Chapter 34 – Externalities: Detailed Notes 13/06/26, 2:00 AM

Intermediate Microeconomics · Varian · Chapter 34

Externalities — Complete Study Notes

Covers: Consumption & Production Externalities · Coase Theorem · Pigouvian Tax · Pollution Vouchers ·
Tragedy of the Commons · Automobile Pollution

CONTENTS

1. Introduction — What Are Externalities?

2. 34.1 Smokers and Nonsmokers — Consumption Externality

3. 34.2 Quasilinear Preferences and the Coase Theorem

4. 34.3 Production Externalities — Steel Mill and Fishery

5. 34.4 Interpretation of the Conditions — Solutions to Externalities

6. 34.5 Market Signals — Mergers and Internalization

7. 34.6 The Tragedy of the Commons

8. 34.7 Automobile Pollution

9. Full Summary of Key Results

INTRODUCTION

What Are Externalities?

DEFINITION — CONSUMPTION EXTERNALITY

An economic situation involves a consumption externality if one consumer

cares directly about another agent's production or consumption. Examples:
neighbour playing loud music at 3am (negative), person next to you in a

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restaurant smoking a cheap cigar (negative), neighbour's beautiful flower garden

(positive).

DEFINITION — PRODUCTION EXTERNALITY

A production externality arises when the production possibilities of one firm are
influenced by the choices of another firm or consumer. Classic example: an
apple orchard next to a beekeeper — mutual positive production externalities. A
fishery downstream from a steel mill polluting the river — negative production
externality.

The Root Cause of Externalities

The crucial feature of externalities is that there are goods people care about that are
not sold on markets. There is no market for loud music at 3am, drifting smoke from
cheap cigars, or a neighbour's flower garden. It is this lack of markets for externalities
that causes problems.

Negative Externalities Positive Externalities

Loud music at 3am Neighbour's flower garden

Smoking in shared spaces Bees and apple orchards (mutual)

Automobile pollution Education (benefits society)

Steel mill polluting fishery Vaccination (herd immunity)

Overfishing of common stock

Previous Assumption Relaxed

In earlier chapters, each agent could make consumption or production decisions

without worrying about what other agents were doing. All interactions took place via the
market — agents only needed to know market prices and their own
consumption/production possibilities. This chapter relaxes that assumption.

KEY FACT

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The First Theorem of Welfare Economics (market achieves Pareto efficiency)

holds only when externalities are absent. If externalities are present, the market
will NOT necessarily result in a Pareto efficient provision of resources. However,
other social institutions — the legal system, government intervention — can
mimic the market mechanism to achieve Pareto efficiency.

SECTION 34.1

Smokers and Nonsmokers — A Consumption Externality

The Setup

Two roommates, A and B, have preferences over "money" and "smoke." Both
consumers like money. A likes to smoke; B likes clean air (i.e. the absence of smoke).
We measure smoke on a scale from 0 to 1, where 0 = no smoke at all and 1 = a
smoke-filled room.

The Edgeworth Box for Externalities

This is displayed in an Edgeworth box, but interpreted differently from the standard
case:

Horizontal axis: Total money of the two agents. A's money measured from lower-
left; B's from upper-right.

Vertical axis: Total amount of smoke, measured from lower-left for both. CRITICAL
DIFFERENCE: there is only ONE amount of smoke — both must face the same
level. Money can be divided, but smoke cannot.

A's preferences: Increasing in both money AND smoke (smoke is a good for A).

B's preferences: Increasing in money and CLEAN AIR (decreasing in smoke —

smoke is a bad for B).

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Figure 34.1 — Preferences for money and smoke

The box looks like a standard Edgeworth box but the interpretation differs. A's
indifference curves slope downward-left (more smoke and more money = better
for A). B's indifference curves slope in the opposite way — B prefers less smoke
(moving toward lower part of box).

Endowment E: A has right to clean air. Both have $100 each, smoke = 0. Initial
endowment is at bottom of vertical line.
Endowment E': A has right to smoke as much as he wants. Both have $100,
smoke = maximum. Endowment at top of vertical line.
Equilibrium X: Pareto efficient outcome starting from E (B has clean-air rights).
Equilibrium X': Pareto efficient outcome starting from E' (A has smoking rights).

Figure 34.1 — Smoke is a good for A but a bad for B. The equilibrium depends on the starting
endowment.

The Role of Property Rights

The initial endowment of smoke depends on the legal system. This is not different from
ordinary goods: to say A "owns" $100 means A can decide to consume it, give it away,
or trade it. Similarly, a property right to clean air means B can consume clean air, or
sell the right to pollute (i.e. accept some smoke in exchange for money).

CASE 1 — B HAS A RIGHT TO CLEAN AIR (ENDOWMENT E)

B starts with the property right to clean air. The initial endowment has A with
(100, 0) and B with (100, 0) — both have $100, and smoke = 0. B can then trade
some of his right to clean air for money — he allows A to generate some smoke
in exchange for compensation. The agents trade to a Pareto efficient point X,
where the MRS of smoke for money is the same for both agents. At X, B is better
off than at E because he's been compensated, but there is now some smoke in
the room.

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CASE 2 — A HAS A RIGHT TO SMOKE FREELY (ENDOWMENT E')

A starts with the right to smoke as much as he wants. The endowment E' has A
at the top of the vertical line. B must now bribe A to smoke less. They trade to a
Pareto efficient point X', where again MRS is equalized for both agents, but at a
different amount of smoke and a different distribution of money.

Pareto Efficiency Condition

A Pareto efficient allocation is one where neither consumer can be made better off
without making the other worse off. This is characterised by the usual tangency
condition:

MRS_A (smoke for money) = MRS_B (smoke for money)

The MRS of smoke for money should be the same for both agents. Both X and X'
satisfy this — they are on the contract curve.

Distributional Consequences

Both X and X' are Pareto efficient, but they have different distributional consequences:

Smoker A is better off at X' (where A has smoking rights) than at X.

Nonsmoker B is better off at X (where B has clean-air rights) than at X'.

On efficiency grounds, both allocations are equally satisfactory.

Different initial property rights → different distributional outcomes, but both can be
efficient.

THE REAL PROBLEM — POORLY DEFINED PROPERTY RIGHTS

The problems with externalities arise when property rights are NOT well defined.
If A believes he has the right to smoke and B believes he has the right to clean
air, we have a conflict. Poorly defined property rights → inefficient production of
externalities → there exist ways to make both parties better off by changing the
level of externality. The solution: clearly define property rights and allow
negotiation.

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The Price Mechanism and Externalities

If property rights are clear, agents can use the price mechanism just as for ordinary
goods. An auctioneer could call out prices for "smoking rights" and find the equilibrium.
With a market for smoke, competitive equilibrium will be Pareto efficient, and
competitive prices will measure the MRS between smoke and money — exactly as in
standard competitive analysis.

SECTION 34.2

Quasilinear Preferences and the Coase Theorem

In general, the efficient amount of smoke depends on who holds the property rights,
because reservation prices (and hence the optimal level of externality) depend on
wealth. But there is a special case where this doesn't matter.

The Coase Theorem

If agents' preferences are quasilinear, then every efficient solution must have
the same amount of the externality — regardless of who holds the initial
property rights. The distribution of income changes with property rights, but the
optimal amount of the externality (smoke) does not.

Why Quasilinear Preferences Imply the Coase Theorem

With quasilinear preferences, utility functions take the form uᵢ = money + vᵢ(smoke).
Indifference curves are horizontal translates of each other — they all have the same
shape, just shifted left and right. In the Edgeworth box, indifference curves are all
horizontal translates:

Figure 34.2 — Quasilinear preferences and the Coase Theorem

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In the Edgeworth box, all of A's indifference curves are horizontal translates of
each other (same shape, shifted horizontally). Same for B. The locus of mutual
tangencies — the set of Pareto efficient allocations — is a horizontal line. This
means the amount of smoke is the same in every Pareto efficient allocation. Only
the dollar amounts held by agents differ across efficient allocations.

Figure 34.2 — Unique smoke level at every Pareto efficient allocation when preferences are
quasilinear.

Economic Meaning

With quasilinear preferences, the demand for the good causing the externality doesn't
depend on the distribution of income. Therefore a reallocation of endowments doesn't
affect the efficient amount of the externality. The Coase theorem holds when there are
no "income effects."

COASE THEOREM — PRECISE STATEMENT

As long as property rights are well defined (regardless of who holds them) and
agents can trade freely, they will reach a Pareto efficient allocation. Under
quasilinear preferences, this efficient allocation will involve the same quantity of
the externality regardless of the initial property rights assignment. The
distribution of wealth will differ, but the level of the externality will be the same.

Note: Ronald Coase (1960 Nobel Prize, 1991) actually emphasised that costless
bargaining over externalities achieves Pareto efficiency — not necessarily that the
outcome is independent of property rights. The independence result requires
quasilinear preferences (no income effects). Some authors interpret Coase more
narrowly.

SECTION 34.3

Production Externalities — The Steel Mill and Fishery

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The Setup

Firm S (steel) produces steel s and generates pollution x, which it dumps into a river.
Firm F (fishery) is downstream and adversely affected by S's pollution.

Notation

s Amount of steel produced by firm S

x Amount of pollution produced by firm S (dumped into river)
f Amount of fish produced by firm F
cₛ(s,x) Cost function of steel firm — depends on both s and x
c_f(f,x) Cost function of fishery — depends on fish output f and pollution x
pₛ, p_f Prices of steel and fish respectively

Key Assumptions

Δc_f/Δx > 0: More pollution increases the fishery's cost of producing fish (bad for
fishery).

Δcₛ/Δx ≤ 0: More pollution decreases/does not increase the steel firm's cost —
reducing pollution increases the cost of producing steel (pollution is a by-product
that saves costs).

The steel mill gets to choose how much pollution it generates; the fishery must take
pollution as outside its control.

Independent Behaviour — The Market Failure

Steel firm's profit-maximisation problem (acting independently):

max_{s,x} pₛs − cₛ(s,x)

Optimality conditions for the steel firm:

STEEL FIRM INDEPENDENTLY MAXIMISING

pₛ = Δcₛ(s*,x*)/Δs (price = marginal cost of steel)

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0 = Δcₛ(s*,x*)/Δx (marginal cost of extra pollution = 0)

The steel firm produces pollution until the marginal cost of generating more pollution is
zero — because pollution has a zero price to the steel firm.

Fishery's problem (taking x as given):

max_f p_f f − c_f(f,x)

p_f = Δc_f(f*,x*)/Δf

THE MARKET FAILURE EXPLAINED

The steel firm looks only at the cost of producing steel when making its profit-
maximising calculation. It doesn't consider the cost it imposes on the fishery. The
increase in the cost of fishing associated with an increase in pollution is part of
the social cost of steel production — but it is ignored by the steel firm. We
expect the steel firm to produce too much pollution from a social point of view.

Pareto Efficient Solution — The Merged Firm

What should the Pareto efficient outcome look like? Suppose the two firms merge into
one that produces both fish and steel (and possibly pollution):

max_{s,f,x} pₛs + p_f f − cₛ(s,x) − c_f(f,x)

Optimality conditions for the merged firm:

MERGED FIRM OPTIMALITY CONDITIONS

̂)/Δs
pₛ = Δcₛ(ŝ,x
̂,x
p_f = Δc_f(f ̂)/Δf

0 = Δcₛ(ŝ,x ̂,x
̂)/Δx + Δc_f(f ̂)/Δx ← KEY CONDITION

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The Critical Condition — Social Cost Internalised

The crucial third equation says:

EQUATION (34.2) — EFFICIENT POLLUTION LEVEL

Δcₛ(ŝ,x ̂,x
̂)/Δx + Δc_f(f ̂)/Δx = 0

Rearranging (since Δcₛ/Δx ≤ 0 and Δc_f/Δx > 0):

EQUATION (34.3) — EQUIVALENT FORM

−Δcₛ(ŝ,x ̂,x
̂)/Δx = Δc_f(f ̂)/Δx > 0

−MCₛ(ŝ,x ̂,x
̂) = MC_F(f ̂)

Interpretation: The merged firm produces pollution until the sum of both firms'
marginal costs of pollution is zero. It reduces pollution to the point where the marginal
benefit to the steel firm of producing one more unit of pollution equals the marginal cost
that extra pollution imposes on the fishery.

Independent Steel Firm (Inefficient) Merged Firm / Social Planner

(Efficient)
Produces pollution until its own
marginal cost = 0: Produces pollution until sum of
marginal costs = 0:
MCₛ(s*,x*) = 0
−MCₛ(ŝ,x ̂,x
̂) = MC_F(f ̂)
Ignores the cost it imposes on the
fishery. Over-produces pollution to Takes both firms' costs into account.
x*. Produces less pollution x̂ < x*.

Figure 34.3 — Social Cost vs. Private Cost

Figure 34.3: Social cost and private cost

Diagram has "PRICE" on vertical axis and "QUANTITY OF POLLUTION" on

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horizontal axis.

−MCₛ curve: Upward sloping. The marginal benefit (negative marginal cost) to
the steel firm of generating more pollution. Starts high, falls as pollution
increases.

MC_F curve: Upward sloping. The marginal cost to the fishery of more pollution.
Starts near zero, rises steeply.

x* (Privately optimal): Where −MCₛ = 0. Steel firm produces this much pollution
when acting alone.

x̂ (Socially optimal): Where −MCₛ = MC_F. The Pareto efficient amount of

pollution. Less than x*.

The gap between x̂ and x* represents the over-production of pollution due to the
externality.

Figure 34.3 — Efficient pollution is where −MCₛ = MC_F; independent firm over-produces to x*.

Example: Pollution Vouchers

Consider the practical problem of nitrogen oxide emissions. Firms have different costs
of reducing emissions. The efficient solution requires equating marginal costs of
emission control across all firms. The minimum-cost solution to achieving an emissions
target X with two firms:

min_{x₁,x₂} c₁(x₁) + c₂(x₂) s.t. x₁ + x₂ = X

Standard economic reasoning: marginal cost of emission control must be equalised

across firms. If one firm has a higher marginal cost than another, total costs can be
reduced by lowering that firm's quota and raising the other's.

THE CALIFORNIA PLAN — POLLUTION VOUCHERS / TRADEABLE PERMITS

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2700 largest polluters in Southern California each assigned a quota set at 8%

below their previous year's emissions. If a firm reduces more than its quota, it
can sell the extra "right to emit" on the open market. Example: quota = 95
tons/year; firm reduces to 90 tons → can sell 5-ton emission credit to another
firm. Firms with low abatement costs sell credits; firms with high costs buy them.
In equilibrium, the market price of a credit equals the marginal cost of reducing
one ton of emissions — which is exactly the condition characterising the optimal
pattern of emissions. The market for emission permits produces the efficient
pattern automatically.

SECTION 34.4

Interpretation of the Conditions — Remedies for Externalities

There are several useful interpretations of the Pareto efficiency condition for production
externalities, each suggesting a different remedy.

Interpretation 1 — The Steel Firm Faces the Wrong Price

The steel firm thinks pollution costs it nothing (price = 0). But pollution imposes real
costs on the fishery. The fix: give the steel firm the correct social price for pollution via
a tax.

THE PIGOUVIAN TAX (ARTHUR PIGOU, 1877–1959)

Place a tax of t dollars per unit of pollution generated by the steel firm. The steel
firm's modified profit-maximisation problem:

max_{s,x} pₛs − cₛ(s,x) − tx

Optimality conditions with the tax:

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pₛ − Δcₛ(s,x)/Δs = 0
−Δcₛ(s,x)/Δx − t = 0 → −Δcₛ/Δx = t

Setting the tax at the right level:

OPTIMAL PIGOUVIAN TAX (EQUALS FISHERY'S MARGINAL COST AT EFFICIENT POINT)

̂, x
t = Δc_f(f ̂)/Δx

This equals the marginal damage cost of pollution to the fishery, evaluated at the
socially optimal output. With this tax, the steel firm's profit-maximising conditions
become identical to the Pareto efficiency conditions.

PROBLEM WITH PIGOUVIAN TAX

To set the tax correctly, the government needs to know the optimal level of
pollution (x̂ ) in advance. But if we already knew the optimal level, we could
simply mandate that level and skip the tax entirely. The difficulty is that gathering
and keeping current all cost information from all firms is staggering.

Interpretation 2 — A Missing Market for Pollution

The externality problem arises because the steel firm faces a zero price for an output
good (pollution) that it produces, even though people would willingly pay to reduce that
output. The social price of pollution should be negative — firms should be charged for
producing it.

Creating a Market for Pollution Rights

Suppose the fishery has the right to clean water and can sell the right to pollute. Let q
= price per unit of pollution. Steel mill's problem:

max_{s,x} pₛs − qx − cₛ(s,x)

Fishery's problem (gets revenue from selling pollution rights):

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max_{f,x} p_f f + qx − c_f(f,x)

Optimality conditions:

(34.4): pₛ = Δcₛ(s,x)/Δs

(34.5): q = −Δcₛ(s,x)/Δx
(34.6): p_f = Δc_f(f,x)/Δf

(34.7): q = Δc_f(f,x)/Δx

From (34.5) and (34.7): −Δcₛ/Δx = Δc_f/Δx, which is exactly the efficiency condition
(34.3). Each firm faces the social marginal cost of its actions. When q adjusts until
demand for pollution equals supply, we have an efficient equilibrium.

Reversing the Property Rights — Same Efficient Outcome

Now suppose the steel mill has the right to pollute up to amount x̄ , and the fishery pays
the steel mill to reduce its pollution. Steel mill's problem:

max_{s,x} pₛs + q(x

̄ − x) − cₛ(s,x)

Optimality conditions (34.8)–(34.11) are exactly the same as (34.4)–(34.7). The optimal
pattern of production is independent of the assignment of property rights. The
distribution of profits differs, but the efficient production plan is the same.

KEY RESULT FOR PRODUCTION EXTERNALITIES

In the case of production externalities, as long as well-defined property rights

exist in the externality good and agents can trade, the optimal pattern of
production is independent of who holds the initial property rights. This is the
Coase Theorem applied to production externalities. Of course, the owners of the
firms may have strong views about the appropriate distribution of profits — which
is why property rights still matter enormously even if efficiency is the same.

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SECTION 34.5

Market Signals — Mergers and Internalization

A third interpretation of externalities: perhaps the most profound. When actions of one
firm affect another, they can make higher profits together by coordinating than by going
alone.

THE MERGER INCENTIVE

If the joint profits of two firms with externalities exceed the sum of profits without
coordination, then the current owners could each be bought out for the present
value of their profit stream, the two firms coordinated, and the buyer retains
excess profits. The objective of profit maximisation itself should encourage
the internalization of production externalities.

The market itself provides a signal to internalise production externalities. This is one
reason production externalities are rarely observed in practice — firms have already
internalised them by merging, contracting, or coordinating.

EXAMPLE — BEES AND ALMONDS

Honeybees pollinate about 1/3 of the human diet and over 50 different
agricultural crops worth more than $20 billion per year in the US. California has
530,000 acres of almond trees requiring over 1 million honeybee hives for
pollination, but California only has 440,000 resident bee hives. The solution is a
ready market for bee services — beekeepers from North Dakota, Washington,
and Colorado bring hives to California. In 2004, bee pollination services sold for
$54 per hive. The externality between orchards and bees is easily internalised
through the market. Apple orchards very commonly keep honey bees for this
purpose.

SOLUTION 1: MERGER SOLUTION 2: SOLUTION 3: CREATE

PIGOUVIAN TAX A MARKET
Two firms merge into one
that internalises the Government taxes the Assign property rights in

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externality by considering polluting firm at a rate the externality good and

all cross-effects when equal to the marginal let firms trade. Market
maximising joint profit. damage it inflicts on price equilibrates supply
others, making it face the and demand for the
true social cost. externality.

SECTION 34.6

The Tragedy of the Commons

A particularly important and well-known inefficiency that arises from poorly defined
property rights.

The Tragedy of the Commons (Hardin, 1968)

When property rights are not well defined, common resources tend to be
overused. Each individual ignores the cost their use imposes on all other users
— the social cost — and instead compares only the private benefit to the
private cost. The result is a Pareto-inefficient overuse of the resource.

The Model — Grazing on a Common Field

An agricultural village where villagers graze cows on a common field. A cow costs a
dollars. Let f(c) = value of milk produced per cow when there are c cows on the field.
Assume f(c)/c is decreasing — output per cow falls as more cows crowd the field.

Optimal (Socially Efficient) Solution

Maximise total village wealth:

max_c f(c) − ac

Optimality condition: marginal product of a cow = its cost:

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MP(c*) = a

If the commons were privately owned, the owner would choose exactly this — adding
cows until MP = a, and removing cows if MP < a.

Common Property Solution (No Ownership)

Each villager independently decides whether to graze a cow. A villager adds a cow as
long as the average product f(c)/c exceeds the cost a. If there are currently c cows,
adding one more gives output f(c+1)/(c+1). Profitable to add if this exceeds a. Villagers
keep adding until:

COMMON PROPERTY EQUILIBRIUM CONDITION

f(ĉ)/ĉ = a (average product = cost)

Equivalently, profits are driven to zero: f(ĉ) − aĉ = 0. Free entry drives profits to zero.

Why Common Property Leads to Over-Grazing

When an individual villager adds a cow, he looks at f(c)/c — his average revenue per
cow — and compares it to cost a. But he ignores the fact that his extra cow reduces
the milk output of all other cows on the commons. This social cost is left out of the
calculation.

Figure 34.4 — The Tragedy of the Commons

Axes: AP/MP (vertical), Number of Cows (horizontal).

MP curve: Downward sloping. Marginal product of an additional cow.

AP curve: Downward sloping. Average product per cow = f(c)/c. Since average
product is falling, the MP curve lies everywhere below the AP curve.

Horizontal line at a: Cost of a cow.

Efficient output c*: Where MP = a (private owner's optimum). Fewer cows.

Equilibrium output ĉ: Where AP = a (common property equilibrium). More

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cows. ĉ > c*.

The gap between c* and ĉ is the overgrazing caused by the lack of property
rights.

Figure 34.4 — Common property leads to overgrazing: AP = a is to the right of MP = a.

WHY MP < AP AT COMMON PROPERTY EQUILIBRIUM

Since AP is falling (congestion), the MP must always be below the AP. Therefore
wherever AP = a, we have MP < a — meaning at the common property
equilibrium, each cow's marginal contribution is less than its cost. Too many
cows are grazed relative to the efficient amount.

Solutions to the Tragedy of the Commons

Private Property Common Rules/Regulation

Assign the commons to a single Formulate rules about how many

owner who decides how many cows cows can be grazed on the village
to graze. Owner maximises profit → common. With legal enforcement,
chooses MP = a → efficient this can be a cost-effective solution.
outcome. Private property However, ambiguous or nonexistent
internalises the congestion law → tragedy returns.
externality.

Real-World Examples of the Tragedy

EXAMPLE 1 — OVERFISHING IN NEW ENGLAND

Fishermen in New England have decimated stocks of cod, haddock, and

flounder. Fishermen were taking 50–70% of available stock — over twice the
sustainable amount. Each fisherman has a negligible impact on total stock, but
thousands of fishermen collectively cause serious depletion. This is the classic

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commons problem: each fisherman looks at average revenue, ignoring the cost
his additional fishing imposes on all others. The New England Fisheries
Management Council has responded by banning new entry, limiting days at sea,
and increasing minimum net mesh size. Fish stocks could be restocked in as
little as 5 years with conservation, and the present value of profits to the industry
as a whole would be larger with regulation — but this requires a substantial
reduction in fishing boats, which is politically unpopular.

EXAMPLE 2 — NEW ENGLAND LOBSTERS (SUCCESS STORY)

Lobster fishermen have applied stringent rules to avoid overfishing: must toss
back egg-bearing females ("eggers"), lobsters below a minimum size ("tiddlers"),
and lobsters above a maximum size. Large lobsters produce more and larger
offspring — removing them would cause genetic drift toward smaller lobsters
over generations. Result: 2003 Maine lobster harvest was 5.4 million pounds —
more than 2.5× the 1945–85 average. However, conservation isn't the only
factor; changes in other marine species populations (sea urchins, finned fish)
also affect lobster populations.

SECTION 34.7

Automobile Pollution

Automobile pollution is a prime example of an economic externality. Each car owner

operating a vehicle lowers the quality of air that other consumers breathe. Without
regulation, too much pollution is produced.

Current U.S. Approach — Emission Standards

Since the Clean Air Act of 1963 and subsequent amendments, the U.S. has required
automobiles to meet certain emission standards. Lawrence White (1982) estimated
costs per car:

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Cost Component Amount (1981 dollars)

Emission control equipment $600 per car

Extra maintenance costs $180 per car

Reduced gasoline mileage + unleaded fuel requirement $670 per car

Total lifetime cost per car $1,450 per car

Problems with the Standards Approach

Problem 1 — One-Size-Fits-All Problem 2 — Manufacturer vs. User

Responsibility
All cars must meet the same
standards regardless of where Most responsibility falls on the
driven. A 1974 National Academy of manufacturer, not the driver. Car
Sciences study found 63% of U.S. owners have little incentive to
cars did not require stringent maintain pollution control equipment
standards then in effect. Drivers in unless their state requires
low-pollution North Dakota pay the inspections. Motorists have no
same $1,450 as drivers in highly incentive to reduce driving —
polluted Los Angeles. someone driving 2,000 miles/year in
North Dakota pays the same as
someone driving 50,000 miles/year
in Los Angeles.

The Better Approach — Effluent Fees

An alternative solution: require annual inspection of all vehicles with an odometer

reading and tests estimating the likely emissions over the past year. Communities levy
fees based on the estimated amount of pollution actually generated. This means:

People face the true cost of generating pollution

Incentive to reduce driving, invest in better pollution control equipment, change

driving habits, change vehicle type

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Higher standards achievable in areas where pollution is a serious problem (e.g. LA)

Lower burden on people in areas where pollution is not a problem

Can achieve any desired pollution level at substantially lower total cost than
mandated standards

PRINCIPLE

The appropriate method of pollution control should depend on a rational analysis

of costs and benefits — as should all social policies of this nature. Mandated
standards may be appropriate for two-thirds of vehicles in low-pollution localities
(if it is cheaper to impose standards than require inspections). But effluent fees
are better for high-pollution areas.

MASTER SUMMARY

Complete Chapter Summary

1. Types of Externalities

Type Definition Examples

Negative One consumer's action harms Smoking in shared space,

Consumption another's utility loud music at 3am

Positive One consumer's action benefits Neighbour's flower garden,

Consumption another's utility vaccination

Negative One firm's output harms another Pollution from steel mill
Production firm's costs hurting fishery

Positive One firm's output benefits another Bees and apple orchards
Production firm's production

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2. Root Cause

Externalities arise because there is no market for the externality good. If there were a
market with well-defined property rights, people would trade until the efficient outcome
was reached.

3. Efficiency Condition — Production Externality

PARETO EFFICIENT POLLUTION LEVEL (STEEL-FISHERY)

−MCₛ(ŝ, x ̂, x
̂) = MC_F(f ̂)

Equivalently: Δcₛ/Δx + Δc_f/Δx = 0

Sum of marginal effects of pollution on ALL firms = 0

4. The Coase Theorem

Coase Theorem (Summary)

If property rights are well-defined and agents can trade freely at zero
transaction cost, they will reach a Pareto efficient allocation regardless of the
initial assignment of property rights. Under quasilinear preferences (no income
effects), the efficient amount of the externality is independent of who holds
property rights — only the distribution of wealth changes.

5. Remedies for Externalities

Remedy Mechanism Problem

Pigouvian Tax Tax the externality at t = MC_F at Requires knowing the

efficient point, forcing firm to face efficient level in advance
social cost

Create a Market Assign property rights in Transaction costs; many

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externality good; let agents trade agents makes negotiation

(e.g. pollution permits) hard

Merger/Integration Firms with externalities merge Antitrust concerns; may not

and internalise it always be feasible

Regulation/Quotas Government mandates specific Requires full information;

levels of output or pollution one-size-fits-all; no
incentive for innovation

Effluent Fees Charge polluters based on actual Requires monitoring and

emissions; lets them choose inspection system
reduction method

Tradeable Permits Issue fixed total permits; firms Initial allocation of permits
trade; equilibrium price = MC of is politically contentious
abatement

6. Tragedy of the Commons

Scenario Equilibrium Condition Efficiency

Private ownership MP(c*) = a (marginal product = Pareto efficient ✓

cow cost)

Common ownership (free AP(ĉ) = a (average product = Over-grazing;

entry) cow cost) inefficient ✗

Since AP is always above MP when AP is declining: ĉ > c* — the common always has
more cows than is optimal.

7. Key Equations at a Glance

Steel firm (independent): Δcₛ/Δx = 0 (private optimum, too much

pollution x*)

Merged firm (efficient): Δcₛ/Δx + Δc_f/Δx = 0 (social optimum,

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̂)
less pollution x

̂, x
Pigouvian tax: t = Δc_f(f ̂)/Δx = MC_F at efficient point

Market for pollution: q = −Δcₛ/Δx = Δc_f/Δx (competitive

equilibrium)

Private commons: MP(c*) = a

Common property: f(ĉ)/ĉ = a → f(ĉ) − aĉ = 0

8. Chapter Summary Points (from textbook)

POINT 1 POINT 2

First Theorem of Welfare Economics: If externalities present, competitive

free competitive market is efficient in market is unlikely to be Pareto
the absence of externalities. efficient.

POINT 3 POINT 4

The state can "mimic" the market The legal system can ensure well-
using prices to signal the social cost defined property rights so efficiency-
of individual actions. enhancing trades can occur.

POINT 5 POINT 6

With quasilinear preferences, efficient Cures for production externalities:

amount of consumption externality is Pigouvian taxes, creating a market,
independent of property rights mergers, or transferring property
assignment (Coase). rights.

POINT 7 (MOST IMPORTANT)

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Tragedy of the Commons: common

property tends to be overused. A
particularly prevalent and destructive
form of externality.

Review Questions (True/False)

Statement Answer

An explicit delineation of True — well-defined property rights allow efficient

property rights usually trades to occur.
eliminates the problem of
externalities.

The distributional consequences True — Coase Theorem: under quasilinear

of the delineation of property preferences, the efficient amount of externality is
rights are eliminated when independent of who holds property rights, though
preferences are quasilinear. the distribution of wealth still differs.

Consumption externality — MRS equalisation

Production externality — sum of marginal costs = 0

Coase theorem — property rights + trade = efficiency Pigouvian tax = MC_F at optimum

Commons — AP = a leads to over-use

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