EXTERNALITIES

■ Figure
■ Detailed Notes Explanations ■ Key Terms ■ Important Topics ■ PYQs
 1. CHAPTER OVERVIEW

Chapter 34 of Varian's Intermediate Microeconomics studies situations where economic agents affect
each other outside the price system. These spillovers — called externalities — cause the free market to
produce a Pareto-inefficient outcome. The chapter analyses tools that can restore efficiency:
property-rights assignment, Pigouvian taxes, pollution vouchers, and merger/internalization.

2. DETAILED NOTES

◆ 34.1 Smokers and Nonsmokers — Consumption Externalities

A consumption externality occurs when one consumer directly cares about another agent's production
or consumption. Examples:

• Negative: loud music at 3 AM, second-hand smoke, automobile pollution.

• Positive: a neighbour's beautiful flower garden.

A production externality arises when the production possibilities of one firm are influenced by the
choices of another firm or consumer. Examples:

• Positive (mutual): apple orchard next to a beekeeper — each benefits the other.
• Negative: a steel mill dumping pollutants into a river used by a fishery.

The crucial feature of externalities: the goods people care about are not sold on markets. There is no
market for loud music, second-hand smoke, or clean air in a shared room. This lack of markets for
externalities causes the efficiency problem.

■ Edgeworth-Box Model: Smoker A vs Nonsmoker B

Two roommates A and B share money and smoke. Both like money; A likes smoke, B likes clean air
(absence of smoke). Smoke is measured 0–1. The setup gives an Edgeworth-box diagram, but with a
crucial difference:

• Money is divisible between A and B — two amounts to measure (horizontally).

• Smoke is a public bad for B — only ONE total amount exists (vertical axis).
• Both must consume the same quantity of smoke.

■ Role of Property Rights in Setting the Initial Endowment

The initial endowment of smoke depends entirely on the legal system:

Legal Situation Endowment Point Implication

E — (100,0) for both, zero

B has right to clean air smoke A must bribe B to allow smoking

B must bribe A to reduce

A has right to smoke freely E' — maximum smoke smoking
 Regardless of the starting endowment, if agents can trade freely, they will negotiate to a Pareto-efficient
allocation on the contract curve (tangency of indifference curves). Both allocations X (from E) and X' (from
E') are Pareto efficient — they differ only in distribution, not in efficiency.
■ Key insight: Well-defined property rights → efficient trading even with externalities.

◆ 34.2 Quasilinear Preferences and the Coase Theorem

In general, the efficient amount of the externality depends on who owns the property rights (different
endowments → different amounts of smoke at the efficient point). However, there is a special case:

If agents' preferences are quasilinear (indifference curves are h

the efficient amount of the externality is the same regardless o
THE COASE THEOREM Only the distribution of money changes.

Why quasilinear? Quasilinear preferences imply no income effects. A reallocation of endowments does
not affect the efficient amount of the externality (the amount of smoke) — it only changes how much
money each person holds.

Caveat: The Coase Theorem holds only when bargaining is costless and property rights are well-defined.
In practice, poorly defined property rights are the primary source of externality problems.
■ The practical problems with externalities generally arise because of poorly defined property rights (Varian's italicised
statement).

◆ 34.3 Production Externalities — The Steel Mill & Fishery

Firm S (steel) produces steel s and pollution x dumped into a river. Firm F (fishery) is downstream; its
costs rise with pollution. Notation:

• cs(s, x) = cost function for the steel firm. More pollution reduces cost: ∆cs/∆x ≤ 0.
• cf(f, x) = cost function for the fishery. More pollution raises cost: ∆cf/∆x > 0.

■ Private Optimum (Steel Mill Acts Alone)

Steel mill maximises profit independently:

max ps·s − cs(s, x)

First-order conditions:

ps = ∆cs(s*, x*)/∆s

0 = ∆cs(s*, x*)/∆x ← pollution is 'free', so MC of extra pollution = 0

The steel mill produces pollution until its own marginal cost of generating an extra unit is zero, completely
ignoring the cost imposed on the fishery. This leads to too much pollution from a social standpoint.

■ Social Optimum (Merged Firm / Joint Maximisation)

If the two firms merge, they solve:
max ps·s + pf·f − cs(s, x) − cf(f, x)

New first-order condition for pollution:

 ∆cs(■, x■)/∆x + ∆cf(f■, x■)/∆x = 0

Rearranging:

−MCS(■, x■) = MCF(f■, x■)

The merged firm accounts for the full social cost of pollution. It chooses less pollution than the private
optimum because it internalises the cost imposed on the fishery. The externality has been internalized.

◆ 34.4 Interpretation of the Conditions — Policy Remedies

■ 1. Pigouvian Tax
Place a tax of t dollars per unit of pollution on the steel firm. The firm now solves: max pss − cs(s,x) − t·x.

Setting the tax equal to the marginal cost the pollution imposes on the fishery at the optimum:

t* = ∆cf(f■, x■)/∆x

This makes the private optimum coincide with the social optimum. The tax is called a Pigouvian tax (after
Arthur Pigou, 1877–1959). Limitation: We need to know the optimal pollution level to set t* — but if we
knew that, we could just mandate it directly.

■ 2. Missing Market for Pollution

From a social view, pollution should have a negative price (since people would pay to reduce it). If the
fishery holds the right to clean water and can sell pollution permits at price q per unit, each firm faces the
correct social cost. Equilibrium condition:

−∆cs/∆x = ∆cf/∆x

This is identical to the merged-firm condition — exactly the Pareto-efficient level of pollution.

■ 3. Merger / Internalization
If the two firms merge, the externality disappears because the combined entity automatically accounts for
all interactions. Profit maximisation itself provides the incentive: joint profits exceed the sum of separate
profits, so there is always an economic incentive to merge when production externalities exist. This is why
such externalities are rarely observed in practice — firms have already internalized them.

■ EXAMPLE: Pollution Vouchers (Cap-and-Trade)

Southern California plan: each of the 2,700 largest polluters receives a quota set 8% below its previous
year's emissions. If it reduces emissions below quota, it can sell the surplus credits; if above quota, it must
buy credits. In equilibrium, the market price of a permit equals the marginal cost of emission reduction
across all firms — automatically achieving the least-cost allocation of emission reductions.
■ Efficient result: the marginal cost of emission control is equalised across firms.

◆ 34.5 Market Signals and Internalization

The profit motive itself is the signal to internalize production externalities. If two firms' actions affect each
other, their combined profit exceeds the sum of separate profits. Hence one firm can always buy the other
and capture the gain — the market provides the incentive to merge.
This is why most production externalities between firms that interact are already internalized (e.g., apple
orchards and beekeepers arrange contracts or share ownership). Externalities that survive tend to involve
large numbers of anonymous agents — e.g., automobile pollution — where bilateral bargaining is
impractical.

◆ 34.6 The Tragedy of the Commons

When a resource is owned in common (open access), each individual user ignores the cost their use
imposes on others. This leads to over-use.

■ Formal Model
A village grazes cows on a common field. Let c = number of cows, a = cost per cow, f(c) = total milk value.
Average product per cow = f(c)/c.

Scenario Decision rule Outcome

Private owner MP(c*) = a Efficient; c* cows

Common land f(■)/■ = a (AP = a) Over-grazed; ■ > c*

Why? The individual villager compares average product f(c)/c to cost a, ignoring that adding a cow
reduces milk output for every other cow. The marginal product curve lies below the average product curve
when AP is falling, so the common equilibrium (AP = a) has more cows than the efficient point (MP = a).
■ Tragedy of the Commons: common property → over-use because social costs are ignored.

Real-world examples: Overfishing in international waters, extinction of species due to overhunting,

overgrazing of common pastures.

◆ 34.7 Automobile Pollution

Automobile emissions are a classic negative consumption externality. Approaches to control:

• Emission standards (Clean Air Act 1963): Requires all cars to meet uniform limits. Criticism: blunt,
imposes equal cost on all drivers regardless of location; owner has no incentive to economise on
driving.
• Effluent fees: Annual inspection estimates likely emissions based on odometer reading and vehicle
tests; communities levy fees proportional to estimated pollution generated. Each driver faces the true
social cost → socially optimal amount of driving.
■ Effluent fees dominate standards economically but are politically harder to implement.
 3. FIGURE EXPLANATIONS

◆ Figure 34.1 — Preferences for Money and Smoke (Edgeworth Box)

Figure 34.1 · Edgeworth Box: Smoker vs Nonsmoker

AXES:
Vertical axis → Total SMOKE (0 = no smoke, 1 = smoke-filled room)
Horizontal axis → MONEY (A's from lower-left; B's from upper-right)

KEY ELEMENTS:
A's indifference curves — slope upward (A likes both money & smoke)
B's indifference curves — slope downward (B likes money, dislikes smoke)
Endowment E — B has right to clean air → initial smoke = 0

KeyEndowment E' —Figure

Lesson from A has right to smoke
34.1: → initial property
Well-defined smoke = 1rights
(maximum)
allow agents to trade to a Pareto-efficient
outcome. The efficiency result is the same regardless of who holds the rights — but the distributional
outcome differs significantly. Person A (smoker) prefers X'; Person B (nonsmoker) prefers X.
EQUILIBRIA:
X (from E) — Pareto efficient; B is better off than at X'
X' (from E') — Pareto efficient; A is better off than at X
◆ Figure 34.2 — Quasilinear Preferences and the Coase Theorem
INSIGHT: Both X and X' are efficient (contract curve); they differ only
Figure 34.2 · Quasilinear Case: Unique Efficient Smoke Level
in distribution. Which one we reach depends on property rights.

AXES: Same as Figure 34.1 (Smoke vertical, Money horizontal)

KEY FEATURE:
A's indifference curves → horizontal translates of each other
B's indifference curves → horizontal translates of each other

RESULT:
The locus of mutual tangencies (contract curve / Pareto-efficient
Key Lesson from Figure 34.2: The horizontal contract curve means every efficient allocation has the
allocations) is a HORIZONTAL LINE
same amount of smoke. Trading shifts only money between A and B. This is the graphical statement of the
Coase Theorem.
IMPLICATION:
The amount of smoke is IDENTICAL at every Pareto-efficient point
Only the 34.3
◆ Figure amounts
—ofSocial
money held
Costdiffer
vsacross efficient
Private allocations
Cost of Pollution

COASE THEOREM: With quasilinear preferences (no income effects),

the efficient externality level is independent of property-rights assignment.
 Figure 34.3 · Marginal Cost Diagram: Steel Mill Pollution

AXES:
Vertical → PRICE (marginal cost)
Horizontal → QUANTITY OF POLLUTION

CURVES:
−MC_S → Negative of marginal cost to steel from extra pollution
(slopes downward: reducing pollution is costly for the mill)
MC_F → Marginal cost to fishery from extra pollution

Key Lesson (slopes

fromupward: more
Figure pollution
34.3: The hurts
steelfishery
firm's more at the
private margin)is where its own marginal saving from
optimum
pollution equals zero (x*). But the socially efficient level (x■) is lower, where the steel mill's marginal
saving
KEY equals
POINTS:the marginal cost it imposes on the fishery. A Pigouvian tax equal to MC_F at the optimum
shifts
x* the
— mill's choice
Privately from
optimal x* to x■.
pollution (where MC_S = 0; mill ignores fishery)
x■ — Socially optimal pollution (where −MC_S = MC_F)
i.e., marginal savings to steel = marginal cost to fishery
◆ Figure 34.4 — The Tragedy of the Commons
RESULT: x■ < x* → Private optimum OVER-pollutes relative to social optimum
Figure 34.4 · Average vs Marginal Product: Common Grazing

AXES:
Vertical → AP / MP (value of milk per cow)
Horizontal → NUMBER OF COWS
Horizontal line at height a → cost of a cow

CURVES:
MP curve — Marginal product (BELOW AP when AP is falling)
AP curve — Average product (falling as more cows added)
Key Lesson from Figure 34.4: When the AP curve is falling, the MP curve lies below it. Free entry drives
profits to zero (AP = a) at more cows than is efficient (MP = a). The gap between the two points quantifies
KEY POINTS:
the over-use due to the tragedy of the commons.
Efficient output → MP = a (private owner's choice)
Equilibrium output→ AP = a (common-access result)
AP = a lies to the RIGHT of MP = a

RESULT: Common access → over-grazing (too many cows relative to efficient)

Private ownership → efficient number of cows
 4. KEY TERMS / GLOSSARY

Externality
A situation in which an agent directly cares about another agent's production or consumption — a cost
or benefit that falls on parties not involved in the transaction and is not reflected in market prices.

Consumption Externality
One consumer directly cares about another agent's production or consumption. Negative examples:
loud music, second-hand smoke. Positive: a neighbour's flower garden.

Production Externality
One firm's production possibilities are directly affected by another firm's or consumer's choices.
Example: steel mill pollution reducing a fishery's catch.

Pareto Efficiency
An allocation where no agent can be made better off without making another worse off. Markets with
externalities may fail to achieve this.

Property Rights
Legal entitlements to use, sell, or transfer a resource. Well-defined property rights are essential for
market solutions to externality problems.

Coase Theorem
If property rights are well-defined and bargaining is costless, agents will trade to a Pareto-efficient
outcome regardless of the initial rights assignment. With quasilinear preferences, the efficient level of
the externality is also independent of who owns the rights.

Quasilinear Preferences
Preferences of the form u(x, m) = v(x) + m, where m is money. Indifference curves are horizontal
translates. These preferences imply no income effects, validating the strong form of the Coase
Theorem.

Pigouvian Tax
A tax equal to the marginal external cost imposed by a polluter at the socially optimal level of output.
Named after Arthur Pigou. Forces the polluter to face the full social cost of its actions.

Internalization
Incorporating the external costs or benefits of an action into the decision-maker's own cost-benefit
calculation, e.g., through merger, taxation, or property-rights assignment.

Social Cost
The total cost of an activity, including private costs borne by the producer and external costs imposed
on third parties.

Private Cost
The cost borne solely by the producing firm or consuming individual, excluding any costs imposed on
third parties.
Pollution Vouchers (Cap-and-Trade)
A market-based system where the regulator sets a total emission cap, allocates tradeable permits, and
lets the market determine the price. Firms with low abatement costs sell permits; high-cost firms buy
them. Achieves cost-efficiency.

Tragedy of the Commons

The over-use of a common (unowned or open-access) resource because each user ignores the cost
imposed on other users. Coined by Garrett Hardin (1968). Examples: overfishing, overgrazing, air
pollution.

Effluent Fee
A charge levied on a polluter proportional to the actual amount of pollution generated. Unlike emission
standards, it gives the polluter an incentive to reduce pollution continuously and economise on
driving/production.

Marginal Social Cost

The sum of the marginal private cost and the marginal external cost. At the Pareto-efficient pollution
level, price = marginal social cost.
5. CHAPTER SUMMARY

Free competitive markets achieve Pareto efficiency in the absence of externalities (First Theorem
1 of Welfare Economics).

When externalities are present, competitive markets are unlikely to be Pareto efficient — private
2 costs diverge from social costs.

The state can sometimes 'mimic' the market by using prices (Pigouvian taxes, effluent fees,
3 tradeable permits) to signal the true social cost of individual actions.

The legal system can ensure property rights are well-defined so that efficiency-enhancing trades
4 can occur (Coase mechanism).

If preferences are quasilinear, the efficient amount of the externality is independent of the
5 assignment of property rights (Coase Theorem).

Remedies for production externalities include Pigouvian taxes, creating a market for the
6 externality, merging the affected firms, or reassigning property rights.

The tragedy of the commons — the tendency for common property to be over-used — is a
7 particularly widespread form of externality arising from poorly defined property rights.
6. MOST IMPORTANT TOPICS FOR EXAMS

★★ Definition & Classification of Externalities

★ Distinguish consumption vs production externalities; positive vs negative. Give examples of
each.

★★ Edgeworth Box with Externalities

★ Draw the smoker-nonsmoker Edgeworth box. Explain why it differs from the standard box
(smoke is a public bad — one amount for both consumers). Locate E, E', X, X' on the diagram.

★★ Role of Property Rights

★ Explain how the initial endowment is determined by legal rights. Show that both E and E' can
lead to Pareto efficiency through trade. Understand distributional vs efficiency consequences.

★★ The Coase Theorem

★ State it precisely. Explain the quasilinear assumption and why no-income-effect implies the
efficient externality level is rights-invariant. Critically evaluate its real-world applicability.

★★ Private vs Social Cost of Pollution

★ The steel mill–fishery model. Derive FOCs for (a) independent firm and (b) merged firm. Show
mathematically that private optimum over-pollutes. Understand Figure 34.3 thoroughly.

★★ Pigouvian Tax
★ Derive the optimal tax: t* = marginal external cost at the efficient output. Show algebraically that
it restores the social optimum. State the information problem.

★★ Tragedy of the Commons

★ Compare private ownership (MP = a) vs open access (AP = a). Show algebraically why AP = a
implies more cows than MP = a when AP is falling. Understand Figure 34.4.

★★ Cap-and-Trade / Pollution Vouchers

Explain the Southern California example. Show that in equilibrium, marginal abatement costs
are equalised — the efficient solution. Compare with uniform standards.

★★ Market Signals & Internalization

Why the profit motive encourages internalization of production externalities. Why such
externalities are rarely observed in practice.

★★ Missing Market Interpretation

The externality exists because the market for pollution is missing. If we create this market
(fishery sells clean-water rights), the equilibrium is Pareto efficient.

★ Automobile Pollution Policy

Critique of uniform emission standards (blunt, no mileage incentive). Advantages of effluent
fees (cost-effective, incentive to drive less).
 7. PREVIOUS YEAR & LIKELY EXAM QUESTIONS

◆ Short-Answer Questions (2–4 marks)

Q1
Define externality. Distinguish between consumption and production externalities with one example
each.

Q2
What is meant by a 'missing market' in the context of externalities?

Q3
State the Coase Theorem. Under what conditions does it hold?

Q4
What is a Pigouvian tax? How does it correct a negative production externality?

Q5
Explain the 'tragedy of the commons' with the help of a diagram.

Q6
Distinguish between private cost and social cost with an example.

Q7
What is meant by quasilinear preferences? Why are they important for the Coase Theorem?

Q8
How does pollution voucher (cap-and-trade) system achieve an efficient allocation of emissions?

◆ Long-Answer / Essay Questions (8–15 marks)

Q9
Analyse the smoker-nonsmoker problem using an Edgeworth box. Show how well-defined property
rights and voluntary trade lead to a Pareto-efficient outcome. How does the outcome differ depending
on who holds the property rights? Discuss efficiency vs equity.

Q10
Consider a steel mill (S) and a fishery (F). Write down the profit-maximisation problems for each firm
separately, and for a merged firm. Derive the efficiency conditions and show that the private optimum
involves too much pollution. Explain how a Pigouvian tax can restore efficiency. [Include mathematical
derivation.]

Q11
Explain the Coase Theorem in the context of the smoker-nonsmoker model. What is the role of
quasilinear preferences? Critically evaluate the real-world validity of the Coase Theorem.

Q12
Describe the tragedy of the commons using a formal model of common grazing land. Show (a) the
socially efficient number of cows and (b) the open-access equilibrium number. Use a diagram. What
policy interventions can restore efficiency?
Q13
Compare and contrast three policy instruments for dealing with production externalities: (i) Pigouvian
taxes, (ii) tradeable pollution permits, and (iii) merger of the affected firms. Which is most practical and
why?

Q14
Using the concepts of this chapter, critically evaluate U.S. automobile emission policy (uniform
standards). What alternative does an effluent fee system provide? What are the advantages and
limitations of each?

◆ Application / Numerical Questions

Q15
A steel firm's cost function is c_s(s, x) = s² − 2x and a fishery's cost function is c_f(f, x) = f² + x². Steel
price p_s = 4, fish price p_f = 6. (a) Find the private optimum (s*, x*) for the steel firm. (b) Find the
socially optimal (■, x■) for the merged firm. (c) Calculate the Pigouvian tax t*.

Q16
In the tragedy-of-the-commons model, f(c) = 100c − c², cost per cow a = 40. (a) Find the efficient
number of cows c*. (b) Find the open-access equilibrium ■. (c) Calculate the excess number of cows
grazed under common access.

Q17
Two firms must together reduce emissions by 100 tons. Firm 1's abatement cost: C■(x■) = 2x■². Firm
2's abatement cost: C■(x■) = x■². (a) Find the cost-minimising allocation (x■*, x■*). (b) What
equilibrium price would emerge in a permit market?

■ EXAM TIP
For this chapter, always draw the diagram first (Edgeworth box or MC diagram) before writing algebra.
Examiners award marks for correct labelling of E, E', X, X', the contract curve, and the tangency
condition. For the tragedy of the commons, show both the AP and MP curves and clearly mark 'Efficient
output' vs 'Equilibrium output'. For Pigouvian tax questions, derive the tax algebraically and state its
informational limitation.