Externalities

When you have completed your study of this chapter, you will be able to

C H A P T E R C H E C K L I S T

Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome.

1

Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, vouchers, and patents can achieve a more efficient outcome.

2

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.

EXTERNALITIES IN OUR DAILY LIVES

Four types of externalities• Negative production externalities• Positive production externalities• Negative consumption externalities• Positive consumption externalities


Negative Production ExternalitiesPollution 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.


Negative Consumption ExternalitiesSmoking tobacco in a confined space

Noisy parties

Positive Consumption ExternalitiesA flu vaccination

Restoration of an historic building

Education and research


9.1 NEGATIVE EXTERNALITIES

Private Costs and Social CostsMarginal private cost

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

The cost of producing an additional unit of a good or service that falls on people other than the producer.


Marginal social cost

The marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. It is the sum of marginal private cost and marginal external cost.

MSC = MC + Marginal external cost


Figure 9.1 shows the relationship between cost and output.When output is 4,000 tons of chemicals per month:

1. Marginal privatecost is $100 a ton.

2. Marginal externalcost is $125 a ton.

3. Marginal social cost is $225 a ton.


Production and Pollution: How Much?When an industry is unregulated, the amount of pollution it creates depends on the market equilibrium price and quantity of the good produced.

If the industry creates external costs, the market equilibrium is inefficient. Too much of the good is produced.


1. Market equilibrium at a price of $100 a ton and 4,000 tons a month is inefficient.

2. Marginal social cost exceeds ...

3. Marginal benefit.

Figure 9.2 shows inefficiency with an external cost.


5. The gray triangle shows the dead-weight loss created by the pollution externality.

4. The efficient quantity is 2,000 tons a month, where marginal social cost equals marginal benefit.


Property Rights

Property rightsLegally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.


Figure 9.3 shows how property rights achieve an efficient outcome.

1. With property rights, the MC curve that excludes pollution costs shows only part of the producers’ marginal cost.


2. The marginal private cost curve includes the cost of pollution, and the supply curve is S = MC.


3. Market equilibrium is at a price of $150 a ton and a quantity of 2,000 tons a month and is efficient because…

4. Marginal social cost equals marginal benefit.


The Coase Theorem

Coase theoremThe 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 costsThe opportunity costs of conducting a transaction.


Application of the Coase Theorem• If factories own homes and river, people pay lower rent the greater the amount of pollution.

• If homeowners own the river, factories must pay homeowners for 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.


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:

• Emission charges• Marketable permits• Taxes


Figure 9.4 shows the effects of a pollution tax.

1. A pollution tax is imposed that is equal to the marginal external cost of pollution.


The supply curve becomes the marginal private cost curve, MC, plus the tax—the curve labeled S = MC + tax.


2. Market equilibrium is at a price of $150 a ton and a quantityof 2,000 tons a month and is efficient because…

3. Marginal social cost equals marginal benefit.


4. The government collects tax revenue shown by the purple rectangle.

9.2 POSITIVE EXTERNALITIES

Private Benefits and Social Benefits

Marginal private benefitThe benefit of an additional unit of a good or service that the consumer of that good or service receives.

Marginal external benefitThe benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.


Marginal social benefitThe marginal benefit enjoyed by society—by the consumers of a good or service and by everyone else who benefits from it. It is the sum of marginal private benefit and marginal external benefit.

MSB = MB + Marginal external benefit


Figure 9.5 shows an external benefit.

When 15 million studentsattend college:

2. Marginal external benefit is $15,000 per student.

1. Marginal private benefit is $10,000 per student.

3. Marginal social benefit is $25,000 per student.


Figure 9.6 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 …

3. Marginal cost.

2. Marginal social benefit exceeds …


5. The gray triangle shows the deadweight loss created by the external benefits of college education.

4. The efficient quantity is 15 million students.


Government Actions In the Face of External BenefitsFour devices that governments can use to achieve a more efficient allocation of resources in the presence of external benefits:

• Public provision• Private subsidies• Vouchers• Patents and copyrights


Public provisionThe production of a good or service by a public authority that receives the bulk of its revenue from the government.

SubsidyA payment that the government makes to private producers that depends on the level of output.

VoucherA token that the government provides to households that can be used to buy specified goods or services.

9.2 POSITIVE EXTERNALITIESFigure 9.7(a) 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 set at $10,000 per year.

4. The taxpayers cover the remaining $15,000 of marginal cost per student.


Figure 9.7(b) shows how a subsidy can achieve an efficient outcome.

1. A $15,000 per student subsidy shifts the supply curve to S = MC – subsidy.

2. The equilibrium price is $10,000.

The efficient number ofstudents is 15 million.


3. The market equilibrium is efficient with 15 million students enrolled in college.

4. Marginal social benefit equals marginal cost.


Figure 9.8 shows how vouchers can achieve an efficient outcome.

The demand curve is D = MSB because…

1. With vouchers, buyers are willing to pay MB plus the value of the voucher.


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.

2. Market equilibrium is efficient with 15 million students enrolled in college.


Intellectual property rightsThe property rights of the creators of knowledge and other discoveries.

Patent or copyrightA government-sanctioned exclusive right granted to the inventor of a good, service, or productive process to produce, use, and sell the invention for a given number of years.