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EXTERNALITIES
ECO 2023
Principles of Microeconomics
Dr. McCaleb
Externalities
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TOPIC OUTLINE
I.
Basic Concepts
II. Positive Externalities
III. Negative Externalities
IV. Property Rights
V.
Resource Conservation
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Economic inefficiency results from
i. taxes
ii. subsidies
iii. price ceilings
iv. price floors
1.
2.
3.
4.
5.
6.
i and iii
ii and iv
i and ii
iii and iv
i, iii, and iv
i, ii, iii, and iv
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True (T) or false (F): The efficient quantity of a good,
service, or activity is the quantity at which MB=MC.
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Basic Concepts
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BASIC CONCEPTS
 Externalities
Definition
A cost or benefit arising from production that falls on someone
other than the producer, or a cost or benefit arising from
consumption that falls on someone other than the consumer.
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BASIC CONCEPTS
 Externalities
Positive externality or external benefit
A production or consumption activity that creates an external
benefit.
Negative externality or external cost
A production or consumption activity that creates an external
cost.
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Positive Externalities
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POSITIVE EXTERNALITIES
 Private Benefits and Social Benefits
Marginal private benefit (MB)
The benefit to the consumer of an additional unit of a good or
service.
Marginal external benefit (MEB)
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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POSITIVE EXTERNALITIES
 Private Benefits and Social Benefits
Marginal social benefit (MSB)
The marginal benefit enjoyed by the entire society—by the
consumers of a good or service and by everyone else who benefits
from it.
Marginal social benefit is the sum of marginal private benefit and
marginal external benefit:
MSB = MB + MEB
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POSITIVE EXTERNALITIES
Private Benefit and Social
Benefit with an Externality
When 15 million students
attend college . . .
• marginal private benefit is
$10,000 per student.
• marginal external benefit is
$15,000 per student.
• marginal social benefit is $25,000
per student.
An external benefit creates a wedge
between social benefit and private
benefit.
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POSITIVE EXTERNALITIES
Inefficiency with an
External Benefit
With an external benefit, the
equilibrium quantity is 7.5 million
students where D=S.
The efficient quantity is 15 million
students, where MSB=MC.
At equilibrium, MSB>MC. The
equilibrium is inefficient because of
underproduction.
The gray triangle shows the
deadweight loss from
underproduction.
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POSITIVE EXTERNALITIES
 Example: Education
Internalizing the Positive Externalities from Education
The problem is underproduction. The solution is to increase quantity.
Possible policies to increase quantity
• Regulation
• Public provision
• Producer subsidies
• Vouchers (consumer subsidies)
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POSITIVE EXTERNALITIES
 Example: Education
(1) Regulation
Government decides on the quantity of education that each student
should have and requires students to purchase that quantity of
education in the market.
For example, government requires that all children attend school until
they are 16 years of age.
With public education, government combines this regulatory policy
with public provision of education.
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POSITIVE EXTERNALITIES
(2) Public Provision
With public provision, a tax-funded
public agency produces education-the case of public schools and
universities.
The agency sets tuition at $10,000
per student, equal to MB at the
efficient quantity. Tax revenues
cover the remaining $15,000 per
student.
At a price of $10,000, the efficient
number of students, 15 million, seek
an education.
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POSITIVE EXTERNALITIES
(3) Producer Subsidies
A subsidy is a payment from the
government to private producers
based on the level of output--in this
case to private schools and
universities.
A $15,000 per student subsidy
increases supply to S = MC –
subsidy. With the subsidy, tuition is
reduced to $10,000.
At a price of $10,000, the efficient
number of students, 15 million, seek
an education.
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POSITIVE EXTERNALITIES
(4) Vouchers
A voucher is a subsidy to
consumers for the purchase of
specified goods or services--in this
case, a subsidy paid to students.
A $15,000 voucher increases
demand from MB to MSB.
With a $15,000 voucher, the
efficient number of students, 15
million, are willing to pay the full
$25,000 per student cost of
education.
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With a positive externality or external benefit, marginal social
benefit is _____ marginal private benefit and the good is
_____.
1. Greater than; overproduced
2. Greater than; underproduced
3. Less than; overproduced
4. Less than; underproduced
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True (T) or false (F): Correcting the inefficiency from a
positive externality requires increasing the quantity of the
good.
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Negative Externalities
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NEGATIVE EXTERNALITIES
 Private Costs and Social Costs
Marginal private cost (MC)
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 (MEC)
The cost of producing an additional unit of a good or service that
falls on people other than the producer.
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NEGATIVE EXTERNALITIES
 Private Costs and Social Costs
Marginal social cost (MSC)
The marginal cost incurred by the entire society—by the producer
and by everyone else on whom the cost falls.
Marginal social cost is the sum of marginal private cost and marginal
external cost:
MSC = MC + MEC
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NEGATIVE EXTERNALITIES
Private Cost and Social
Cost with an Externality
When output is 4,000 tons of
chemicals per month . . .
• marginal private cost is $100 a
ton.
• marginal external cost is $125 a
ton.
• marginal social cost is $225 a
ton.
An external cost creates a wedge
between social cost and private
cost.
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NEGATIVE EXTERNALITIES
Inefficiency with an
External Cost
With an external cost, the
equilibrium quantity is 4,000 tons
per month where D=S.
The efficient quantity is 2,000 tons,
where MB=MSC.
At equilibrium, MB<MSC. The
equilibrium is inefficient because of
overproduction.
The gray triangle shows the
deadweight loss from
overproduction.
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NEGATIVE EXTERNALITIES
 Example: Pollution
Economic efficiency with pollution
Pollution imposes costs on society, but the production activities that
generate pollution also confer benefits.
Zero pollution is not efficient. As the amount of pollution is reduced,
we reach a level where the marginal benefit from less pollution is less
than the marginal cost of having less production and consumption.
Efficiency requires balancing the costs of pollution against the
benefits from the goods and services whose production generates
pollution—in other words, finding the level at which MSB=MSC.
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NEGATIVE EXTERNALITIES
 Example: Pollution
Correcting for the Negative Externalities from
Pollution
The problem is overproduction, so the solution is to decrease quantity.
Possible policies to decrease quantity
• Regulation
• Marketable permits (or tradable emission rights)
• Pollution taxes and emission charges
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NEGATIVE EXTERNALITIES
 Example: Pollution
(1) Regulation
Government decides on the total amount of pollution allowed in a
geographic area and assigns a quota to each pollution source so that
the quotas add up to the total amount allowed.
Alternatively, government may require each pollution source to use
a certain technology that is intended to reduce the amount of
pollution.
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NEGATIVE EXTERNALITIES
• Example: Pollution
(2) Marketable permits
As with regulation, government decides the total allowed amount of
pollution in a geographic area.
Each polluter is given permits to pollute. The total number of permits
equals the total allowed amount of pollution.
Polluters are allowed to buy and sell their pollution permits at market
prices determined by the demand for or marginal benefit of pollution
rights.
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NEGATIVE EXTERNALITIES
(3) Pollution Taxes
Government imposes a pollution tax
on each polluter equal to the MEC
of pollution.
With the tax, MSC=MC+Tax.
The tax increases the cost of
production and provides an
incentive for the producer to reduce
quantity.
The equilibrium quantity with the
tax is the efficient quantity, 2,000
tons a month.
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NEGATIVE EXTERNALITIES
 Example: Pollution
Advantages of permits and taxes over regulation
• Lower cost of pollution reduction with permits and taxes
• Greater incentives for substitution and development of lesspolluting techniques with permits and taxes
• Permits and taxes less costly to administer than regulation
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NEGATIVE EXTERNALITIES
 Example: Pollution
Lower cost of pollution reduction
With permits, the target amount of pollution is is achieved at the
lowest possible cost.
Permits are more valuable to polluters for whom the cost of pollution
reduction is higher and less valuable to polluters for whom the cost is
lower.
High cost polluters buy permits from low cost polluters. High cost
polluters continue to pollute. Most of the pollution reduction is
accomplished by those who can reduce pollution at the lowest cost.
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NEGATIVE EXTERNALITIES
 Example: Pollution
Substitution and new technologies
Permits have a market value so using permits or paying taxes
represent an additional cost of production to the polluter.
The additional cost is an incentive for polluters to substitute highercost but less-polluting production methods and to invest resources in
developing new less-polluting methods.
The additional cost is reflected in goods and services prices. The
higher prices are an incentive for consumers to substitute lesspollution-generating goods for more-pollution-generating goods.
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NEGATIVE EXTERNALITIES
 Example: Pollution
Costs of regulation
Regulations typically imposes higher costs on polluters to comply
with the regulations and on taxpayers for monitoring the performance
of polluters and enforcing the regulations.
Regulation shifts decision-making from consumers and producers who
have better information about benefits and costs to bureaucrats and
politicians who have less information about benefits and costs.
Regulations are often adopted that protect and promote politically
influential special interests rather than promoting low-cost pollution
reduction and efficient production.
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With a negative externality or external cost, marginal social
cost is _____ marginal private cost and the good is _____.
1. Greater than; overproduced
2. Greater than; underproduced
3. Less than; overproduced
4. Less than; underproduced
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True (T) or false (F): Correcting the inefficiency from a
negative externality requires increasing the quantity of the
good.
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Why are passenger pigeons extinct, tigers almost so, and bald
eagles, condors, and bison barely saved from extinction, but
dogs, cats, horses, and even deer are plentiful?
Why must we limit fishing of Atlantic cod and Gulf snapper
but not catfish or shrimp?
Why are sheep in the west being destroyed by marauding
coyotes but not by marauding dogs even though dogs are
more numerous and, given the opportunity, dogs will attack
sheep?
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With a negative externality or external cost, marginal social
cost is _____ marginal private cost and the good is _____.
1. Greater than; overproduced
2. Greater than; underproduced
3. Less than; overproduced
4. Less than; underproduced
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Property Rights
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The incentives for maintaining a resource in good condition
are greater with _____ property rights. The incentives for
conserving a resource are greater with _____ property rights.
1. Common; private
2. Common; common
3. Private; common
4. Private; private
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PROPERTY RIGHTS
 The Coase Theorem
Private bargaining can correct for an externality
If property rights are clearly defined and enforced, only a small
number of individuals are involved, and transaction costs are low,
then private negotiation among the affected individuals can correct
the inefficiency that arises from an externality.
Where the conditions of the Coase Theorem are met, government
action to correct for an externality is unnecessary. The individuals
who are affected by the externality have an incentive to negotiate an
efficient solution.
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PROPERTY RIGHTS
 The Coase Theorem
Example: Property rights and pollution
Polluters own the river
Suppose polluting factories own a river and the homes along it. The
more the factories pollute, the less rent people are willing to pay to
live in the riverside homes.
The factories pay for their pollution in the form of lower rental
income. The effect of pollution on their rental income provides an
incentive for factories to limit their pollution to the efficient level.
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PROPERTY RIGHTS
 The Coase Theorem
Residents own the river
Suppose the residents own the river and the homes. Then, the
factories must either cease polluting or compensate the homeowners
for the decline in the value of the river due to pollution. The more the
factories pollute, the more they pay.
The compensation the factories pay for the decreased value of the
river to the residents provides an incentive for the factories to limit
their pollution to the efficient level.
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PROPERTY RIGHTS
 The Coase Theorem
Efficiency of private bargaining and market outcome
It doesn’t matter who owns the river, so long as someone owns it.
Whether the factories own it or the residents own it, the factories bear
the full social cost of polluting the river. This provides incentives for
them to limit pollution to the efficient level.
When property rights are well-defined and enforced and transaction
costs are low, market-style bargaining and market prices provide
incentives for individuals to reach an efficient outcome.
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PROPERTY RIGHTS
 Externalities and Property Rights
Inefficiency without property rights
If property rights in the river are not well-defined and enforced, the
factories can pollute without bearing the cost. The costs of the
pollution are externalized to the residents.
Without well-defined and enforced property rights, the factories have
no incentive to limit pollution. There is inefficiency from
overproduction, too much pollution, and a deadweight loss.
Externalities arise when property rights are not well-defined or not
enforced.
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PROPERTY RIGHTS
 Final Observation
Not every externality problem is worth solving
Externalities impose an opportunity cost on society. The opportunity
cost is the deadweight loss that arises from overproduction with a
negative externality or underproduction with a positive externality.
But, there are also costs to correcting an externality. Sometimes the
costs of correcting the externality are greater than the cost of the
externality itself. Correcting the externality costs more than it is
worth and the best course of action is no action—do nothing.
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Use statements I and II to answer the question. (I) According
to the Coase Theorem, one way to internalize externalities is
to create well-defined and enforced private property rights.
(II) Economic efficiency requires that every externality be
internalized.
1. Both I and II are true.
2. Both I and II are false.
3. I is true; II is false.
4. I is false; II is true.
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Resource Conservation
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RESOURCE CONSERVATION
 Common Property Resources
Definition
A resource for which rights are held in common by a group of
individuals none of whom has exclusive ownership. With common
property resources, property rights are not well-defined and are nonexclusive.
An individual has the right to use the resource, but not to change its
form or transfer it to other individuals even if transformation or
transfer would increase the value of the resource.
In particular, an individual has no guarantee of future use of the
resource, no future interest in the resource.
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RESOURCE CONSERVATION
 Common Property Resources
Lack of incentives for conservation
Many people mistakenly believe that resources are more likely to be
conserved for the future and less likely to be depleted if they are
owned in common than if they are private property. In fact, quite the
opposite is true.
If one person conserves on current use of a common property
resource, that person bears the full cost of the conservation. But with
common property rights, that person cannot exclude others from
sharing in the increased future value of the resource that results from
increased conservation.
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RESOURCE CONSERVATION
 Common Property Resources
Common property resources tend to be overused,
poorly maintained, and depleted too rapidly
Conservation of a common property resource generates external
benefits so there is underproduction of conservation. There is too
little conservation and too much current consumption of a common
property resource.
And because the only right a person has in a common property
resource is a non-exclusive right to current use of the resource, the
incentive is to maximize use of the resource.
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RESOURCE CONSERVATION
 Property Rights and Conservation
Private property encourages efficient conservation
Unlike common property rights, private property rights
• provide incentives for efficient conservation of a resource and
• ensure against too rapid depletion of a resource.
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RESOURCE CONSERVATION
 Property Rights and Conservation
MB and MC of conservation
MB of conservation: Value of having one more unit of a resource
available for use in the future.
MC of conservation: Loss in value from not using that unit of the
resource today.
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RESOURCE CONSERVATION
 Property Rights and Conservation
Efficient conservation
If MB of conservation>MC of conservation, having one more unit in
the future is worth more than having it todaymore conservation.
If MB of conservation<MC of conservation, having one more unit in
the future is worth less than having it todayless conservation.
Efficient conservation: The amount where
MB of conservation=MC of conservation.
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RESOURCE CONSERVATION
 Property Rights and Conservation
Market prices reflect benefits and costs of conservation
In a competitive market, the expected future price of a resource equals
the value of having one more unit of the resource in the future, the
MB of conservation:
PF=MB of conservation
The current price of the resource equals the value of having one more
unit of the resource today, the MC of conservation:
PC=MC of conservation
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RESOURCE CONSERVATION
 Property Rights and Conservation
Resource owners allocate resources to maximize value
With property rights, the owner bears the cost of conservation but also
is guaranteed the full future benefits of conservation. Market prices
provide an incentive for resource owners to allocate their resources
between current and future use to maximize resource value:
PF>PCfuture use is more valuable than current usconserve more,
use less
PF<PCfuture use is less valuable than current useconserve less,
use more
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RESOURCE CONSERVATION
 Property Rights and Conservation
Competitive markets encourage efficient conservation
With property rights, the equilibrium amount of conservation in a
competitive market is where
PF=PC
But because PF=MB of conservation and PC=MC of conservation,
this is also the efficient amount where
MB of conservation=MC of conservation
Externalities
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Which of the following statements is true?
i.
The known supplies of oil are decreasing.
ii.
The known supplies of cheap oil are decreasing.
iii.
We have enough known oil reserves to supply the
entire planet for a century if the price is high enough to make
extracting it profitable.
1. i only
2. ii only
3. iii only
4. ii and iii
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RESOURCE CONSERVATION
 Property Rights and Resource Depletion
Property rights also prevent too rapid depletion of a
resource
Contrary to popular belief, resource depletion is less likely to occur
with private property rights in resources, competitive markets, and
unregulated prices than with common property rights and regulation.
Markets and prices provide a self-limiting mechanism that prevents
rapid depletion of a valuable resource. As a resource becomes
scarcer, its price increases and consumption decreases so that
depletion is avoided.
Externalities
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RESOURCE CONSERVATION
$
60
Markets, Prices, and
Resource Depletion
Reduced
Supply
Initial
Supply
50
As a resource is used up, the supply
of the resource decreases, shown by
the shift in the supply curve to the
left.
Supply at $30 per barrel decreases
from 20 million barrels to 5 million
barrels.
40
Excess
Demand
30
20
Demand
10
0
The decrease in supply creates an
excess demand of 15 million
barrels.
0
Externalities
5
10
15
20
25
30
35
Millions of barrels
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RESOURCE CONSERVATION
Markets, Prices, and
Resource Depletion
$
60
Reduced
Supply
Initial
Supply
50
Because of the excess demand,
price increases from $30 to $40 and
quantity demanded decreases from
20 million barrels to 10 million
barrels.
The higher price also makes it
profitable to produce more of the
resource from known but previously
uneconomical sources. Quantity
supplied increases from 5 million to
10 million barrels.
40
Excess
Demand
30
20
Demand
10
0
0
Externalities
5
10
15
20
25
30
35
Millions of barrels
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RESOURCE CONSERVATION
Markets, Prices, and
Resource Depletion
$
60
In the long run, higher prices also
create incentives for . . .
consumers to substitute other
activities that use the resource less
intensively, and for . . .
producers to develop alternatives
that use less of the resource, both of
which decrease demand, and for . . .
Reduced
Supply
Initial
Supply
50
40
30
20
Demand
10
0
0
producers to search for and develop
new sources of supply.
Externalities
5
10
15
20
25
30
35
Millions of barrels
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