Chapter 14: Externalities

Intermediate Microeconomics: A Tool-Building

Approach, 2ed.
Routledge, UK

Contents
1 Introduction to Externalities 3

2 Externalities and Market Inefficiency 3

2.1 Consumption Externality Example . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 Figure 14.1: Walras Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.3 Equilibrium Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3 Production Externality 4
3.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2 Free Market Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.3 Merged Firm Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

4 Mitigating Inefficiencies 6
4.1 Pigouvian Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.2 Limitations of Pigouvian Taxes . . . . . . . . . . . . . . . . . . . . . . . . . 6

5 Arrow’s Missing Markets 6

5.1 Pollution Tax Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
5.2 Direct Regulation Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
5.3 Figure 14.3: Marginal Abatement Cost Curves . . . . . . . . . . . . . . . . . 7
5.4 Cost-Effective Abatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
5.5 Carbon Tax Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

6 Cap and Trade 9

6.1 Pollution Permit System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
6.2 Permit Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

7 Coase Theorem and Property Rights 9

7.1 Theorem Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
7.2 Roommate Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
7.3 Figure 14.4: Edgeworth Box for Coase Theorem . . . . . . . . . . . . . . . . 10

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 7.4 Pareto Efficient Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
7.5 Endowment Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
7.6 Walras Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
7.7 Limitations of Coase Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . 11

8 Summary of Key Numerical Results 11

9 Conclusion 11

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1 Introduction to Externalities
Definition 1. An externality is an uncompensated impact (positive or negative) of an
agent’s consumption or production behavior on others. It is an outcome that is not internal
to the market and is not accounted for in costs or benefits.

2 Externalities and Market Inefficiency

2.1 Consumption Externality Example
Consider two consumers, a and b, with two goods, x and y, in the market. Their endowments
are:

wa = (0, 1)
wb = (1, 0)

Utility functions are:

ua (xa , ya , xb ) = xa + ya − 0.5xb
ub (xb , yb ) = xb yb

Note that consumer a derives negative utility from b’s consumption of good x. Indifference
curves for a have slope -1.

2.2 Figure 14.1: Walras Equilibrium

← xb Ob

ua ub

Budget
E line: px /py = 1
ya → ← yb
(1/2, 1/2)
F

Oa xa → Endowment w = ((0, 1), (1, 0))

Figure 1: Edgeworth Box: Walras Equilibrium at E

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2.3 Equilibrium Calculations
At point E, where both goods are priced at $1:

ma = 1 (from endowment (0,1))

mb = 1 (from endowment (1,0))

Utility at E = (xa , ya ) = (1/2, 1/2) and (xb , yb ) = (1/2, 1/2):

 
a 1 1 1
u = + − 0.5 = 1 − 0.25 = 0.75
2 2 2
  
b 1 1
u = = 0.25
2 2
At point F = (xa , ya ) = (7/12, 3/8) ≈ (0.583, 0.375) and (xb , yb ) = (5/12, 5/8) ≈
(0.417, 0.625):
 
a 7 3 5
u = + − 0.5 = 0.583 + 0.375 − 0.208 = 0.75
12 8 12
  
b 5 5 25
u = = ≈ 0.26
12 8 96
Therefore, at F , consumer a is no worse off, but consumer b is better off, indicating
inefficiency at E.

3 Production Externality
3.1 Setup
Two firms:
• Acid factory (A) producing acid output a
• Fishery (F) producing fish output f
Prices:

Pa = $36
Pf = $48

Cost functions:

cA (a) = a2
cF (f, a) = f 2 + af

Profit functions:

πA (a) = 36a − a2
πF (f, a) = 48f − f 2 − af

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3.2 Free Market Solution
In the free market, each firm maximizes independently:
For firm A:
dπA
= 36 − 2a = 0
da
a∗ = 18
πA∗ = 36(18) − (18)2 = 648 − 324 = 324
For firm F (taking a = 18 as given):
dπF
= 48 − 2f − a = 48 − 2f − 18 = 30 − 2f = 0
df
f ∗ = 15
πF∗ = 48(15) − (15)2 − 18(15) = 720 − 225 − 270 = 225
Total profit: πA∗ + πF∗ = 324 + 225 = 549

3.3 Merged Firm Solution

If both firms merge, the combined profit function is:
πM = πA + πF = 36a − a2 + 48f − f 2 − af
Maximizing with respect to both variables:
∂πM
= 36 − 2a − f = 0
∂a
∂πM
= 48 − 2f − a = 0
∂f
Solving the system:
36 − 2a − f = 0 ⇒ f = 36 − 2a
48 − 2(36 − 2a) − a = 0
48 − 72 + 4a − a = 0
−24 + 3a = 0
a=8
f = 36 − 2(8) = 20
Merged profit:
πM = 36(8) − (8)2 + 48(20) − (20)2 − (8)(20)
= 288 − 64 + 960 − 400 − 160
= 624
This is higher than the free market total of 549, showing inefficiency in the unregulated
market.

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4 Mitigating Inefficiencies
4.1 Pigouvian Tax
A Pigouvian tax can internalize the externality. With a0 = 8, the optimal tax is:
t = 20
Firm A’s profit with tax:
πAtax = 36a − a2 − ta = 36a − a2 − 20a = 16a − a2
Maximizing:
dπAtax
= 16 − 2a = 0
da
a=8
Profit outcomes:
πAtax = 16(8) − 64 = 128 − 64 = 64
πF = 48(20) − (20)2 − 8(20) = 960 − 400 − 160 = 400
Tax Revenue = t · a = 20 × 8 = 160
Total gains from trade under tax:
πA + πF + Tax Revenue = 64 + 400 + 160 = 624

4.2 Limitations of Pigouvian Taxes

• Information necessary to set appropriate tax/subsidy is often unavailable
• Distributional consequences: A’s profit plummets from $324 to $64; F’s profit rises
from $223 to $400
Real-world applications include taxes on tobacco/alcohol and subsidies for flu shots and
public education.

5 Arrow’s Missing Markets

5.1 Pollution Tax Example
Three electric power plants each emit 10 tons of SO2 . Total abatement cost (TAC) functions:
e21
TAC1 =
2
e22
TAC2 =
4
e23
TAC3 =
6

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where ej is the emission abatement of plant j.
Marginal abatement cost (MAC) functions:

MAC1 = e1
e2
MAC2 =
2
e3
MAC3 =
3

5.2 Direct Regulation Approach

Goal: Reduce total emissions by 12 tons (from 30 to 18 tons).
Under direct regulation requiring each plant to reduce by 4 tons:

42
Cost1 = =8
2
42
Cost2 = =4
4
42
Cost3 = ≈ 2.67
6
Total Cost = 8 + 4 + 2.67 = 14.67

5.3 Figure 14.3: Marginal Abatement Cost Curves

Marginal Abatement Cost Curves

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MAC1 = e1
Marginal Cost ($/ton)

MAC2 = e2 /2
6 MAC3 = e3 /3
Tax = $2
4

0
0 2 4 6 8 10
Abatement (tons)
Figure 2: Marginal Abatement Cost Curves and Emission Tax

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5.4 Cost-Effective Abatement
The socially cost-effective allocation occurs when MACs are equalized:
e2 e3
e1 = =
2 3
With total abatement of 12 tons:

e1 + e2 + e3 = 12

Let e1 = t, then e2 = 2t, e3 = 3t:

t + 2t + 3t = 6t = 12 ⇒ t = 2

Therefore:

e1 = 2 tons
e2 = 4 tons
e3 = 6 tons

Total cost at this allocation:

22
Cost1 = =2
2
42
Cost2 = =4
4
62
Cost3 = =6
6
Total Cost = 2 + 4 + 6 = 12

Savings compared to uniform regulation: 14.67 − 12 = 2.67

5.5 Carbon Tax Mechanism

With a tax of $2 per unit of pollution:

• Firm 1: MAC1 ¡ $2 for first 2 units → abates 2 tons

• Firm 2: MAC2 ¡ $2 for first 4 units → abates 4 tons

• Firm 3: MAC3 ¡ $2 for first 6 units → abates 6 tons

This achieves the desired reduction without requiring the government to know individual
firms’ cost functions.

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6 Cap and Trade
6.1 Pollution Permit System
Three plants emit 30 tons of SO2 initially:

• Plant 1: 12 tons

• Plant 2: 10 tons

• Plant 3: 8 tons

Government caps emissions at 18 tons and issues 18 permits (1 permit = 1 ton emission).
Initial permit distribution:

• Plant 1: 7 permits

• Plant 2: 5 permits

• Plant 3: 6 permits

6.2 Permit Market Equilibrium

At price P = $3 per permit, setting MAC = P:

Plant 1: e1 = 3 ⇒ Abatement = 3, Emissions = 12 − 3 = 9, Permits needed = 9 − 7 = 2 (buyer)

Plant 2: e2 /2 = 3 ⇒ e2 = 6, Emissions = 10 − 6 = 4, Permits needed = 4 − 5 = −1 (seller)
Plant 3: e3 /3 = 3 ⇒ e3 = 9, Emissions = 8 − 9 = −1 (impossible), actually e3 ≤ 8

At equilibrium price P = $2:

Plant 1: e1 = 2, Emissions = 10, Permits needed = 10 − 7 = 3 (buyer)

Plant 2: e2 /2 = 2 ⇒ e2 = 4, Emissions = 6, Permits needed = 6 − 5 = 1 (buyer)
Plant 3: e3 /3 = 2 ⇒ e3 = 6, Emissions = 2, Permits needed = 2 − 6 = −4 (seller)

Total permits demanded = 3 + 1 = 4, permits supplied = 4 → Market clears.

7 Coase Theorem and Property Rights

7.1 Theorem Statement
Theorem 1 (Coase Theorem). If property rights are well-defined and transaction costs are
negligible, private parties can bargain to reach a Pareto efficient outcome regardless of the
initial allocation of property rights.

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7.2 Roommate Example
Two roommates: smoker (a) and non-smoker (b). Utility functions:

ua (xa , s) = xa + ln s
ub (xb , s) = xb + 4 ln(1 − s)

where:

• x = food

• s = smoke that ’a’ likes but imposes negative externality on b

• 0 ≤ s ≤ 1 (maximum smoke normalized to unity)

Define pollution rights: ya + yb = 1, where ya is smoke rights for a, yb for b.

With quasilinear utilities:

ua (xa , ya ) = xa + ln ya
ub (xb , yb ) = xb + 4 ln yb

7.3 Figure 14.4: Edgeworth Box for Coase Theorem

7.4 Pareto Efficient Allocations
The set of interior Pareto efficient allocations is given by the tangency of indifference curves:
M Uya
MRS for a: M Ux
= 1/y
1
a
= y1a
a
M Uyb 4/yb 4
MRS for b: M U xb
= 1
= yb
a b
Setting MRS = MRS :
1 4 4
= =
ya yb 1 − ya
Solving:
1 − ya = 4ya ⇒ 1 = 5ya ⇒ ya = 0.2
This gives the horizontal contract curve at ya = 0.2.

7.5 Endowment Scenarios

Two endowment points:

ω = ((5, 0), (5, 1)) (’a’ has no right to smoke)

ω ′ = ((5, 1), (5, 0)) (’a’ has complete right to smoke)

The magenta line connecting ω and ω ′ represents all possible property rights allocations.

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7.6 Walras Equilibrium
For different initial allocations of property rights along the magenta line, Walrasian alloca-
tions will end up somewhere between points E and F on the contract curve. The amount
of x each person ends up with depends on who is purchasing property rights—distributional
effects result from who is ”bribing” the other—but the level of externality is constant at
ya = 0.2, illustrating the theorem.

7.7 Limitations of Coase Theorem

1. The invariance result relies on there being a horizontal (interior) contract curve, which
is not common.

2. With arbitrary preferences, the allocation of property rights does make a difference
to the level of externality even in theory (though the allocation reached will still be
Pareto efficient).

3. Transaction costs in reality reduce the theorem’s applicability.

8 Summary of Key Numerical Results

Table 1: Summary of Key Numerical Examples

Scenario Values Outcome

Consumption Externality ua = 0.75, ub = 0.25 at E Inefficient
ua = 0.75, ub = 0.26 at F Pareto improvement
Production Externality a∗ = 18, f ∗ = 15, π = 549 Free market
a∗ = 8, f ∗ = 20, π = 624 Merged firm
Pigouvian Tax Tax = 20 πA = 64, πF = 400, T R = 160
Emission Abatement Uniform: cost = 14.67 Inefficient
Optimal: e = (2, 4, 6), cost = 12 Efficient
Cap and Trade Permits at $2 Market clears
Coase Theorem ya = 0.2 Invariant externality level

9 Conclusion
Externalities create market inefficiencies that can be addressed through various policy in-
struments:

• Pigouvian taxes/subsidies internalize external costs/benefits

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 • Cap and trade systems create markets for pollution rights

• Property rights assignments enable Coasian bargaining

Each approach has limitations, including information requirements, distributional conse-

quences, and transaction costs.

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