CHAPTER 5

Externalities

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Externalities
 Externality – An activity on one entity that affects the
welfare of another entity in a way that is outside the market
mechanism. In other words, an external factor which is
beyond pricing mechanism.
 Suppose, A no. of rural people decided to live in urban area:
 Price of urban land increases
 Urban property owners are better off while citizens are worse off
 Merchants in the city gets benefited from the increased demand while
the welfare of tenants decreases
 Economy settles into new equilibrium changing the distribution
drastically
 This is not a case of Externality – Suburban-urban Migration
example-all effects transmitted via market price changes
5-2
Externalities
 For Example, as a by-product of their activities, PAPER
MILLS produce the Chemical Dioxin. It forms when the
Chlorine used for bleaching wood pulp combines with a
substance in the pulp.
 Once Dioxin is released into the environment, it ends up
being in everyone’s FAT TISSUE and in MILK of Nursing
Mothers. As per the scientists, Dioxin is responsible for Birth
defects and Cancer, among other health hazards.
 These health problems is the consequence of the direct
output choices by Paper Mills owners which directly affect
the health of the neighboring citizens and factory owners are
not paying any price for that pollution is a case of
EXTERNALITY.

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The Nature of Externalities
 Privately-owned (via Property rights) versus commonly-owned
resources (No particular owner that’s why free for all)
 Externalities can be produced by consumers as well as firms
 Consumers- Smoker Roommate-pollutes fresh air
 Firms-Polluting Rivers with garbage
 Externalities can be positive. Example, vaccine for smallpox against the
threat of terrorist/bioterrorism attack. Once, one member of the society is
vaccinated, then there is less to spread it from an injured by terrorist attack
into the society.
 Public goods can be viewed as a special kind of externality: For
example, A road built by volunteers to all pedestrians of a village, a
positive externality enjoyed by all in the society (A Pure Public Good case).
However, if that particular road is only used by a small fraction of the society,
then it is POSITIVE EXTERNATITY. 5-4
The Nature of Externalities-Graphical Analysis
MSC = MPC + MD
$

MPC

h
d
g

c
MD

b f MB
a e
0
Q* Q1 Q per year
Socially efficient output 5-5
Actual output
What Pollutants Do Harm?
 Empirical Evidence: What is the Effect of
Pollution on Health?
 What Activities Produce Pollutants?
 What is the Value of the Damage Done?
 Empirical Evidence: The Effect of Air
Pollution on Housing Values

5-6
Private Responses
 We know that in the presence of externalities,
markets can lead to inefficient outcomes.
 This section discusses the circumstances
under which private Individuals, acting on
their own, can avoid externality problems.

5-7
Bargaining and the Coase Theorem
MSC = MPC + MD
$

MPC

h
d
g

c
MD

MB
0
Q* Q1 Q per year
5-8
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.
 Assumptions necessary for Coase Theorem to work
 The costs to the parties of bargaining are low
 The owners of resources can identify the source of
damages to their property and legally prevent damages

5-9
Other Private Solutions

 Mergers
 Mergers can be a solution to externality problem if the both parties
namely Pollutant firm and Pollute combines together- it is called
internalizing the effect of externality.
 Social conventions:
 Unlike firms, individuals can’t merge to internalize externalities. But
certain social conventions can force people to take into account the
externalities they generate.
 School children are taught that wastage is irresponsible and not nice.
 So the golden rule is: “Do unto others as you would have others do
unto you.”
 In other words, Before you undertake some activity, take into account its external
benefits and costs.”

5-10
Public Responses to Externalities – Pigouvian Tax

 Pigouvian tax:
 A tax levied on each unit of an externality
generator’s output in an amount equal to the
marginal damage at the efficient level of output.
 In Figure 5.4, the marginal damage at the
efficient output Q* is distance cd. This is
vertical distance between MSC and MPC is
MD. Pigouvian Tax.

5-11
Public Responses to Externalities - Taxes
MSC = MPC + MD
$ (MPC + cd)
Pigouvian MPC
tax revenues

d
i

j c
MD

MB
0
Q* Q1 Q per year
5-12
Public Responses to Externalities - Subsidies
MSC = MPC + MD
$ (MPC + cd)
MPC
Pigouvian
subsidy

d k
i f
g
j c h
MD

MB
e
0
Q* Q1 Q per year
5-13
 Public Responses to Externalities: Emissions
Fees and Cap-and-Trade Programs
 Emission Fees: A tax levied on each unit of
pollution.
 Cap-and-Trade: A policy of granting permits to
pollute, with the number of permits set at the
desired pollution level, and allowing polluters to
trade the permits.

5-14
Emissions Fee
MC
$

f*

MSB
0
e* Pollution reduction
5-15
 Uniform Pollution Reductions
MCH

Bart’s Tax
Payment Homer’s Tax
MCB Payment

f= f=
$50 $50

50 75 90 Bart’s 25 50 75 90 Homer’s
pollution pollution
reduction reduction
5-16
 Cap-and-Trade
MCH

MCB

f= f=
$50 $50
a

10 50 75 90 Bart’s 25 50 75 90 Homer’s
pollution pollution
reduction reduction
5-17
Cap-and-Trade v Emissions Fee
MC’
$ MC*

f*

MSB
0 ef e’ e* Pollution reduction
5-18
Too little pollution reduction Too much pollution reduction
Cap-and-Trade v Emissions Fee
MC’
$ MC*

f*

MSB

0 ef e’ e* Pollution reduction
5-19
Too little pollution reduction Too much pollution reduction
Emissions Fee v Cap-and-Trade
 Responsiveness to Inflation
 Responsiveness to Cost Changes
 Responsiveness to Uncertainty

5-20
Distributional Effects
 Emissions fee
 Cap-and-Trade

5-21
Command-and-Control Regulation
 Incentive-based regulations
 Command-and-control regulations
 technology standard
 performance standard
 Is command-and-control ever better?
 hot spots

5-22
The U.S. Response
 Clean Air Act
 1970 amendments
 Command-and-control in the 70s
 How well did it work?

5-23
Progress with Incentive-based Approaches

 Policy Perspective: Cap-and-Trade for Sulfur

Dioxide
 Policy Perspective: Cap-and-Trade to Protect
Fisheries and Wildlife
 individual transferable quotas

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Implications for Income Distribution
 Who Benefits?
 Poor neighborhoods suffer more than high-income groups
 Improvements in recreational centers benefit more to the high-income
groups who use more

 Who Bears the Cost?

 As the polluters are charged with different fees, the suppliers of war-
materials and laborers suffer from less demand of raw-materials and labor
works respectively. Therefore, environmental cleanup distorts income
equality.
 Supporters of having factories in inner cities claim, removing factories
from inter cities worsened the economic woes of the poor people.
 If the polluting products are consumed by the high-income group than
poor-income category, this will result in better equality because the price
of the goods are higher due to the fines against pollution.
5-25
Positive Externalities
$

MC

MSB = MPB + MEB

MPB
MEB
R1 R* Research
per year 5-26
A Cautionary Note
 Requests for subsidies
 Resource extracted from taxpayers
 Market does not always fail
 Policy Perspective: Owner-Occupied Housing

The End!

5-27