EXTERNALITIES
• An externality occurs when a person’s action affects the well-being of others
(bystanders) without compensation.
o Negative externality: Harmful effects on third parties (e.g., pollution).
o Positive externality: Beneficial effects on third parties (e.g., restored
historic buildings).
• Market failure happens when externalities prevent the market from allocating
resources efficiently. In such cases, the market equilibrium does not maximize
total societal benefits.
Government Action and Market Failure
• Government intervention can improve market outcomes when externalities are
present, as markets may fail to address the external effects.
• Governments can use various policies to correct these market failures.
Examples of Externalities & Government Response
• Negative Externalities:
o Automobile Exhaust: Creates smog that others have to breathe.
Government Response: Setting emission standards and taxing
gasoline to reduce driving.
o Barking Dogs: Disturb neighbors.
Government Response: Laws against disturbing the peace.
• Positive Externalities:
o Historic Building Restoration: Provides aesthetic and historical value to the
public, but owners don’t get full benefit.
Government Response: Regulations preventing destruction and tax
breaks for restoration.
o Research and Innovation: New technologies benefit society but researchers
can’t capture all the benefits.
Government Response: Patents give exclusive rights to inventors for
a limited time, encouraging innovation.
Key Principle: Government Intervention
• In the presence of externalities, self-interested market participants (firms and
consumers) may ignore the social costs or benefits of their actions.
• Governments can improve the market's efficiency by regulating these externalities
and correcting for market failure.
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Externalities and Market Inefficiency
How externalities cause markets to allocate resources inefficiently and how to remedy those
externalities
Welfare Economics : A Recap
● To make our analyse concrete we will consider the market for steel
● This graph shows information about cost and benefits
● It shows the marginal change for the supply and the demand
● In a market without government intervention we see the market will be efficient
shown as Q market
1. Welfare Economics Overview
• Welfare Economics studies how the allocation of resources affects economic well-
being.
• The market for aluminum is used as an example to demonstrate the concepts of
consumer surplus and producer surplus.
2. Demand and Supply Curves in Welfare Economics
• Demand Curve:
o Reflects the value of aluminum to consumers.
o The height of the demand curve at any quantity shows the willingness to
pay of the marginal buyer (the value to the consumer for the last unit
purchased).
• Supply Curve:
o Reflects the cost of producing aluminum.
o The height of the supply curve at any quantity shows the cost to the
producer of the last unit sold.
3. Market Equilibrium
• In the absence of government intervention, the price adjusts to balance the supply
and demand for aluminum.
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• The quantity produced and consumed at the market equilibrium (QMARKET) is
efficient because it maximizes the sum of producer surplus and consumer
surplus.
o Consumer Surplus: The difference between what consumers are willing to
pay and what they actually pay.
o Producer Surplus: The difference between what producers receive and the
minimum amount they are willing to accept.
4. Efficient Resource Allocation
• The market equilibrium maximizes the total value to consumers and minimizes the
total costs to producers.
• This leads to the optimal allocation of resources, where total economic welfare
(surplus) is maximized.
Negative Externalities
● The steel production emit pollutants
● For each unit of steel produced, a certain amount of smoke enter the atmosphere
● For each steel produced the social cost equals the private cost of the steel
production plus the cost of those bystanders harmed by pollution
● The social cost is above the supply curve because it takes into account the external
cost imposed on society by steel production
● The social planner wants to maximize the total surplus derived from the market—the
value to consumers of steel minus the cost of producing steel.
● The planner would choose the level of steel production at which the demand curve
crosses the social-cost curve
● Below this level of production, the value of the steel to consumers exceeds the social
cost of producing it
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● Above this level of production, the social cost of producing additional steel exceeds
the value to consumers.
● The graph shows the market inefficiency that occurs if we compare between Q
optimum and Q market
● To move the graph towards achieving the optimal outcome is to tax every production
of steel
● The use of such tax is call internalizing the externality, altering incentives so that
people take into account the external effects of their actions
● This would make an incentive to buy less steel and produce less
1. Negative Externalities in Aluminum Production
• Pollution as an Externality:
o Aluminum factories emit pollution (smoke), which harms those who breathe
the air—this is a negative externality.
o The cost to society of producing aluminum is larger than the cost to
producers, as it includes the private production costs plus the external
cost (pollution).
2. Social Cost of Aluminum Production
• The social cost of producing aluminum is higher than the private cost, as it includes
the costs imposed on society by the pollution.
• Social-Cost Curve: This curve is above the supply curve because it accounts for
the external costs (pollution) that aluminum production imposes on others.
• The difference between the supply curve and the social-cost curve reflects the cost
of the pollution emitted.
3. Efficient Level of Aluminum Production
• A social planner would aim to maximize total surplus (consumer value minus
producer costs), considering both private and external costs.
• The optimal quantity of aluminum should be where the demand curve intersects
the social-cost curve (at QOPTIMUM).
o Below this quantity, the benefit to consumers (demand) exceeds the social
cost of production.
o Above this quantity, the social cost exceeds the value to consumers,
making further production inefficient.
4. Market Inefficiency
• The market equilibrium (at QMARKET) produces too much aluminum because it
reflects only the private costs of production, not the external cost (pollution).
• At QMARKET, the marginal consumer values aluminum less than the marginal
social cost of producing it, leading to overproduction.
5. Achieving the Optimal Outcome
• Taxation to Internalize the Externality:
o To correct this inefficiency, the government can impose a tax on aluminum
producers for each unit of aluminum sold.
o The tax would shift the supply curve upward by the amount of the tax,
aligning it with the social-cost curve.
o This new market equilibrium would result in the socially optimal quantity of
aluminum (QOPTIMUM).
6. Internalizing the Externality
• The tax internalizes the externality, meaning it encourages aluminum producers to
account for the external costs (pollution) when deciding how much to produce.
• Incentive for Consumers and Producers:
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o Aluminum producers will factor in the pollution costs because they have to
pay the tax.
o Consumers, facing higher prices due to the tax, will have an incentive to
reduce consumption.
• This aligns with the principle: People respond to incentives.
Positive Externalities
● Consider education as part of positive externalities
● With education it creates more informed people and more productive workers in a
private sense
● But in an external sense, it has created more informed voters, lowered the crime rate
and encouraged technological advancement within a nation.
● The demand curve does not reflect the value to society of the good
● The social value is above the private value
● This can be corrected by the government by inducing market participants to
internalize the externality
● Therefore we need subsidization
1. Positive Externalities in Education
• Private Benefits:
o Education provides private benefits, such as higher wages and increased
productivity for individuals who receive it.
• External Benefits:
o Education also generates positive externalities that benefit society:
More informed voters, leading to better government.
Lower crime rates due to the social benefits of education.
Technological advancements, leading to higher productivity and
wages for everyone.
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• Preference for Educated Neighbors:
o A more educated population benefits everyone, making it desirable for
individuals to have well-educated neighbors.
2. Social Value vs. Private Value
• The social value of education (and other goods with positive externalities) is
greater than the private value.
• In Figure 3 (not provided here), the social-value curve lies above the demand
curve because it accounts for the additional benefits to society.
• The optimal quantity is where the social-value curve intersects the supply curve,
which is higher than the quantity produced by the market on its own.
3. Government Intervention
• To achieve the socially optimal quantity, government intervention is necessary.
• Subsidy for Positive Externalities:
o In the case of positive externalities, the government can subsidize the good
or service to encourage more production and consumption.
o In the case of education, the government subsidizes education through
public schools and scholarships to increase the supply of education and
move the market closer to the social optimum.
4. Key Concept
• When there are positive externalities, the market underproduces the good
relative to the socially optimal amount.
• The government can correct this by providing subsidies to increase production and
consumption.
To summarize
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is socially [Link]
remedy the problem, the government can internalize the externality by taxing goods with
negative externalities and subsidizing goods with positive externalities.
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Public Policies toward Externalities
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Externalities cause inefficiency market allocation therefore we need government intervention
to remedy the efficient allocation.
There are two ways which are the Command and control policies and Market based policies
Command-and-Control Policies: Regulation
● The government can remedy an externality by either requiring or forbidding certain
behaviors
Market-Based Policy 1: Corrective Taxes and Subsidies
● Instead of regulating behavior in response to an externality, the government can use
market-based policies to align private incentives with social efficiency
● For example are taxing externality which are called corrective taxes or Pigovian
taxes
● The corrective taxes would equal the external benefit to turn the negative externality
to a positive one
● Taxing externalities make the goals more effective as the tax works more flexible and
are made to make incentives
● Corrective taxes alter incentives to make the society far better off
Market-Based Policy 2: Tradable Pollution Permits
● For example the EPA tells two factories that factory A and B must only pollute 300
tons of emissions. But at the end of the year Factory A wants to pollute 400 tons and
factory B only needs to pollute 200 tons. Thus Factory B agrees to lower their
emission if Factory A pays. The total pollution stays the same but the social welfare
change
● This creates a new kind of scare resources which is a tradable pollution permit
● This resource will be governed by the market mechanism of supply and demand
Objections to the Economic Analysis of Pollution
● There is an argument to be made that no one should have the right to pollute
● But this argument isn't realistic because we face trade off every day and we must act
upon it
Private Solutions to Externalities
The Types of Private Solutions
● Sometimes the problem of externalities is solved with moral codes and social
sanctions
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● The private market can often solve the problem of externalities by relying on the
selfinterest of the relevant parties. Sometimes the solution takes the form of
integrating different types of businesses
● Another way for the private market to deal with external effects is for the interested
parties to enter into a contract.
The Coase Theorem
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
The Coase theorem says that private economic actors can potentially solve the problem
of externalities among themselves. Whatever the initial distribution of rights, the
interested parties can reach a bargain in which everyone is better off and the outcome is
efficient.
Why Private Solutions Do Not Always Work
Not everyone is willing to bargain and fail to solve a problem because of a transaction cost
transaction costs, the costs that parties incur during the process of agreeing to and following
through on a bargain
Reaching an efficient bargain is especially difficult when the number of interested
parties is large, because coordinating everyone is costly
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