1

Chapter 3

Externalities and Public Policy

2

Externalities Externalities are costs or benefits of

market transactions not reflected in prices. Negative externalities are costs to third

parties. Positive externalities are benefits to third

parties .

3

Externalities and Efficiency

The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good.

4

Social Costs

MSC = MPC + MEC

5

Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency

MPC + MEC = MSC

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Tons of Paper Per Year (Millions)

D = MSB

S = MPC

5

100 A

105

4.5

B10

110G

6

Positive externalities

The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production or consumption of a good.

7

Social Benefit

MSB = MPB + MEB

8

Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency

MPB + MEB = MSBH10

V30

12

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Inoculations Per Year (Millions)

0

S = MSC

MPB

U25

10

Z45

9

Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output

S = MSC

S' = MSC'

MPBi

A 25

10

B

12

MPBi + MEB = MSB

16

C 20

20 Pri

ce

, B

en

efi

t, a

nd

Co

st

(Do

llars

)

Inoculations per Year (Millions)

0

F 30

10

Internalization of Externalities An externality can be

internalized under policies that force market participants to account for the costs of benefits of their actions.

11

Corrective Taxes to Negative Externalities

Setting a tax equal to the MEC will internalize a negative externality.

12

Figure 3.4 A Corrective TaxP

rice

, B

enef

it,

and

Co

st (

Do

llar

s)

Tons of Paper Per Year (Millions)

D = MSB

S = MPC

S’ = MPC + T = MSC

T100

5

A

110Net Gains in Well-Being

G

105

95

4.5

Tax Revenue = TotalExternal Costs

B

13

Results of a Corrective Tax Price rises. The tax revenue is sufficient

to pay costs to third parties. Socially optimal levels of

production are achieved.

14

A Polluting Monopolist Monopoly creates a loss to society. 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.

15

Figure 3.5 A Second Best Efficient Solution

MR

Pri

ce

Output per Year 0

MPC + MEC = MSC

D = MSB

MPC

M

M

Q

P A

C

Q*

B

F

16

Theory of the Second Best

When two opposing factors contribute to efficiency losses, the can offset one another’s distortions.

17

Corrective Subsidies Setting a subsidy equal to

MEB will internalize a positive externality.

18

Subsidy Payments

Figure 3.6 A Corrective Subsidy

0

Pric

e, B

en

efit

, an

d C

ost

(D

olla

rs)

Inoculations per Year (Millions)

Y 10 X

D' = MPBi + $20 = MSB

D = MPBi

S = MSC

25

10

U

30

12

V R

45 Z

19

Property Rights and Internalization of Externalities 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.

20

Coase's Theorem By establishing rights to use

resources, government can internalize externalities when transactions or bargaining costs are zero.

21

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.

22

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 others.

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.

23

Figure 3.8 Pollution Rights and Emissions

S = Supply of Pollution Rights

D = MSB of Emitting Wastes

100,000Pri

ce

an

d M

arg

ina

l So

cia

l Be

ne

fit

Tons of Annual Emissions and Number of Pollution Rights

0

$20

75,000

24

Figure 3.9 The Efficient Amount of Pollution Abatement

MSB

MSC

E

A*

Ma

rgin

al S

oc

ial C

os

t a

nd

Be

ne

fit

Percent Reduction in Waste Emitted per Year 0 100

25

Regulatory Solutions Instead of using market

forces to force firms to internalize externalities, we can use emission standards and apply these to all market players.

26

Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of

Emissions

MSB

MSB QRB

QRA

A

B

G

H

QR

MEC = MSC

MEC = MSC

10

10

C

F

QA*

QB* 0

Firm A

Co

st a

nd

Ben

efit

(D

oll

ars)

Firm B

QB1

QA1

Tons of Emissions per Year

27

Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions

MEC = MSC

QRD

QRC

MEC = MSC 20

X

QC*

T

QD*

Firm C

Tons of Emissions per Year

Firm D

Co

st a

nd

Ben

efit

(D

oll

ars)

MSB

MSB

S

Y

Z

R

QRQR

28

Costs and Benefits to the EPA The EPA estimates that annual compliance costs

could be in the range of $225 billion per year. The EPA estimated in 1990 that the benefits of

the Clean Air Act were nearly 50 times the costs. Ninety percent of the benefits are estimated to

come from laws pertaining to power plants and factories.