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© 2013 Pearson
How can we limit climate change?
© 2013 Pearson
10
Externalities
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain why negative externalities lead to inefficient
overproduction and how property rights, pollution charges,
and taxes can achieve a more efficient outcome.
2 Explain why positive externalities lead to inefficient
underproduction and how public provision, subsidies, and
vouchers can achieve a more efficient outcome.
© 2013 Pearson
EXTERNALITIES IN OUR DAILY LIVES
An externality is a cost or a benefit that arises from:
• Production that falls on someone other than the
producer
• Consumption that falls on someone other than the
consumer
Negative externality
A production or consumption activity that creates an
external cost.
Positive externality
A production or consumption activity that creates an
external benefit.
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EXTERNALITIES IN OUR DAILY LIVES
Four types of externalities:
• Negative production externalities
• Positive production externalities
• Negative consumption externalities
• Positive consumption externalities
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EXTERNALITIES IN OUR DAILY LIVES
Negative Production Externalities
Pollution is the major example of this type of
externality.
Others are noise and congestion.
Positive Production Externalities
Example: Orchards provide positive production
externalities to honey producers, who in turn provide
positive production externalities to orchards.
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EXTERNALITIES IN OUR DAILY LIVES
Negative Consumption Externalities
Smoking tobacco in a confined space
Noisy parties
Positive Consumption Externalities
Education is a major example of this type of externality.
Others are a flu vaccination and restoration of an
historic building
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Private Costs and Social Costs
Marginal private cost is the cost of producing an
additional unit of a good or service that is borne by the
producer of that good or service.
Marginal external cost is the cost of producing an
additional unit of a good or service that falls on people
other than the producer.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Marginal social cost is the marginal cost incurred by
the entire society—by the producer and by everyone
else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal
private cost (MC) and marginal external cost.
MSC = MC + Marginal external cost
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.1 shows the
relationship between cost
and output.
When output is 4,000 tons
of chemicals a month:
1. Marginal private
cost is $100 a ton.
2. Marginal external
cost is $125 a ton.
3. Marginal social cost is
$225 a ton.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Production and Pollution: How Much?
When an industry is unregulated, the amount of
pollution it creates depends on the market equilibrium
price and the quantity of the good produced.
If the industry creates an external cost, the market
equilibrium is inefficient. Too much of the good is
produced.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.2 shows
inefficiency with an
external cost.
1. The market is in
equilibrium at a price
of $100 a ton and
4,000 tons of chemical
a month is inefficient.
2. Marginal social cost
exceeds ...
3. Marginal benefit.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
4. The efficient quantity is
2,000 tons of chemical,
where marginal social
cost equals marginal
benefit.
5. The gray triangle
shows the deadweight
loss created by the
pollution externality.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Property Rights
Property rights are legally established titles to the
ownership, use, and disposal of factors of production
and goods and services that are enforceable in the
courts.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.3 shows
how property rights
achieve an efficient
outcome.
1. With property
rights, the MC curve
that excludes the
cost of pollution
shows only part of
the producers’
marginal cost.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
2. The marginal
private cost curve
includes the cost of
pollution, and the
supply curve is
S = MC.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
3. Market equilibrium
is at a price of $150
a ton and a quantity
of 2,000 tons of
chemical a month
and is efficient
because…
4. Marginal social
cost equals
marginal benefit.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
The Coase Theorem
Coase theorem is the proposition that if property
rights exist, only a small number of parties are involved,
and transactions costs are low, then private
transactions are efficient and the outcome is not
affected by who is assigned the property right.
Transactions costs are the opportunity costs of
conducting a transaction.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Application of the Coase Theorem
• If factories own homes and river, the rent people
willingly pay decreases as the amount of pollution
increases.
• If homeowners own the river, factories must pay
homeowners for any pollution, and the more they
pollute, the more they pay.
• Regardless of who owns the river, so long as someone
owns it, the factories bear the cost of pollution, and the
quantity of production and pollution are efficient.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Government Actions in the Face of External
Costs
The three main methods that governments can use to
achieve a more efficient allocation of resources in the
presence of external costs are
• Pollution limits
• Pollution charges or taxes
• Marketable permits (cap-and-trade)
© 2013 Pearson
10.1 NEGATIVE EXTERNALITIES: POLLUTION
Pollution Limits
A pollution limit seeks an efficient
outcome by placing a quantity
limit on a polluting activity.
The 1990 Clean Air Act
administered by the
Environmental Protection Agency
(EPA) employs this method.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.4 shows the
effects of a pollution limit.
1. A pollution limit is
imposed that restricts
production to the efficient
quantity.
2. The efficient market
equilibrium pollution limit
is achieved.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
3. The market price is
equal to marginal
benefit, MB, and
marginal social
benefit, MSB.
4. Because the price
exceeds marginal
cost, producers get
a producer surplus
equal to the area of
the blue rectangle.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Pollution Charges or Taxes
Pollution charges or pollution taxes confront the
producers with the external cost of pollution and
provide an incentive to seek technologies that are less
polluting.
To work out the pollution charge or pollution tax that
achieves efficiency, the regulator needs a lot of
information about the industry, which is generally not
available.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Marketable Pollution Permits (Cap-and-Trade)
A marketable pollution permit seeks an efficient
outcome by assigning or selling pollution rights to each
producer in an industry.
Producers can buy and sell permits in the market.
Producers with a low marginal cost of reducing
pollution will sell permits and producers with a high
marginal cost of reducing pollution will buy.
Producers will buy and sell permits until their marginal
cost of pollution equals the market price of a permit.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.5 shows the
effects of a pollution
charge or pollution tax.
1. A pollution charge or tax
is imposed that is equal to
the marginal external cost
of pollution.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
The supply curve becomes
the marginal private cost
curve, MC, plus the tax—the
curve labeled
S = MC + tax.
Because the charge or tax
equals the marginal external
cost, the MSC curve
becomes the supply curve.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
2. Market equilibrium
at a price of $150 a
ton and 2,000 tons
of chemical a month
is efficient
because…
3. Marginal social cost
equals marginal
benefit.
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10.1 NEGATIVE EXTERNALITIES: POLLUTION
4. The government
collects revenue
equal to the area
of the purple
rectangle.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Private Benefits and Social Benefits
Marginal private benefit is the benefit of an
additional unit of a good or service that the consumer of
that good or service receives.
Marginal external benefit is the benefit of an
additional unit of a good or service that people other
than the consumer of the good or service enjoy.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Marginal social benefit is the marginal benefit
enjoyed by society—by the consumer of a good or
service and by everyone else who benefits from it.
Marginal social benefit (MSB) is the sum of marginal
private benefit (MB) and marginal external benefit.
MSB = MB + Marginal external benefit
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Figure 10.6 shows an
external benefit.
When 15 million students
attend college:
1. Marginal private benefit
is $10,000 per student.
2. Marginal external benefit
is $15,000 per student.
3. Marginal social benefit is
$25,000 per student.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Figure 10.7 shows
inefficiency with an
external benefit.
1. Market equilibrium
is at a tuition of
$15,000 a year and
7.5 million students
and is inefficient
because …
2. Marginal social
benefit exceeds …
3. Marginal cost.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
4. The efficient
number of students
is 15 million.
5. The gray triangle
shows the
deadweight loss
created because
too few students
enroll in college.
© 2013 Pearson
10.2 POSITIVE EXTERNALITIES: EDUCATION
Government Actions In the Face of External
Benefits
Three devices that governments can use to achieve a
more efficient allocation of resources in the presence of
external benefits:
• Public provision
• Private subsidies
• Vouchers
© 2013 Pearson
10.2 POSITIVE EXTERNALITIES: EDUCATION
Public provision is the production of a good or
service by a public authority that receives the bulk of its
revenue from the government.
A subsidy is a payment that the government makes to
private producers to cover part of the costs of
production.
A voucher is a token that the government provides to
households that can be used to buy specified goods or
services.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Public Provision
Figure 10.8 shows how public
provision can achieve an
efficient outcome.
1. Marginal social benefit equals
marginal cost with 15 million
students enrolled in college.
2. The efficient quantity.
3. Tuition is $10,000 per year.
4. Taxpayers cover the
remaining $15,000 of
marginal cost per student.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Private Subsidies
Figure 10.9 shows
how a subsidy achieves
an efficient outcome of
15 million students.
1. A $15,000 subsidy
per student shifts
the supply curve to
S = MC – subsidy.
2. The dollar price is
$10,000 a student.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
3. The market equilibrium
is efficient with 15 million
students enrolled in
college.
4. Marginal social
benefit equals
marginal cost.
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10.2 POSITIVE EXTERNALITIES: EDUCATION
Vouchers
Figure 10.10 shows how
vouchers can achieve an
efficient outcome.
The MSB curve becomes
the demand curve
because…
1. With vouchers, buyers
are willing to pay MB
plus the value of the
voucher.
© 2013 Pearson
10.2 POSITIVE EXTERNALITIES: EDUCATION
2. Market equilibrium is
efficient with 15 million
students enrolled.
3. Price, marginal
social benefit, and
marginal cost are
equal.
4. Tuition equals the dollar
price of $10,000 plus the
value of the voucher.
© 2013 Pearson
How Can We Limit Climate Change?
The average
temperature of the
Earth is rising and
so is the
atmospheric
concentration of
carbon dioxide,
CO2.
The figure shows
these upward
trends.
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How Can We Limit Climate Change?
Scientists debate the contribution of human economic
activity to these trends, but most believe it to be a major
source.
Economists debate the costs and benefits of alternative
ways of slowing CO2 and other greenhouse gas
emissions, but most favor some action.
Economists agree that lowering greenhouse gas
emissions requires incentives to change.
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How Can We Limit Climate Change?
One idea is to cap emissions and issue tradeable
emissions permits, a system called cap-and-trade.
Carbon emission permits are already priced on a global
carbon trading market.
American Clean Energy and Security Act of 2009 would
use a cap-and-trade scheme.
With 2005 levels as the base, emissions would be
capped at 97 percent by 2012, 83 percent by 2020,
58 percent by 2030, and 17 percent by 2050.
The cost of the scheme would be about $175 per
household per year.
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How Can We Limit Climate Change?
Another incentive might be a hike in the tax on gasoline.
Americans pay a much lower gas tax than Europeans
pay.
The figure shows the stark difference between the United
States and the United Kingdom.
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How Can We Limit Climate Change?
Why don’t we have more aggressive caps and stronger
incentives to encourage a larger reduction in emissions?
There are three reasons.
First, many people don’t accept the scientific evidence
that emissions produce global warming.
Second, the costs are certain and would be borne now,
while the benefits would come many years in the future.
Third, if current trends persist, by 2050, three quarters of
carbon pollution will come not from the United States but
from the developing economies.
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