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THE ECONOMICS OF THE PUBLIC SECTOR
10
Externalities
Market Failure
• Recall from Chapter 7:
– Adam Smith had argued that the “invisible hand”
of the marketplace leads self-interested buyers and
sellers to an outcome in which the total surplus of
society is maximized.
But markets can fail. Why?
CHAPTER 10 EXTERNALITIES
3
EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality is the uncompensated impact of
one person’s actions on the well-being of a
bystander.
– Al’s action may affect the well-being of Betty, a
bystander.
– If Al pays no compensation (when his action has a
negative effect on Betty) nor receives a reward
(when his action has a positive effect on Betty), the
effect of Al’s action on Betty is called an
externality.
CHAPTER 10 EXTERNALITIES
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• In this case, Al will ignore the effects of his
action on Betty when deciding whether or not
to take the action
• Therefore, Al may take this action even if it is
undesirable for society
• And, conversely, Al may refuse to take this
action even if it is desirable for society
• In other words, when actions have external
effects, society’s total surplus might not be
maximized in the free market equilibrium
• Government intervention may be able to
increase total surplus
CHAPTER 10 EXTERNALITIES
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EXTERNALITIES AND MARKET
INEFFICIENCY
• When the impact of a person’s action on a
bystander is harmful, the externality is called a
negative externality.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.
CHAPTER 10 EXTERNALITIES
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Society and the Individual
Socially desirable activity
• To figure out the extent of
an activity that is ideal for
society, we need to
compare the benefits and
costs—to society—of an
additional unit of that
activity
Individually desirable activity
• To figure out the extent of
an activity that is ideal for
an individual, we need to
compare the benefits and
costs—to the individual—of
an additional unit of that
activity
Society and the Individual
Socially desirable activity
• An additional unit of an
activity is socially desirable
if and only if its social
benefit exceeds its social
cost
Individually desirable activity
• An additional unit of an
activity is individually
desirable if and only if its
individual benefit exceeds
its individual cost
Society and the Individual
Socially desirable activity
• An additional unit of an
activity is socially desirable
if and only if its social
benefit exceeds its social
cost
Social
benefits
Social
costs
Individually desirable activity
• An additional unit of an
activity is individually
desirable if and only if its
individual benefit exceeds
its individual cost
Individual
benefits
Individual
costs
Society and the Individual
Socially desirable activity
• An additional unit of an
activity is socially desirable
if and only if its social
benefit exceeds its social
cost
Individually desirable activity
• An additional unit of an
activity is individually
desirable if and only if its
individual benefit exceeds
its individual cost
When there are no externalities, there is no difference between social benefits and
individual benefits, and no difference between social costs and individual costs.
Social
benefits
Social
costs
Individual
benefits
Individual
costs
Society and the Individual
Socially desirable activity
• An additional unit of an
activity is socially desirable
if and only if its social
benefit exceeds its social
cost
Individually desirable activity
• An additional unit of an
activity is individually
desirable if and only if its
individual benefit exceeds
its individual cost
When there are no externalities, there is no difference between social benefits and
individual benefits, and no difference between social costs and individual costs.
Individual
benefits
Individual
costs
Individual
benefits
Individual
costs
Therefore, in this case, what’s individually ideal is also what’s socially ideal.
Therefore, the equilibrium quantity is also the optimum quantity, as Adam Smith had
argued.
Society and the Individual
Socially desirable activity
• An additional unit of an
activity is socially desirable
if and only if its social
benefit exceeds its social
cost
Individually desirable activity
• An additional unit of an
activity is individually
desirable if and only if its
individual benefit exceeds
its individual cost
But when there are positive and negative externalities,
social benefits = individual benefits + positive externalities, and
social costs = individual costs + negative externalities.
Individual
benefits +
positive
externalities
Individual
costs +
negative
externalities
Individual
benefits
Individual
costs
Therefore, what’s ideal for the individual may not be what’s ideal for society.
Society and the Individual
Socially desirable activity
Individually desirable activity
When there are positive externalities,
social benefits = individual benefits + positive externalities, and
social costs = individual costs.
Individual
benefits +
positive
externalities
Individual
costs
Individual
benefits
Individual
costs
Therefore, the individual ignores positive externalities that affect bystanders.
Therefore, an activity may be undesirable to the individual but desirable to society.
Therefore, when there are positive externalities, the equilibrium quantity of an
activity will be less than the optimum quantity of that activity.
Society and the Individual
Socially desirable activity
Individually desirable activity
When there are positive externalities,
social benefits = individual benefits + positive externalities, and
social costs = individual costs.
Individual
benefits +
positive
externalities
Individual
costs
Individual
benefits
Individual
costs
Therefore, the individual ignores positive externalities that affect bystanders.
Therefore, an activity may be undesirable to the individual but desirable to society.
Therefore, when there are positive externalities, the equilibrium quantity of an
activity will be less than the optimum quantity of that activity. But this problem can
be fixed (a) with corrective subsidies and (b) bargaining among the affected private
parties.
Society and the Individual
Socially desirable activity
Individually desirable activity
When there are negative externalities,
social benefits = individual benefits, and
social costs = individual costs + negative externalities.
Individual
benefits
Individual
costs +
negative
externalities
Individual
benefits
Individual
costs
The individual ignores negative externalities that affect bystanders. Therefore, an
activity may be desirable to the individual but undesirable to society. Therefore, when
there are negative externalities, the equilibrium quantity of an activity will be more
than the optimum quantity of that activity.
Society and the Individual
Socially desirable activity
Individually desirable activity
When there are negative externalities,
social benefits = individual benefits, and
social costs = individual costs + negative externalities.
Individual
benefits
Individual
costs +
negative
externalities
Individual
benefits
Individual
costs
The individual ignores negative externalities that affect bystanders. Therefore, an
activity may be desirable to the individual but undesirable to society. Therefore, when
there are negative externalities, the equilibrium quantity of an activity will be more
than the optimum quantity of that activity. But this problem can be fixed (a) with
corrective taxes and (b) bargaining among the affected private parties.
Corrective Taxes and Subsidies
• We have just seen that when externalities
exist the equilibrium outcome may not be the
same as the optimum outcome
• But we have seen before that a tax reduces
the equilibrium output and a subsidy
increases the equilibrium output
• Therefore, any gap between the equilibrium
and optimum outputs can be closed with
taxes and subsidies
CHAPTER 10 EXTERNALITIES
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Society and the Individual
Socially desirable activity
Individually desirable activity
When the individual receives a subsidy equal to the positive external effects of the
activity, …
Individual
benefits +
positive
externalities
Individual
costs
Individual
benefits +
subsidy (positive
externalities)
Individual
costs
… the individual can no longer ignore the positive externalities that affect bystanders.
Therefore, in this case, what’s individually ideal is also what’s socially ideal, and the
equilibrium quantity is also the optimum quantity.
A subsidy like this is unusual because it increases the total surplus. Such corrective
subsidies are called Pigovian subsidies .
Society and the Individual
Socially desirable activity
Individually desirable activity
When the individual has to pay a tax equal to the negative external effects of the
activity, …
Individual
benefits
Individual
costs +
negative
externalities
Individual
benefits
Individual
costs +
Tax (negative
externalities)
… the individual can no longer ignore the negative externalities that affect bystanders.
Therefore, in this case, what’s individually ideal is also what’s socially ideal, and the
equilibrium quantity is also the optimum quantity.
A tax like this is unusual because it increases the total surplus. Such corrective taxes are
called Pigovian taxes.
Coase Theorem: Private Bargaining
• When private citizens can bargain with each
other without too much difficulty, the
equilibrium and optimum outcomes may be
brought closer to each other without the need
for government intervention (in the form of
Pigovian taxes and subsidies).
CHAPTER 10 EXTERNALITIES
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Negative Externalities
•
•
•
•
•
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
The Club, an anti-theft device for cars
CHAPTER 10 EXTERNALITIES
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Dealing with negative externalities
• Should we completely ban an activity that has
negative externalities?
–
–
–
–
–
Should we ban all cars?
Should we ban all smoking in public spaces?
Should we muzzle all dogs?
Should we ban stereos in apartment buildings?
Should we ban The Club?
CHAPTER 10 EXTERNALITIES
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Dealing with negative externalities
• How should we determine the extent to which
activities that have negative externalities
should be tolerated?
• We can evaluate virtually any policy proposal
by asking how it would affect total surplus.
– Recall from Chapter 7, the concept of total
surplus.
CHAPTER 10 EXTERNALITIES
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Positive Externalities
•
•
•
•
•
Immunizations
Education
Restored historic buildings
Research into new technologies
LoJack, an anti-theft device for cars
CHAPTER 10 EXTERNALITIES
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Externalities can cause markets to become
inefficient.
–We saw in chapter 7 that total surplus is
maximized in a perfectly competitive economy.
– But when there are externalities, this is no longer
true:
•total surplus might be less than the maximum
achievable.
• This might provide a justification for
government intervention.
CHAPTER 10 EXTERNALITIES
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EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative externalities from the production or
consumption of a good can cause markets to
produce more than is socially desirable.
• Positive externalities cause markets to produce
less than is socially desirable.
• If and when markets fail (to produce the
socially desirable quantity), government
intervention may be necessary.
CHAPTER 10 EXTERNALITIES
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Figure 1 The Market for Aluminum
When there are no externalities in
aluminum production or
consumption, the equilibrium
quantity (QMARKET) maximizes social
surplus.
Price of
Aluminum
Supply
(private cost)
Equilibrium
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
Welfare Economics Without Externalities: A Recap
• When there are no externalities, the
equilibrium quantity:
– is efficient
– maximizes total surplus
• Total surplus = total benefits – total costs
– is the socially desirable quantity
CHAPTER 10 EXTERNALITIES
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Social, private, and external costs
• When the production of aluminum causes
pollution …
• Social cost of aluminum = private cost +
external cost
• Private cost is the cost to aluminum producers
of the raw materials and labor used in
production
• External cost is the cost to bystanders of
having to deal with the effects of pollution
CHAPTER 10 EXTERNALITIES
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Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Optimum
A
Supply
(private cost)
Total Surplus
G
B
E F
C
D
H I
J
K
Equilibrium
Equilibrium
ABCD – G
Optimum
ABCD
L
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Public Policies for Negative Externalities
• What can be done to get the market to reduce
production to the socially optimal level?
Price of
Aluminum
Social
cost
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
CHAPTER 10 EXTERNALITIES
QOPTIMUM QMARKET
Quantity of
Aluminum
35
Market-Based Policy: Put a Tax on Negative
Externalities
• Either the producers or the consumers (or both) of
aluminum can be taxed
– We saw in chapter 6 that a tax reduces the equilibrium
output, and that is exactly what we want.
• A tax solves the problem by forcing the consumers
and producers of aluminum to internalize the
externality of aluminum
– Internalizing an externality involves altering incentives so
that people take account of the external effects of their
actions.
CHAPTER 10 EXTERNALITIES
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Recall: The Effect of a Tax
Price
Price buyers pay
Supply
Tax
Price without tax
Price sellers
receive
Demand
0
Quantity after tax
Quantity before tax
Quantity
Negative externalities should be taxed
• When there are negative externalities, the
free market equilibrium output exceeds the
socially optimum output
• Therefore, it is socially desirable to reduce
output
• A tax would reduce output
• Therefore, a tax is a socially desirable
response to a negative externality
• But how big should the tax be?
CHAPTER 10 EXTERNALITIES
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Tax > External Cost is too much
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Tax
Equilibrium
Desired output
reduction
Demand
(private value)
0
The tax is too large and
reduces output too much
QOPTIMUM QMARKET
Quantity of
Aluminum
Tax < External Cost is too little
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Supply
(private cost)
Optimum
Tax
Equilibrium
Desired output
reduction
The tax is too small and
reduces output too little
0
QOPTIMUM QMARKET
Demand
(private value)
Quantity of
Aluminum
Tax = External Cost solves the problem!
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Optimum
Tax
Equilibrium
Now the tax is exactly
equal to the external
cost. It reduces the
quantity by exactly the
ideal amount.
0
QOPTIMUM QMARKET
Supply
(private cost)
We saw earlier that reducing
output from QMARKET to
QOPTIMUM increases total
surplus.
Now we see that a tax can do
this. (So, unlike what we saw in
Chapter 8, not all taxes reduce
total surplus.) This is a
Pigovian tax.
Demand
(private value)
Quantity of
Aluminum
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Unit Cost of
pollution
Optimum
Equilibrium
Supply
(private cost)
Another way to ensure
that QOPTIMUM is produced
is to use tradable pollution
permits.
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Tradable Pollution Permits
• The government can do the following:
– require permits for aluminum production
– issue QOPTIMUM permits by auctioning them off
• Each permit will sell for a price equal to the
unit cost of pollution
• The effect will be identical to a Pigovian tax
equal to the unit cost of pollution
CHAPTER 10 EXTERNALITIES
43
Tradable Pollution Permits
• The price of each tradable pollution permit
will be equal to the unit cost of pollution
• Why?
CHAPTER 10 EXTERNALITIES
44
Positive Externalities: Examples
• A technology spillover is a positive externality
that is created when a firm’s innovation not
only benefits the firm, but enters society’s pool
of technological knowledge and benefits
society as a whole.
• Education benefits the student and also all
members of society who are affected by the
student
CHAPTER 10 EXTERNALITIES
46
Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QMARKET
QOPTIMUM
Social
value
Quantity of
Education
Total Surplus
Figure 3 Education and the Social Optimum
Price of
Education
Equilibrium
AB
Optimum
ABF
Supply
(private cost)
A
F
E
Equilibrium
B
Optimum
C
D
Demand
(private value)
0
QMARKET
QOPTIMUM
Social
value
Quantity of
Education
Supply-Demand and Positive Externalities
• The intersection of the supply curve and the
social-value curve determines the optimal
output level.
– The optimal output level is more than the
equilibrium quantity.
– The market produces a smaller quantity than is
socially desirable.
– The social value of the good exceeds the private
value of the good.
CHAPTER 10 EXTERNALITIES
50
Subsidies for positive externalities
• What can be done to get the market to
increase education to the optimal level?
• A subsidy for either students (buyers of
education) or educational institutions (sellers)
will work.
• A subsidy will make students and educational
institutions internalize the positive externality
of education
CHAPTER 10 EXTERNALITIES
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Subsidies for Positive Externalities: example
• Recall that technology spillovers are positive
externalities
• Therefore, the equilibrium level of spending on
research will be less than the socially desirable
level
• Government intervention may promote
technology-enhancing industries
– Patent laws are a form of technology policy that give
the individual (or firm) with patent protection a
property right over its invention.
– The patent is then said to internalize the externality.
CHAPTER 10 EXTERNALITIES
52
PRIVATE SOLUTIONS TO EXTERNALITIES
• Government action is not always needed to
solve the problem of externalities.
• In some cases, the free market ends up
maximizing total surplus even when there are
externalities
CHAPTER 10 EXTERNALITIES
53
PRIVATE SOLUTIONS TO EXTERNALITIES
•
•
•
•
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting (bargaining, negotiations) between
those causing the externalities and those
affected by the externalities
CHAPTER 10 EXTERNALITIES
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The Coase Theorem
• The Coase Theorem is the proposition—
due to Ronald Coase—that if people
can bargain without transaction costs
over the allocation of resources, they
can solve the problem of externalities
on their own.
– Transaction costs are the costs that people
incur in the process of agreeing to and
following through on a bargain.
CHAPTER 10 EXTERNALITIES
55
Bob, Spot, and Jane and Ronald Coase
Bob and Jane are room mates. Bob gets Spot, a noisy dog, as a birthday gift.
Benefit = $500; Cost =
$800
Benefit = $1000; Cost =
$800
Social optimum
Bob returns Spot
Bob keeps Spot
Government solution
Bob forced to pay $800 tax. No action required. Bob
Bob returns Spot
keeps Spot
Private solution: Jane has
right to quiet
Jane sues to enforce her
right. Bob can’t afford to
pay Jane a big enough
bribe. Bob returns Spot
Bob pays Jane $800. Bob
keeps Spot
Private solution: Bob has
right to keep Spot
Jane pays Bob $500. Bob
returns Spot
Jane can’t afford to pay
Bob a big enough bribe.
Bob keeps Spot
Coase Theorem: Private solutions to externalities can work
56
Dick, Spot, and Jane and Ronald Coase
• Note that when the free market outcome is
not optimal, bargaining between Bob and Jane
will bring about the optimal outcome,
irrespective of who is favored by the law
– The law is important in other ways, however. For
example, in one case in which the law favors Bob ,
Jane has to pay a $500 compensation to Bob to
get him to return Spot
CHAPTER 10 EXTERNALITIES
57
Coase Theorem: Exercise
• In the case of pollution by an aluminum
factory, how might production of the socially
desirable amount be brought about without
taxation by the government?
• Why might Coase’s solution fail, as a practical
matter, in this case?
CHAPTER 10 EXTERNALITIES
58
Why Private Solutions Do Not Always Work
• Sometimes the private solution fails because
transaction costs are so high that private
agreement is not possible.
– Bob might get greedy and try to haggle with Jane
for more than $500
– Change the story by substituting three people (Jan,
Jeanne and Joan) instead of Jane. Jan, Jeanne and
Joan may find it hard to raise $500 for Bob’s
compensation. Each might try to free ride on the
others.
CHAPTER 10 EXTERNALITIES
59
PUBLIC POLICY TOWARD EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through…
– command-and-control policies.
– market-based policies.
CHAPTER 10 EXTERNALITIES
60
PUBLIC POLICY: Command-and-Control
Policies
– Such policies usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
– Examples:
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
CHAPTER 10 EXTERNALITIES
61
PUBLIC POLICY: MARKET-BASED POLICIES
• Taxes and subsidies can align private
incentives with social efficiency.
– We have seen this already
– These corrective taxes and subsidies
are called Pigovian taxes and subsidies.
• They were originally proposed by the
British economist, A. C. Pigou.
CHAPTER 10 EXTERNALITIES
62
PUBLIC POLICY TOWARD POLLUTION:
Command-and-Control
• If the EPA decides it wants to reduce the
amount of pollution coming from a specific
plant, it could…
– tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
– levy a tax of a given amount for each unit of
pollution the firm emits (i.e. Pigovian tax).
CHAPTER 10 EXTERNALITIES
63
PUBLIC POLICY TOWARD POLLUTION:
Market-Based
• Pigovian Taxes on the producers or consumers
of pollution
• Tradable pollution permits that allow the
voluntary transfer of the right to pollute from
one firm to another.
– A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
CHAPTER 10 EXTERNALITIES
64
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigovian
tax sets the
price of
pollution . . .
Demand for
pollution rights
0
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits
(b) Pollution Permits
Price of
Pollution
Supply of
pollution permits
P
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Q
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
Policy Exercises
• Should we punish the use of SUV’s and
promote the use of smaller cars?
• Should we force car makers to sell cars with
higher mileage?
• Should we limit the use of gasoline by each
car owner?
• Should we tax gasoline?
• Should we tax all fuels based on the damage
each fuel causes?
CHAPTER 10 EXTERNALITIES
67
Any Questions?
CHAPTER 10 EXTERNALITIES
68
Summary
• When a transaction between a buyer and a
seller directly affects a third party, the effect is
called an externality.
• Negative externalities cause the socially
optimal quantity in a market to be less than
the equilibrium quantity.
• Positive externalities cause the socially optimal
quantity in a market to be greater than the
equilibrium quantity.
CHAPTER 10 EXTERNALITIES
69
Summary
• Those affected by externalities can sometimes
solve the problem privately.
• The Coase theorem states that if people can
bargain without a cost, then they can always
reach an agreement in which resources are
allocated efficiently.
CHAPTER 10 EXTERNALITIES
70
Summary
• When private parties cannot adequately deal
with externalities, then the government steps
in.
• The government can either regulate behavior
or internalize the externality by using Pigovian
taxes or by issuing pollution permits.
CHAPTER 10 EXTERNALITIES
71