ECO 602 (H)
ENVIRONMENTAL ECONOMICS
SEMESTER 6
Unit I
Externalities
An externality is an indirect cost or benefit that affects a third party who is not directly involved in an
economic activity. Externalities can be positive or negative, and are also known as "external costs" or
"external benefits".
Externalities occur when the actions of one agent have an impact on the utility (or profit) of another
agent in unintended ways, without any compensation/payment made to the affected party.
External costs/benefits are the wedge between private costs/benefits and social costs/benefits. Since
most of the analysis is carried out in ‘marginal’ terms, it can be said that marginal social cost (MSC) and
marginal social benefit (MSB) diverge from their private counterparts (i.e. MPC and MPB). The market
also fails to achieve social efficiency when there is a discrepancy between marginal social benefit (MSB)
and marginal social cost (MSC).
The difference between them is accounted for by marginal external cost/benefit (MEC/MEB). Thus:
MSC = MPC + MEC
MSB = MPB + MEB
With a free market, quantity and price are such that PMB = PMC
Social optimum is such that SMB = SMC
⇒ Private market leads to an inefficient outcome
MPC: The direct cost to producers of producing an additional unit of a good. These are the actual
monetary costs to firms of producing good (raw materials, wage costs and other inputs)
MSC: These are the total costs of production borne by society as a whole (include the MPC and all
external costs)
Markets usually do not capture ‘marginal external cost’ (MEC). It tends to equate ‘marginal private
benefit’ (MPB) with MPC and end up either overproduce when ‘marginal social cost is greater than
marginal private cost’ (i.e. MSC > MPC) or under-produce when ‘marginal social benefit is greater than
marginal private benefit’ (i.e. MSB > MPB).
TYPES OF EXTERNALITIES
Positive Negative
externality externality
Positive Negative
consumption consumption
externality externality
Positive Negative
production production
externality externality
POSITIVE CONSUMPTION EXTERNALITY
Positive consumption externalities can arise when consuming a good or service generates benefits to
other individuals.
The market equilibrium (QM) occurs where MPB = MPC
(lower P, lower Q)
Socially optimal equilibrium (QS) occurs where MSB = MSC
(higher P, higher Q)
MSB > MPB
At QM, the quantity produced is lower than the socially
optimal quantity QS, leading to underconsumption of
the good.
The triangle ABC represents the welfare loss or
deadweight loss due to the market failure of not accounting for the external benefit.
If the market produces at QS, the deadweight loss is eliminated.
Examples:
Using public transportation reduces traffic congestion and pollution, which benefits the
environment and other road users.
Getting vaccinated protects the individual and reduces the spread of disease in the
community.
An educated population leads to a more productive society with lower unemployment rates
and higher economic growth.
Policy Implications:
Governments can encourage consumption of goods with positive externalities by:
•Subsidizing the good or service (lowering the cost to consumers).
•Providing direct government provision (offering public goods like education or
healthcare).
•Tax incentives for consumers or producers.
POSITIVE PRODUCTION EXTERNALITY
A positive production externality occurs when the production of
a good or service generates additional benefits to third parties or
society beyond the producer’s private benefits. E.g. a company investing
in R&D may create new technologies that benefit other businesses and
society as a whole.
Market equilibrium (Q) => lower Q, higher P
Socially optimal quantity (Q1) => higher Q, lower P
SMC < PMC
The difference between PMC and SMC represents the Marginal
External Benefit (MEB) of production.
At Q, the good is underproduced compared to the socially optimal
level Q1.
The triangle ABC represents the deadweight loss due to
underproduction, which could be eliminated if production were
increased to Q1.
NEGATIVE CONSUMPTION
EXTERNALITY
A negative consumption externality is when the
consumption of a good or service harms third
parties without compensating them. This results in
a social cost that's higher than the private benefit.
Example: Cigarette smoking
Market equilibrium (Q1) => higher Q, higher P
Socially optimal quantity (Q2) => lower Q, lower P
SMB < PMB
At Q1, the quantity produced is higher than the
socially
optimal quantity Q2, leading to
overconsumption of
the good.
NEGATIVE PRODUCTION EXTERNALITY
Negative Production Externality occurs when the
production of a good or service imposes external
costs on third parties that are not reflected in the
market price.
Market equilibrium (QM) => higher Q, lower P
Socially optimal quantity (Q) => lower Q, higher P
SMC > PMC
Efficiency requires output to be Q and price should
get set at PS. Thus, non-consideration of MEC allows
over-production of the commodity and charging of
lower price. MSC > MSB at quantity QM but QM is
inefficient and its production misallocates resources. It
therefore makes sense to reduce output from QM to
Q thereby avoiding deadweight loss equivalent to
ΔABC.
SOLUTIONS TO EXTERNALITIES
1. GOVERNMENT INTERVENTIONS
[Link] and Subsidies
• Pigouvian Tax: Named after economist Arthur Pigou, this tax is intended to make producers bear the external
cost of their actions. For example: Carbon Tax, Cigarette Tax
• Subsidies: Encouraging activities with positive externalities by lowering their costs. For example: Subsidies on
Education, Renewable Energy Subsidies
b. Regulations and Standards
• Command-and-Control Policies: Direct regulation that specifies limits on pollution or technology use.
Example: Setting limits on automobile emissions or requiring factories to use scrubbers to reduce air pollution.
• Quotas and Bans: Limiting the quantity of certain harmful activities or outright banning them. Example: Banning
single-use plastics to reduce environmental harm.
[Link] Permits (Cap-and-Trade)
A market-based approach where the government sets a total pollution limit (cap) and issues permits to polluters.
Companies can buy or sell these permits. Example: The European Union Emissions Trading System (EU ETS) limits
carbon emissions and allows trading of carbon allowances to incentivize reductions.
2. MARKET-BASED SOLUTIONS
a. Coase Theorem
The Coase Theorem, proposed by economist Ronald Coase in his seminal 1960 paper "The Problem of Social Cost", addresses
how private parties can efficiently solve externality problems through negotiation, assuming certain conditions are met. If
property rights are well-defined and transaction costs are negligible, parties will bargain to reach an efficient allocation of
resources regardless of who holds the initial property rights.
Example: A factory causing pollution negotiates with a nearby community to install pollution controls. Compensation is
agreed upon without government intervention.
Key Assumptions of the Coase Theorem:
[Link]-Defined Property Rights: Clear ownership and rights over resources must be established.
[Link] or Zero Transaction Costs: Bargaining between parties should be costless or involve minimal costs.
[Link] Information: All parties have full knowledge of the costs and benefits involved in the transaction.
Implications:
[Link] Outcome: The allocation of resources will be economically efficient, maximizing total welfare.
[Link] of Distribution: The final outcome is independent of the initial assignment of property rights, though the
distribution of wealth depends on who initially holds the rights.
Role of Property Rights
Property rights play a crucial role in determining how resources are used and allocated in the presence of
externalities.
[Link] and Enforcement: Clearly defined and enforceable property rights reduce conflicts and facilitate
bargaining.
[Link] Externalities: Assigning property rights can internalize external costs or benefits, making the
responsible party account for the full social costs or benefits of their actions.
[Link] Allocation: Proper property rights prevent the overuse of common resources, reducing problems like
the "tragedy of the commons."
b. Pollution Markets
Systems where pollution permits can be bought and sold. Example: In the acid rain program in the United States,
sulfur dioxide emissions were capped, and firms could trade pollution permits.
3. PRIVATE SOLUTIONS
[Link] Agreements
Industries or groups agree to adopt standards or reduce harmful activities without regulatory enforcement.
Example: Companies agreeing to reduce plastic packaging voluntarily to limit waste.
b. Corporate Social Responsibility (CSR)
Firms undertake actions to minimize negative externalities, motivated by ethical considerations, public image, or
long-term profitability. Example: A company investing in renewable energy for its operations to reduce carbon
footprint.
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