and more likely to end up with a job and to earn a
higher salary later in life.
• Another study in 2003 looked at early childhood intervention
programs from a dollars-and-cents perspective, finding from
$4 to $7 in benefits for every $1 spent on early childhood
intervention programs.
Network Externalities
• A good is subject to a network externality when the value of
the good to an individual is greater when a large number of
other people also use the good.
• Examples include:
 communication systems: telephones, telegraphs, fax
machines, etc.
 railway systems
 air travel: hub and spoke
Network Externalities
• Any way in which other people’s consumption of a good
increases your own marginal benefit from consumption of
that good can give rise to network effects.
 Example: computer operating systems like Windows
Network Externalities
• Windows is used widely so it attracts more attention from
software developers.
 As a result, there are more programs that run on Windows
than on any other operating system.
• A good is subject to positive feedback when success breeds
greater success and failure breeds failure.
ECONOMICS IN ACTION
THE MICROSOFT CASE
• In 2000 the Justice Department took on Microsoft in one of
the most watched antitrust cases in history.
 By that time, Microsoft had become the world’s most valuable
corporation, and its founder, Bill Gates, was the world’s richest
man.
ECONOMICS IN ACTION
THE MICROSOFT CASE
• The case involved almost all of the issues raised by goods
with network externalities.
 Microsoft was, by any reasonable definition, a monopoly:
leaving aside the niches of Apple customers and Linux users,
just about all personal computers ran the Windows operating
system.
 The key fact sustaining the Windows system was the force of a
network externality: people used Windows because other
people used Windows.
ECONOMICS IN ACTION
THE MICROSOFT CASE
• What the government claimed, however, was that Microsoft
had used its monopoly position in operating systems to give
its other products an advantage over competitors.
ECONOMICS IN ACTION
THE MICROSOFT CASE
• Why was this considered harmful? The government argued
both that monopolies were being created unnecessarily and
that Microsoft was discouraging innovation.
 Potential innovators in software, the government claimed,
were unwilling to invest large sums out of fear that Microsoft
would use its control of the operating system to take away any
market competitors might win.
 Microsoft would produce a competing product that would
then be sold as a bundle with the Windows operating system.
ECONOMICS IN ACTION
THE MICROSOFT CASE
• For its part, Microsoft argued that by setting the precedent
that companies would be punished for success, the
government was the real opponent of innovation—
innovation that had benefited customers with lower prices
and increasingly sophisticated products.
• In November 2001, the government reached a settlement
with Microsoft in which the company agreed to provide
other companies with the technology to develop products
that interacted seamlessly with Microsoft’s software, thus
removing the company’s special advantage acquired
through bundling its products.
VIDEO
 PBS News: Who Do You Hurt When You Walk Away?
 More from the strategic default debate today
 Economist Luigi Zingales of the University of Chicago argues
there are damaging spillover effects (negative externalities)
when homeowners strategically default.
 "By walking away, not only do you damage the lenders,"
Zingales said, "but you damage the community which you
leave and you damage everybody else who in the future will
try to borrow because the cost of borrowing will be higher."
http://www.pbs.org/newshour/businessdesk/2011/01/whodo-you-hurt-when-you-walk.html
Summary
1. When pollution can be directly observed and controlled,
government policies should be geared directly to producing
the socially optimal quantity of pollution, the quantity at
which the marginal social cost of pollution is equal to the
marginal social benefit of pollution.
2. The costs to society of pollution are an example of an
external cost; in some cases, however, economic activities
yield external benefits. External costs and benefits are
jointly known as externalities, with external costs called
negative externalities and external benefits called positive
externalities.
Summary
3. According to the Coase theorem, individuals can find a way
to internalize the externality, making government
intervention unnecessary, as long as transaction costs—the
costs of making a deal—are sufficiently low.
4. Governments often deal with pollution by imposing
environmental standards, a method, economists argue,
that is usually an inefficient way to reduce pollution. Two
efficient (cost-minimizing) methods for reducing pollution
are emissions taxes, a form of Pigouvian tax, and tradable
emissions permits. The optimal Pigouvian tax on pollution
is equal to its marginal social cost at the socially optimal
quantity of pollution.
Summary
5. When a good or activity yields external benefits, such as
technology spillovers, the marginal social benefit of the
good or activity is equal to the marginal benefit accruing to
consumers plus its marginal external benefit.
Without government intervention, the market produces
too little of the good or activity. An optimal Pigouvian
subsidy to producers, equal to the marginal external
benefit, moves the market to the socially optimal quantity
of production. This yields higher output and a higher price
to producers. It is a form of industrial policy, a policy to
support industries that are believed to generate positive
externalities.
Summary
6. When only the original good or activity can be controlled,
government policies are geared to influencing how much of
it is produced. When there are external costs from
production, the marginal social cost of a good or activity
exceeds its marginal cost to producers, the difference being
the marginal external cost.
Without government action, the market produces too
much of the good or activity. The optimal Pigouvian tax on
production of the good or activity is equal to its marginal
external cost, yielding lower output and a higher price to
consumers. A system of tradable production permits for
the right to produce the good or activity can also achieve
efficiency at minimum cost.
Summary
7. Communications, transportation, and high-technology
goods are frequently subject to network externalities,
which arise when the value of the good to an individual is
greater when a large number of people use the good. Such
goods are likely to be subject to positive feedback: if large
numbers of people buy the good, other people are more
likely to buy it, too.
Producers have an incentive to take aggressive action in the
early stages of the market to increase the size of their
network. Markets with network externalities tend to be
monopolies.
Key Terms
• Marginal social cost of
pollution
• Marginal social benefit of
pollution
• Socially optimal quantity of
pollution
• External cost
• External benefit
• Externalities
• Negative externalities
• Positive externalities
• Coase theorem
• Transaction costs
•
•
•
•
•
•
•
•
Internalize the externality
Environmental standards
Emissions tax
Pigouvian tax
Tradable emissions permits
Pigouvian subsidy
Technology spillover
Positive feedback