EXTERNALITIES
CHAPTER 10
K A N I K A TA LW A R
E C O N O M I C S D E PA R T M E N T
SGTB KHALSA COLLEGE
OBJECTIVE
• Markets are usually a good way to organize economic activity.
• Markets do many things well, but they do not do everything well. . Sometimes government
intervention can improve market outcomes.
• In this chapter we examine why markets sometimes fail to allocate resources efficiently, and
how government policies can potentially improve the market’s allocation, and what kinds of
policies are likely to work best.
• The market failures examined in this chapter fall under a general category called externalities.
INTRODUCTION
• An externality arises when a person engages in an activity that influences the well-being of a
bystander and yet neither pays nor receives any compensation for that effect.
• If the impact on the bystander is adverse, it is called a negative externality; if it is beneficial, it
is called a positive externality.
• Because buyers and sellers neglect the external effects of their actions when deciding how much
to demand or supply, the market equilibrium is not efficient when there are externalities. That is,
the equilibrium fails to maximize the total benefit to society as a whole.
EXAMPLES
• The exhaust from automobiles is a negative externality because it creates smog that other people
have to breathe.
• Restored historic buildings convey a positive externality because people who walk or ride by them
can enjoy their beauty and the sense of history that these buildings provide.
• Barking dogs create a negative externality because neighbors are disturbed by the noise. Dog owners
do not bear the full cost of the noise and, therefore, tend to take too few precautions to prevent
their dogs from barking.
• Research into new technologies provides a positive externality because it creates knowledge that
other people can use. Because inventors cannot capture the full benefits of their inventions, they tend
to devote too few resources to research.
EXTERNALITIES & MARKET
INEFFICIENCIES
• Quick Recap:
– The supply and demand curves contain important information
about costs and benefits.
– The demand curve reflects the value of good to consumers, as
measured by the prices they are willing to pay.
– Similarly, the supply curve reflects the costs of producing a
good. (Aluminium in this case )
– In the absence of government intervention, the price adjusts to
balance the supply and demand in the market.
– The equilibrium quantity, Q , maximizes the total value to
buyers minus the total costs of sellers.
– In the absence of externalities, therefore, the market
equilibrium is efficient.
NEGATIVE EXTERNALITIES IN
PRODUCTION
• Now let’s suppose that aluminium factories emit pollution.
• For each unit of aluminium produced, a certain amount of smoke enters the atmosphere.
• Because of the externality, the cost to society of producing aluminium is larger than the cost to the aluminium
producers.
• For each unit of aluminium produced, the social cost includes the private costs of the aluminium producers plus
the costs to those bystanders adversely affected by the pollution.
• The social-cost curve is above the supply curve because it takes into account the external costs imposed on
society by aluminium producers.
• The difference between these two curves reflects the cost of the pollution emitted.
POLLUTION & SOCIAL OPTIMUM
Profit maximizing Q :MR = MPC = 8
Profit maximizing Q : MR = MSC (MPC + social cost)
• In the presence of a negative externality to
production, the social cost of producing
aluminium exceeds the private cost.
• The optimal quantity of aluminium, QOPTIMUM,
is therefore smaller than the equilibrium
quantity, QMARKET.
• The reason for this inefficiency is that the
market equilibrium reflects only the private
costs of production.
• In the market equilibrium, the marginal
consumer values aluminium at less than the
social cost of producing it.
INTERNALIZING EXTERNALITY
• How can the social planner achieve the optimal outcome? One way would be to tax aluminium
producers for each to of aluminium sold. The tax would shift the supply curve for aluminium upward
by the size of the tax.
• If the tax accurately reflected the social cost of smoke released into the atmosphere, the new supply
curve would coincide with the social-cost curve.
• In the new market equilibrium, aluminium producers would produce the socially optimal quantity of
aluminium.
• The use of such a tax is called internalizing the externality because it gives buyers and sellers in
the market an incentive to take account of the external effects of their actions.
• Aluminium producers would, in essence, take the costs of pollution into account when deciding how
much aluminium to supply because the tax now makes them pay for these external costs.
POSITIVE EXTERNALITY IN
PRODUCTION
• In the presence of a positive externality to
production, the social cost of producing robots
is less than the private cost. The optimal
quantity of robots, QOPTIMUM, is therefore
larger than the equilibrium quantity, QMARKET.
EXTERNALITY IN CONSUMPTION
LESSONS LEARNT
• Negative externalities in production or consumption lead markets to produce a larger quantity
than is socially desirable.
• Positive externalities in production or consumption lead markets to produce a smaller quantity
than is socially desirable.
• To remedy the problem, the government can internalize the externality by taxing goods that have
negative externalities and subsidizing goods that have positive externalities.
PRIVATE SOLUTIONS
• Coase Theorem:
• the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the
problem of externalities on their own.
– Suppose that Dick owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets a benefit from owning the
dog, but the dog confers a negative externality on Jane.
– If Dick has the legal right to keep a barking dog then Jane can simply offer to pay Dick to get rid of the dog. Dick will accept
the deal if the amount of money Jane offers is greater than the benefit of keeping the dog.
– For instance, suppose that Dick gets a $500 benefit from the dog and Jane bears an $800 cost from the barking. In this case,
Jane can offer Dick $600 to get rid of the dog, and Dick will gladly accept. Both parties are better off than they were before,
and the efficient outcome is reached.
– Now if Jane has the right ?
GOVERNMENT INTERVENTION
• When an externality causes a market to reach an inefficient allocation of resources, the
government can respond in one of two ways:
1. Command and control policies
2. Market based policies
REGULATION
• The government can remedy an externality by making certain behaviors either required or forbidden.
• For example, it is a crime to dump poisonous chemicals into the water supply. The government
therefore institutes a command-and-control policy that prohibits this act altogether.
• In most cases of pollution, however, the situation is not this simple. For example, virtually all forms of
transportation—even the horse—produce some undesirable polluting by-products. But it would not
be sensible for the government to ban all transportation.
• Thus, instead of trying to eradicate pollution altogether, society has to weigh the costs and benefits to
decide the kinds and quantities of pollution it will allow.
• Thus there several government rules and regulations in place. Environmental regulations can take
many forms. Sometimes the EPA dictates a maximum level of pollution that a factory may emit. Other
times the EPA requires that firms adopt a particular technology to reduce emissions.
PIGOUVIAN TAX
• It is a tax enacted to correct the effects of a negative externality.
• Economists usually prefer Pigovian taxes over regulations as a way to deal with pollution because they
can reduce pollution at a lower cost to society.
• Suppose that two factories—a paper mill and a steel mill—are each dumping 500 tons of glop into a
river each year. The EPA decides that it wants to reduce the amount of pollution. It considers two
solutions:
– Regulation: The EPA could tell each factory to reduce its pollution to 300 tons of glop per year.
– Pigouvian tax: The EPA could levy a tax on each factory of $50,000 for each ton of glop it emits.
• The regulation would dictate a level of pollution, whereas the tax would give factory owners an
economic incentive to reduce pollution.
• The regulation requires each factory to reduce pollution by the same amount, but an equal reduction
is not necessarily the least expensive way to clean up the water.
• It is possible that the paper mill can reduce pollution at lower cost than the steel mill. If so, the paper
mill would respond to the tax by reducing pollution substantially to avoid the tax, whereas the steel
mill would respond by reducing pollution less and paying the tax.
• In essence, the Pigouvian tax places a price on the right to pollute. Just as markets allocate goods to
those buyers who value them most highly, a Pigouvian tax allocates pollution to those factories that
face the highest cost of reducing it.
• Whatever the level of pollution the EPA chooses, it can achieve this goal at the lowest total cost using
a tax.
• Economists also argue that Pigouvian taxes are better for the environment. Under the command-and-
control policy of regulation, factories have no reason to reduce emission further once they have
reached the target of 300 tons of glop. By contrast, the tax gives the factories an incentive to develop
cleaner technologies, because a cleaner technology would reduce the amount of tax the factory has
to pay.
WHY IS GASOLINE SO HEAVILY TAXED
• The gas tax is a Pigouvian tax aimed at correcting three negative externalities associated with
driving:
• Congestion
• Accidents
• Pollution
TRADABLE POLLUTION PERMITS
• Another way to correct the situation of externality is to create a market for tradeable permits.
• Creating a market is is similar to any market for a private good where the ones value the good
the most pay for it and an efficient outcome is achieved . It is based on similar principle as Coase
Theorem.
• In the graph in case of Pigouvian Tax the supply curve is perfectly elastic and the tax is fixed by
the government.
• In case of tradeable permits the government decided the number of permit so the supply get
fixed. Now the demand curve decided the price of the permit.
QUESTION ON MONOPOLY P
MC
Q
• Suppose that a monopolist has a MC of Rs. 4 and a fixed cost of 48. Also the demand curve is given by
Q= 12-(P/2) or P = 24-2Q
1. what is the MR function (dTR/dQ) = (d(P.Q)/dQ) =(d(24Q-2Q2 )/dQ = 24-4Q
2. What is profit maximizing Q and P : Q= 5 and P = 14
3. What is the efficient price & Q : P = 4 & Q = 10 P = AC or P-
AC = o
4. What is the dead weight loss: 25
5. what is the profit of the monopolist : 2
6. If regulators force the monopolist to charge a price at which profit = o then what is the price : 12
7. If the monopolist can perfectly price discriminate then what is the profit?
8. If the government imposes a per unit tax of Rs. 4 on monopolist then what will be the equilibrium price
and quantity ?
9. if the government imposes a lumpsum tax of Rs. 20 what is he equilibrium price and quantity ?