Unformatted text preview: Externalities and Public Policy 1 Externalities
Externalities are costs or benefits of market transactions not
reflected in prices.
A third party is affected by production or consumption.
Benefits or costs to the third party not considered by buyers or
sellers. 2 Externalities
Negative externalities – costs to third parties other than buyers or
sellers not reflected in the market price.
- Damage by industrial pollution to people and property. Positive externalities – benefits to third parties other than buyers or
sellers not reflected in prices.
- Fire prevention, such as smoke alarms. Pecuniary externalities – effects of increases or decreases in the
price of a good on existing customers as a result of changes in the
demand or supply of a good.
3 Externalities and Efficiency
Marginal external cost (MEC) – extra cost to third parties resulting
from production of another unit of a good or service.
MEC part of the marginal social cost (MSC) of making a good
MEC is not reflected in the price of the good.
Producers base decisions on marginal private cost (MPC). 4 Social Costs MSC = MPC + MEC 5 Price, Benefit, and Cost (Dollars) Figure 3.1 Market Equilibrium, A Negative Externality
and Efficiency 6 MPC + MEC = MSC
100 B S = MPC
D = MSB 4.5 5
Tons of Paper Per Year (Millions) Implications of Figure 3.1
Market equilibrium occurs where MPC = MSB
Efficiency Requires that
MSC = MPC + MEC = MSB 7 Positive externalities
In a positive externality, prices do not fully equal the marginal
social benefit (MSB) of a good or service.
Marginal external benefit (MEB) – benefit of additional output
accruing to parties other than buyers and sellers of the good.
Consumers base decisions on marginal private benefit (MPB). 8 Social Benefit MSB = MPB + MEB 9 Price, Benefit, and Cost (Dollars) Figure 3.2 Market Equilibrium, A Positive
Externality and Efficiency
25 10 S = MSC V
MPB + MEB = MSB
10 Z 10 12 Inoculations Per
Year (Millions) Price, Benefit, and Cost (Dollars) Figure 3.3 A Positive Externality for Which MEB Declines
With Annual Output 11 MPBi + MEB = MSB
A S = MSC B S' = MSC' 25 C 20 0 MPBi 10 12 16 20 Inoculations per Year (Millions) Internalization of Externalities
Internalization of an externality – marginal private benefit or cost of
goods and services are adjusted so that users consider the actual
marginal social benefit or cost of their decisions.
- Negative externality: MEC is added to MPC.
- Positive externality: MEB is added to MPB.
Corrective tax – designed to adjust MPC of a good or service in such
a way as to internalize the externality; must equal MEC per unit. 12 Price, Benefit, and Cost (Dollars) Figure 3.4 A Corrective Tax 13 S’ = MPC + T = MSC
S = MPC
Tax Revenue = Total
External Costs T A Net Gains in
Well-Being D = MSB 4.5 5
Tons of Paper Per Year (Millions) Results of a Corrective Tax
The tax revenue is sufficient to pay costs to third parties.
Socially optimal levels of production are
achieved. 14 Using a Corrective Tax
The greenhouse effect and a “Carbon Tax”
The greenhouse effect is caused by burning carbon-based fuels. A carbon tax can be imposed to limit greenhouse
gasses to their socially optimal levels.
It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel. 15 Carbon Pricing
The 2015 Paris Agreement Lays the foundation for progress on addressing climate change
Reducing carbon emissions: mitigation pledges submitted by 186 countries (96 percent of
Parties agreed on procedures for evaluating progress
Global temperatures projected to rise by about 3-4degrees C by 2100.
How to address loss in competitiveness ? Carbon price floor arrangements.
Disclosure of firms’ carbon footprints
What are the policy instruments best suited for implementing countries’
Intended Nationally Determined Contributions (INDCs) 16 Submitted INDCs, Largest Emitting
Countries/Regions 17 Carbon Taxes around the World 18 Theory of the Second Best
General theory of second best – states that when two opposing
factors contribute to efficiency losses, they can offset one
- Economists treat each problem on an ad hoc basis to
determine if there are any “second best” problems present.
Corrective subsidy – payment made by government to either
buyers or sellers so that the price paid by consumers is reduced. 19 A Polluting Monopolist
Chapter 2 showed that monopoly creates a loss to society. This chapter shows that a negative
externality causes a loss as well.
The losses do not necessarily add to one
another. In fact, they can cancel each other out. 20 Figure 3.5 A Second Best Efficient Solution
MPC + MEC = MSC
F MPC A
C D = MSB
21 0 QM Q*
Output per Year Corrective Subsidies
Setting a subsidy equal to MEB will internalize a positive externality. 22 Price, Benefit, and Cost (Dollars) Figure 3.6 A Corrective Subsidy 23 Z 45 30
25 S = MSC
U Subsidy Payments 10 Y X D' = MPBi +$20 = MSB
D = MPBi 0 10 12
Inoculations per Year (Millions) Property Rights and Internalization of
Externalities arise because some resource users’ property rights are not considered in the marketplace by buyers or
sellers of products.
Governments can give businesses the right to emit wastes in
the air and water or it can give individuals the right to clean
air and water. 24 Coase's Theorem
By establishing rights to use resources, government can internalize externalities
when transactions or bargaining costs are
zero. 25 The Significance of Coase’s Theorem
The efficient mix of output will result simply as a consequence of the establishment of exchangeable
It makes no difference which party is assigned the right
to use a resource.
If the transactions costs of exchanging the rights are zero,
the efficient mix of outputs among competing uses of the
resource will emerge. 26 Figure 3.7 Coase’s Theorem
B MPCB + MEC = MSC
MPCB PB QB* QB1
Beef Output per Year 27 Price of Wheat (Dollars) Price of Beef (Dollars) A MCW MCW* PW
Wheat Output per Year Limitations of Coase’s Theorem
Transactions costs are not zero in many situations.
However you allocate the property rights, the distribution of income is affected. 28 Applying Coase's Theorem
The Clean Air Act of 1990 allows for the sale of the "right to pollute." Firms face a tradeoff
when they pollute. If they pollute, they forgo
the right to sell their emission permits to
In markets for electricity, Clean Air Act has motivated firms to shift to natural gas and
away from coal as a means of producing
electricity. 29 Price and Marginal Social Benefit
30 Figure 3.8 Pollution Rights and Emissions
S = Supply of Pollution Rights $20 0 D = MSB of
Emitting Wastes 75,000 100,000
Tons of Annual Emissions
and Number of Pollution Rights Marginal Social Cost and Benefit Figure 3.9 The Efficient Amount of Pollution
Abatement 31 MSC E MSB A*
Percent Reduction in Waste Emitted per Year ...
View Full Document
- Fall '16
- Externalities, Externality, MEB, Marginal private benefit, MEC