Chapter 10

1
Externalities

EXTERNALITIES
0
WHAT’S NEW IN THE EIGHTH EDITION:

Three new features have been added, an In the News feature on “The Coase Theorem in
Action,” an Ask the Experts feature on “Vaccines,” and an Ask the Experts feature on
“Carbon Taxes.”

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

 what an externality is.

 why externalities can make market outcomes inefficient.

 the various government policies aimed at solving the problem of externalities.

170

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
171 ❖ Chapter 10/Externalities

 how people can sometimes solve the problem of externalities on their own.

 why private solutions to externalities sometimes do not work.

CONTEXT AND PURPOSE:

Chapter 10 is the first chapter in the microeconomic section of the text. It is the first chapter
in a three-chapter sequence on the economics of the public sector. Chapter 10 addresses
externalities—the uncompensated impact of one person’s actions on the well-being of a
bystander. Chapter 11 will address public goods and common resources (goods that will be
defined in Chapter 11) and Chapter 12 will address the tax system.

In Chapter 10, different sources of externalities and a variety of potential cures for
externalities are addressed. Markets maximize total surplus to buyers and sellers in a
market. However, if a market generates an externality (a cost or benefit to someone
external to the market) the market equilibrium may not maximize the total benefit to
society. Thus, in Chapter 10 we will see that while markets are usually a good way to
organize economic activity, governments can sometimes improve market outcomes.

KEY POINTS:

 When a transaction between a buyer and seller directly affects a third party, the effect is
called an externality. If an activity yields negative externalities, such as pollution, the
socially optimal quantity in a market is less than the equilibrium quantity. If an activity
yields positive externalities, such as technology spillovers, the socially optimal quantity
is greater than the equilibrium quantity.

 Governments pursue various policies to remedy the inefficiencies caused by

externalities. Sometimes the government prevents socially inefficient activity by
regulating behavior. Other times it internalizes an externality using corrective taxes.
Another public policy is to issue permits. For example, the government could protect the
environment by issuing a limited number of pollution permits. The result of this policy is
similar to imposing corrective taxes on polluters.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 172

 Those affected by externalities can sometimes solve the problem privately. For instance,
when one business imposes an externality on another business, the two businesses can
internalize the externality by merging. Alternatively, the interested parties can solve the
problem by negotiating a contract. According to the Coase theorem, if people can
bargain without cost, then they can always reach an agreement in which resources are
allocated efficiently. In many cases, however, reaching a bargain among the many
interested parties is difficult, so the Coase theorem does not apply.

CHAPTER OUTLINE:

I. Definition of externality: the uncompensated impact of one person’s actions on

the well-being of a bystander.

A. If the impact on the bystander is adverse, we say that there is a negative externality.

B. If the impact on the bystander is beneficial, we say that there is a positive

externality.

Give students several examples of both positive and negative externalities.

Use current health debates or political topics to maintain interest.

C. In either situation, decision makers fail to take account of the external effects of their
behavior.

II. Externalities and Market Inefficiency

A. Welfare Economics: A Recap

1. The demand curve for a good reflects the value of that good to consumers,
measured by the price that the marginal buyer is willing to pay.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
173 ❖ Chapter 10/Externalities

2. The supply curve for a good reflects the cost of producing that good.

3. In a free market, the price of a good brings supply and demand into balance in a
way that maximizes total surplus (the difference between the consumers’
valuation of the good and the sellers’ cost of producing it).

Figure 1

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 174

B. Negative Externalities

1. Example: An aluminum firm emits pollution during production.

ALTERNATIVE CLASSROOM EXAMPLE:

A coal-fired power plant emits pollution during production.

2. Social cost is equal to the private cost to the firm of producing the aluminum plus
the external costs to those bystanders affected by the pollution. Thus, social cost
exceeds the private cost paid by producers.

3. The optimal amount of aluminum in the market will occur where total surplus is
maximized.

a. Total surplus is equal to the value of aluminum to consumers minus the cost
(social cost) of producing it.

b. This will occur where the social-cost curve intersects with demand curve. At
this point, producing one more unit would lower total surplus because the
value to consumers is less than the cost to produce it.

Figure 2

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
175 ❖ Chapter 10/Externalities

4. Because the supply curve does not reflect the true cost of producing aluminum,
the market will produce more aluminum than is optimal.

Make sure that students understand how this pollution by the firm imposes
costs on third parties. Point out that the firm is likely emitting pollution
because this is the cheapest method of production. Stress that the firm is
using a resource in production that it is not paying for.

5. This negative externality could be internalized by a tax on producers for each unit
of aluminum sold.

6. Definition of internalizing an externality: altering incentives so that

people take account of the external effects of their actions.

This is a good time to discuss why the government taxes goods like
alcohol, tobacco, and gasoline. You will find that students have heard the
phrase “sin tax,” but they often do not understand why economists might
support such taxes (given the deadweight loss from taxes discussed in
Chapter 8).

C. Positive Externalities

1. Example: education.

2. Education yields positive externalities because better-educated voters lead to a

better government. Crime rates also drop as the education level of the population
rises.

3. In this case, the demand curve does not reflect the social value of a good.

ALTERNATIVE CLASSROOM EXAMPLE:

The purchase of a fire extinguisher when an individual lives in an apartment

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 176

4. If there is a positive externality, the social value of the good is greater than the
private value, and the optimal quantity will be greater than the quantity produced
in the market.

5. To internalize a positive externality, the government could use a subsidy.

Figure 3

Make sure that students realize how heavily subsidized education is in the
United States – both primary education and secondary education.
6. Case Study: Technology Spillovers, Industrial Policy, and Patent Protection

a. A technology spillover occurs when one firm’s research and production efforts
affect another firm’s access to technological advance.

b. It is difficult to measure the amounts of technology spillover that occur and

this leads to a debate over whether the government should pursue policies to
encourage the production of technology.

c. Patent protection is a type of technology policy of the government because it

protects the rights of inventors who create new technologies. Without patents,
there would be less incentive to develop new ideas and technologies.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
177 ❖ Chapter 10/Externalities

III. Public Policies toward Externalities

A. When an externality causes a market to reach an inefficient allocation of resources,

the government can respond in two ways.

1. Command-and-control policies regulate behavior directly.

2. Market-based policies provide incentives so that private decision makers will

choose to solve the problem on their own.

B. Command-and-Control Policies: Regulation

1. Externalities can be corrected by requiring or forbidding certain behaviors.

2. In the United States, the Environmental Protection Agency (EPA) develops and
enforces regulations aimed at protecting the environment.

3. EPA regulations include maximum levels of pollution allowed or required adoption

of a particular technology to reduce emissions.

4. Ask the Experts: Vaccines

a. 100 percent of economic experts agreed that declining to be vaccinated

against contagious diseases imposes costs on others, resulting in a negative
externality.

b. 89 percent of economic experts on the panel agreed that the social benefit of
mandating the measles vaccine for all Americans (except those with a
compelling medical reason) exceeds the social cost associated with restricting
free choice.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 178

C. Market-Based Policy 1: Corrective Taxes and Subsidies

1. Externalities can be internalized through the use of taxes and subsidies.

2. Definition of corrective tax: a tax designed to induce private decision

makers to take account of the social costs that arise from a negative
externality.

a. These taxes are preferred by economists over regulation, because firms that
can reduce pollution with the least cost are likely to do so (to avoid the tax)
while firms that encounter high costs when reducing pollution will simply pay
the tax.

b. Thus, this tax allows firms that face the highest cost of reducing pollution to
continue to pollute while encouraging less pollution over all.

c. Unlike other taxes, corrective taxes do not cause a reduction in total surplus.
In fact, they increase economic well-being by forcing decision makers to take
into account the cost of all of the resources being used when making
decisions.

3. Case Study: Why Is Gasoline Taxed So Heavily?

a. In the United States, almost half of what drivers pay for gasoline goes to gas
taxes.

b. This is to correct for three negative externalities associated with driving:

congestion, accidents, and pollution.

4. In the News: What Should We Do about Climate Change?

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
179 ❖ Chapter 10/Externalities

a. Many policy analysts believe that taxing carbon is the best approach to
dealing with global climate change.

b. This article from The New York Times explains how the revenue-neutral
carbon tax works in British Columbia and argues for its implementation in the
United States.

5. Ask the Experts: Carbon Taxes

a. 98 percent of expert economists on the panel agreed that a proposed carbon

tax would distort the U.S. economy less than a tax increase on labor income
that resulted in the same amount of revenue. The other 2 percent were
uncertain.

b. 95 percent of expert economists on the panel agreed that a tax on the carbon
content of fuels would be a less expensive way to reduce carbon dioxide
emissions than the command and control policies affecting fuel efficiency of
automobiles.

D. Market-Based Policy 2: Tradable Pollution Permits

1. Example: EPA regulations restrict the amount of pollution that two firms can emit
at 300 tons of glop per year. Firm A wants to increase its amount of pollution.
Firm B agrees to decrease its pollution by the same amount if Firm A pays it $5
million.

2. Social welfare is increased if the EPA allows this situation. Total pollution remains
the same so there are no external effects. If both firms are doing this willingly, it
must make them better off.

3. If the EPA issued permits to pollute and then allowed firms to sell them, this
would also increase social welfare. Firms that could control pollution most
inexpensively would do so and sell their permits, while those who encounter high
costs when reducing pollution would buy additional permits.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 180

Figure 4

4. Tradable pollution permits and corrective taxes are similar in effect. In both
cases, firms must pay for the right to pollute.

a. In the case of the tax, the government basically sets the price of pollution and
firms then choose the level of pollution (given the tax) that maximizes their
profit.

b. If tradable pollution permits are used, the government chooses the level of
pollution (in total, for all firms) and firms then decide what they are willing to
pay for these permits.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
181 ❖ Chapter 10/Externalities

E. Objections to the Economic Analysis of Pollution

Stress to students that the socially optimal level of pollution is not “zero.”
Make sure that they understand that society faces a trade-off because of
the resources used to combat pollution.

1. Some individuals dislike the idea of allowing companies to purchase the right to
pollute.

2. Economists point out that “people face trade-offs” (Principle #1) and we must
decide how much we would be willing to give up in exchange for no pollution. It
would likely not be enough.

3. A clean environment can be viewed as any other good that obeys the law of
demand. The lower the price of environmental protection, the more the public will
want.

IV. Private Solutions to Externalities

A. We do not necessarily need government involvement to correct externalities.

B. The Types of Private Solutions

1. Problems of externalities can sometimes be solved by moral codes and social

sanctions.

a. Do not litter.

b. The Golden Rule

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 182

2. Many charities have been established that deal with externalities. The
government encourages this private solution by allowing a deduction for
charitable contributions in the determination of taxable income.

a. Sierra Club (environment)

b. University Alumni Association (scholarships)

3. The parties involved in this externality (either the seller and the bystander or the
consumer and the bystander) can possibly enter into an agreement to correct the
externality.

C. The Coase Theorem

1. Definition of 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.

2. Example: Dick owns a dog Spot who disturbs a neighbor (Jane) with its barking.

a. One possible solution to this problem would be for Jane to pay Dick to get rid
of the dog. The amount that she would be willing to pay would be equal to her
valuation of the costs of the barking. Dick would only agree to this if Jane paid
him an amount greater than the value he places on owning Spot.

b. Even if Jane could legally force Dick to get rid of Spot, another solution could
occur. Dick could pay Jane to let him keep the dog.

3. Whatever the initial distribution of rights, the parties involved in an externality

can potentially solve the problem themselves and reach an efficient outcome
where both parties are better off.

4. In the News: The Coase Theorem in Action

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
183 ❖ Chapter 10/Externalities

a. This New York Times article illustrates how the Coase theorem can be applied
to reclining seats on airlines.

b. With low bargaining costs, passengers with the greatest value over the
property right will end up with it, because the property right is clearly defined
initially.

D. Why Private Solutions Do Not Always Work

1. Definition of transaction costs: the costs that parties incur in the process
of agreeing and following through on a bargain.

2. Coordination of all of the interested parties may be difficult so that bargaining

breaks down. This is especially true when the number of interested parties is
large.

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes

1. Examples of negative externalities include pollution, barking dogs, and

consumption of alcoholic beverages. Examples of positive externalities include
the restoration of historic buildings, research into new technologies, and
education. (Many other examples of negative and positive externalities are
possible.) Market outcomes are inefficient in the presence of externalities
because markets produce a larger quantity than is socially desirable when there
is a negative externality and a smaller quantity than is socially desirable when
there is a positive externality. The market outcomes do not account for all of the
costs (negative externalities) or benefits (positive externalities) to society.

2. The town government might respond to the externality from the smoke in three
ways: (1) regulation, (2) corrective taxes, or (3) tradable pollution permits.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 184

Regulation prohibiting pollution beyond some level is good because it is often

effective at reducing pollution. But doing so successfully requires the government
to have a lot of information about the industries and the alternative technologies
that those industries could adopt.

Corrective taxes are a useful way to reduce pollution because the tax can be
increased to get pollution to a lower level and because the taxes raise revenue
for the government. The tax is more efficient than regulation because it gives
factories economic incentives to reduce pollution and to adopt new technologies
that pollute less. The disadvantage of corrective taxes is that the government
needs to know a lot of information to pick the right tax rate.

Tradable pollution permits are similar to corrective taxes but allow the firms to
trade the right to pollute with each other. As a result, the government does not
need as much information about the firms’ technologies. The government can
simply set a limit on the total amount of pollution, issue permits for that amount,
and allow the firms to trade the permits. This reduces pollution while allowing
economic efficiency.

3. Examples of private solutions to externalities include moral codes and social

sanctions, charities, and relying on the interested parties entering into contracts
with one other.

The Coase theorem is 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.

Private economic participants are sometimes unable to solve the problems

caused by an externality because of transaction costs or because bargaining
breaks down. This is most likely when the number of interested parties is large.

Chapter Quick Quiz

1. c

2. b

3. a
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
185 ❖ Chapter 10/Externalities

4. c

5. b

6. c

Questions for Review

1. Examples of negative externalities include pollution, barking dogs, and

consumption of alcoholic beverages. Examples of positive externalities include
the restoration of historic buildings, research into new technologies, and
education. (Many other examples of negative and positive externalities are
possible.)

2. Figure 1 illustrates the effect of a negative externality. The equilibrium quantity

provided by the market is Qmarket. Because of the externality, the social cost of
production is greater than the private cost of production, so the social-cost curve
is above the supply curve. The optimal quantity for society is Qoptimum. The private
market produces too much of the good because Qmarket is greater than Qoptimum.

Figure 1

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 186

3. The patent system helps society solve the externality problem from technology
spillovers. By giving inventors exclusive use of their inventions for a certain
period, the inventor can capture much of the economic benefit of the invention. In
doing so, the patent system encourages research and technological advance,
which benefits society through spillover effects.

4. Corrective taxes are taxes enacted to correct the effects of a negative externality.
Economists prefer corrective taxes over regulations as a way to protect the
environment from pollution because they can reduce pollution at a lower cost to
society. A tax can be set to reduce pollution to the same level as a regulation. The
tax has the advantage of letting the market determine the least expensive way to
reduce pollution. The tax gives firms incentives to develop cleaner technologies
to reduce the taxes they have to pay.

5. Externalities can be solved without government intervention through moral codes

and social sanctions, charities, merging firms whose externalities affect each
other, or by contract.

6. According to the Coase theorem, you and your roommate will bargain over
whether your roommate will smoke in the room. If you value clean air more than
your roommate values smoking, the bargaining process will lead to your
roommate not smoking. But if your roommate values smoking more than you
value clean air, the bargaining process will lead to your roommate smoking. The
outcome is efficient as long as transaction costs do not prevent an agreement
from taking place. The solution may be reached by one of you paying off the
other either not to smoke or for the right to smoke.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
187 ❖ Chapter 10/Externalities

Problems and Applications

1. The Club conveys a negative externality on other car owners because car thieves
will not attempt to steal a car with The Club visibly in place. This means that they
will move on to another car. The Lojack system conveys a positive externality
because thieves do not know which cars have this technology. Therefore, they are
less likely to steal any car. Policy implications include a subsidy for car owners
that use the Lojack technology or a tax on those who use The Club.

2. a. Fire extinguishers exhibit positive externalities because even though people

buy them for their own use, they may prevent fire from damaging the
property of others.

Figure 2

b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that
the social-value curve is above the demand curve and the social-cost curve is
the same as the supply curve.

c. The market equilibrium level of output is denoted Qmarket and the efficient level
of output is denoted Qoptimum. The quantities differ because in deciding to buy
fire extinguishers, people don't account for the benefits they provide to
others.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 188

d. A government policy that would result in the efficient outcome would be to

subsidize people $10 for every fire extinguisher they buy. This would shift the
demand curve up to the social-value curve, and the market quantity would
increase to the optimum quantity.

3. a. The market for alcohol is shown in Figure 3. The social-value curve is the
same as the demand curve in this case. The social-cost curve is above the
supply curve because of the negative externality from increased motor
vehicle accidents caused by those who drink and drive. The market
equilibrium level of output is Qmarket and the efficient level of output is Qoptimum.

b. The triangular area between points A, B, and C represents the deadweight

loss of the market equilibrium. This area shows the amount by which social
costs exceed social value for the quantity of alcohol consumption beyond the
efficient level.

Figure 3

4. a. It is efficient to have different amounts of pollution reduction at different firms

because the costs of reducing pollution differ across firms. If all firms were
made to reduce pollution by the same amount, the costs would be low at
some firms and prohibitively high at others, imposing a greater burden
overall.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
189 ❖ Chapter 10/Externalities

b. Command-and-control approaches that rely on uniform pollution reduction

among firms give the firms no incentive to reduce pollution beyond the
mandated amount. Instead, every firm will reduce pollution by just the
amount required and no more.

c. Corrective taxes or tradable pollution rights give firms greater incentives to

reduce pollution. Firms are rewarded by paying lower taxes or spending less
on permits if they find methods to reduce pollution, so they have the incentive
to engage in research on pollution control. The government does not have to
figure out which firms can reduce pollution the mostit lets the market give
firms the incentive to reduce pollution on their own.

5. a. At a price of $1.50, each Whovillian will consume 4 bottles of Zlurp. Each

consumer’s total willingness to pay is $14 (= $5 + $4 + $3 + $2). The total
spent by each Whovillian on Zlurp is $6 (= $1.50  4). Therefore, each
consumer receives $8 in consumer surplus (=$14 − $6).

b. Total surplus would fall by $4 to $4.

c. If Cindy Lou only consumes 3 bottles of Zlurp, her consumer surplus is $4.50.
Her willingness to pay for 3 bottles is $5 + $4 + $3 = $12. She pays $1.50 x 3
= $4.50 and the externality is $1 x 3 = $3. Thus, Cindy Lou's consumer
surplus is $12 - $4.50 - $3.00 = $4.50. Cindy’s decision increases consumer
surplus in Whoville by $0.50 ($4.50-$4.00).

d. The $1 tax raises the price of a bottle of Zlurp to $2.50. (The entire tax will be
borne by consumers because supply is perfectly elastic.) Each resident will
purchase only 3 bottles at the higher price and each consumer’s total
willingness to pay is now $12 (= $5 + $4 + $3). Each resident pays $7.50 (=
$2.50  3). Therefore, each resident receives $4.50 ($12-$7.50) in consumer
surplus.

Because each bottle has an external cost of $1, the per-resident external cost
is $3 ($1 per bottle x 3 bottles). The government collects $3 per resident in
revenue. Total surplus with the tax is equal to $4.50 - $3.00 + $3.00 = $4.50.

e. Yes, because total surplus is now higher than before the tax.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 190

6. a. The externality is noise pollution. Bruno’s consumption of rock and roll music
affects Placido, but Bruno does not consider that in deciding how loudly he
plays his music.

b. The landlord could impose a rule that music could not be played above a
certain decibel level. This could be inefficient because there would be no harm
done by Bruno playing his music loud if Placido is not home.

c. Bruno and Placido could negotiate an agreement that might, for example,
allow Bruno to play his music loudly at certain times of the day. They might
not be able to reach an agreement if the transaction costs are high or if
bargaining fails because each holds out for a better deal.

7. a. An improvement in the technology for controlling pollution would reduce the

demand for pollution rights, shifting the demand curve to the left. Figure 4
illustrates what would happen if there were a corrective tax, while Figure 5
shows the impact if there were a fixed supply of pollution permits. In both
figures, the curve labeled D1 is the original demand for pollution rights and the
curve labeled D2 is the new demand for pollution rights after the improvement
in technology.

Figure 4

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
191 ❖ Chapter 10/Externalities

b. With a corrective tax, the price of pollution remains unchanged and the
quantity of pollution declines, as Figure 4 shows. With pollution permits, the
price of pollution declines and the quantity of pollution is unchanged, as
Figure 5 illustrates.

Figure 5

8. a. In terms of economic efficiency in the market for pollution, it does not matter
if the government distributes the permits or auctions them off, as long as
firms can sell the permits to each other. The only difference would be that the
government could make money if it auctioned the permits off, thus allowing it
to reduce taxes, which would help reduce the deadweight loss from taxation.
There could also be some deadweight loss occurring if firms use resources to
lobby for additional permits.

b. If the government allocated the permits to firms who did not value them as
highly as other firms, the firms could sell the permits to each other so they
would end up in the hands of the firms who value them most highly. Thus, the
allocation of permits among firms would not matter for efficiency. But it would
affect the distribution of wealth, because those who got the permits and sold
them would be better off.

9. a. The firms with the highest cost of reducing pollution will buy permits rather
than reduce their pollution. Firms that can sell their permits for more than it
costs them to reduce their pollution will sell.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.
 Chapter 10/Externalities ❖ 192

Because firm B faces the highest costs of reducing pollution, $30 per unit, it
will keep its own 20 permits and buy 20 permits from the other firms, so that
it can still pollute 40 units. Thus, firm B does not reduce its pollution at all.

Of the two remaining firms, firm A has the higher cost of reducing pollution so
it will keep its own 20 permits and reduce its pollution by 10 units at a cost of
$20 x 10 units = $200.

Firm C sells all 20 of its permits to firm B and reduces its pollution by 20 units
at a cost of $10 × 20 = $200. The total cost of pollution reduction is $400.

b. If the permits could not be traded, then firm A would have to reduce its
pollution by 10 units at a cost of $20 × 10 = $200, firm B would have to
reduce its pollution by 20 units at a cost of $30 × 20 = $600, and firm C
would not have to reduce its pollution because its permits would cover the 20
units it emits. The total cost of pollution reduction would be $800, $400 higher
than in the case in which the permits could be traded.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
system for classroom use.