EXTERNALITIES

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EXTERNALITIES
Externalities can be caused by the production
(supply) of goods (eg., emissions of air
pollutants from smokestacks and creation of new
knowledge), or from the consumption of goods
(eg., second hand smoke from cigarette smokers
and yard and home beautification).
Externalities can be negative (air pollution
and second hand smoke) or positive (new knowledge
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EXTERNALITIES
and yard beautification).
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EXTERNALITIES
Production
Consumption
Externalities
Externalities negative air water pollution
second hand cigar smoke
factory noise noisy
parties positive technology spillovers
yard beautification historic
restoration install ABS system on car
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EXTERNALITIES
When all of the costs of production are borne
only by the supplier and all of the value
of consumption is reaped only by the consumer,
i.e., when
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EXTERNALITIES
there are no eternal benefits or costs to other
producers or citizens, then the producers
private costs is societies cost, and
consumers private benefits are
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EXTERNALITIES
The benefits to society. Therefore, when there
are no externalities, private production costs
and social production costs are identical and
the private value
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EXTERNALITIES
of consumption is the same as the social value of
consumption. Then individuals acting rationally
(acting to maximize their personal well- being)
interact in competitive markets
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EXTERNALITIES
to decide on an allocation of resources that
maximizes the sum of consumer surplus and
producer surplus. Then the market equilibrium
quantity also
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EXTERNALITIES
maximizes the net social benefit, when there are
no externalities. When there are externalities,
private costs and values are not the same as
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EXTERNALITIES
social cost and values. For example, when there
is a negative production externality, such
as smokestack emissions of
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EXTERNALITIES
pollutants, producers supply only considers
their private production costs, not the
additional pollution costs to the rest of
society. With the externality, social
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NEGATIVE PRODUCTION EXTERNALITIES
cost and private cost diverge. The social cost
of production includes the producers
private costs plus the costs of the pollution
borne by the rest of society.
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NEGATIVE PRODUCTION EXTERNALITIES
With a negative production externality, social
cost exceeds private cost (supply) so that the
market allocates too many resources to the
production of this good. The
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NEGATIVE PRODUCTION EXTERNALITIES
optimum output for society is smaller than the
market equilibrium output. This is because
producers make production decisions based only on
their private costs, not
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NEGATIVE PRODUCTION EXTERNALITIES
including the pollution costs they cause.
Therefore, any output greater than QOPTIMUM
reduces the benefit to society, because social
cost exceeds the social (and
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NEGATIVE PRODUCTION EXTERNALITIES
private) value of the good being produced. There
is a deadweight social loss from this
misallocation of resources.
Deadweight loss
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POSITIVE PRODUCTION EXTERNALITIES
Consider a firm whose research and development
discovers cost saving technology for its own
production, but also is available for other
firms, at no charge to also reduce
Value of technology spillover
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POSITIVE PRODUCTION EXTERNALITIES
Their production costs. Then this firm will
undertake a quantity of RD activity consistent
with its private benefits, ignoring the
benefits to other firms. This is
Value of technology spillover
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POSITIVE PRODUCTION EXTERNALITIES
because it is not receiving
payments from the other firms for this new
technology. Since there are external benefits
from this firms RD activity, the social cost of
this
Value of technology spillover
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POSITIVE PRODUCTION EXTERNALITIES
firms RD activity is less than the
firms private cost (supply). The Social Cost
curve lies below the Supply curve. The
quantity of RD by this firm, determined by
a competitive market,
Value of technology spillover
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POSITIVE PRODUCTION EXTERNALITIES
is less than the socially optimum quantity.
There is a deadweight loss from the
misallocation of resources.
Value of technology spillover
Deadweight Loss
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NEGATIVE CONSUMPTION EXTERNATITIES
The consequences of alcohol consumption often
include traffic accidents which imposes costs on
drivers. Therefore the private benefits to the
drinker-driver should be reduced by
Negative costs of alcohol consumption
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NEGATIVE CONSUMPTION EXTERNATITIES
the costs imposed on others. Then the social
value of alcohol consumption is less than the
private value, and the market equilibrium
results in a larger amount of alcohol consumption
Negative costs of alcohol consumption
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NEGATIVE CONSUMPTION EXTERNATITIES
than is socially optimal. A deadweight
loss results from the misallocation of
resources.
Negative costs of alcohol consumption
Deadweight Loss
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POSITIVE CONSUMPTION EXTERNALITIES
Better educated citizens make better voters, who
make a more reasoned selection of representatives
to government. Better government
officials benefit all members
Value to society of better educated
voters
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POSITIVE CONSUMPTION EXTERNALITIES
of society. Therefore the social value
of education exceeds the private value of the
individuals receiving the education. Then
the market devotes fewer resources to
Value to society of better educated
voters
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POSITIVE CONSUMPTION EXTERNALITIES
education than is socially optimal. A deadweight
loss results from this misallocation of resources.
Value to society of better educated
voters
Deadweight Loss
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SOLUTIONS TO EXTERNALITIES
Private Solutions Social codes of
behavior Special interest groups --
Charitable donations Mergers -- Apple
grower and bee keeper Legal contracts --
Apple grower and bee keeper Assignment of
property rights -- The Coase
Theorem High transactions costs make it
difficult to arrange private solutions.
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SOLUTIONS TO EXTERNALITIES
Public Solutions Regulation Pigovian
taxes and subsidies Pollution permits --
tradable and non-tradable
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SOLUTIONS TO EXTERNALITIES
A COMPARISON OF REGULATION AND TAXES
FOR POLLUTION CONTROL
There are three firms (A, B and C) that currently
are emitting 40 parts per million (ppm) sulfur
dioxide (SO2) particulates in their smokestack
emissions. These are the only polluting firms
in the community and they each have identical
levels of smokestack emissions. The
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SOLUTIONS TO EXTERNALITIES
community wishes to reduce SO2 particulates
in the air and decides to reduce the average
smoke- stack emissions to 30 ppm SO2. The
pollution abatement costs to the three firms are
given in the following table.
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SOLUTIONS TO EXTERNALITIES
The table indicates the cost in thousands of
dollars to each firm to reduce SO2 smokestack
A B C 40ppm
0 0 0 30ppm 20
10 5 20ppm 50 25
10 10ppm 90 45 15
emissions to the indicated levels. For firm B
to reduce from 40ppm to 20ppm SO2 will cost
it 25,000. If the community requires all three
firms
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SOLUTIONS TO EXTERNALITIES
To reduce their emissions to 30ppm, the resource
cost will be (20105) 35,000. This
will achieve reducing
A B C 40ppm
0 0 0 30ppm 20
10 5 20ppm 50 25
10 10ppm 90 45 15
the average emissions of the three firms to
30ppm. Alternatively, the community could tax
firms according to the level of their smokestack
emissions.
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SOLUTIONS TO EXTERNALITIES
Facing a tax of 1,000 for each 10ppm SO2, firm
A could pay 40,000 to continue to pollute 40ppm.
A B C 40ppm
0 0 0 30ppm 20
10 5 20ppm 50 25
10 10ppm 90 45 15
To pollute 30ppm they could pay a tax of
30,000 and pollution abatement costs of 20,000
for a total of 50,000. Similarly firm A would
pay a total of
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SOLUTIONS TO EXTERNALITIES
70,000 to pollute 20ppm and 100,000 to pollute
10ppm.
A B C 40ppm
0 0 0 30ppm 20
10 5 20ppm 50 25
10 10ppm 90 45 15
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SOLUTIONS TO EXTERNALITIES
TAX POLLUTION TOTAL
ABATEMENT
A B C A B C 40ppm
40 0 0 0 40 40
40 30ppm 30 20 10 5 50
40 35 20ppm 20 50 25 10
70 45 30 10ppm 10 90 45
15 100 55 25
Firm A has minimum total costs of 40,000 by
continuing to pollute at 40ppm. Firm B
minimizes cost at 40,000 by polluting at
30ppm. (Firms are socially conscious and will
choose a lower pollution level if there is no
additional cost.)
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SOLUTIONS TO EXTERNALITIES
TAX POLLUTION TOTAL
ABATEMENT
A B C A B C 40ppm
40 0 0 0 40 40
40 30ppm 30 20 10 5 50
40 35 20ppm 20 50 25 10
70 45 30 10ppm 10 90 45
15 100 55 25
Firm C has minimum total cost of 25,000 by
polluting at 10ppm. Then the average
level of smokestack emissions will be
(403010)/3 26.7 for a pollution abatement cost
of (01015) 25,000. Although firms are paying
pollution taxes
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SOLUTIONS TO EXTERNALITIES
TAX POLLUTION TOTAL
ABATEMENT
A B C A B C 40ppm
40 0 0 0 40 40
40 30ppm 30 20 10 5 50
40 35 20ppm 20 50 25 10
70 45 30 10ppm 10 90 45
15 100 55 25
totaling (4030 10) 80,000, this is not a
resource cost. (In fact it could lead to reduced
Property taxes for the three firms so that their
net total cost is only 25,000. Then, in this
example, using Pigovian taxes reduces pollution
emissions

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SOLUTIONS TO EXTERNALITIES
TAX POLLUTION TOTAL
ABATEMENT
A B C A B C 40ppm
40 0 0 0 40 40
40 30ppm 30 20 10 5 50
40 35 20ppm 20 50 25 10
70 45 30 10ppm 10 90 45
15 100 55 25
to a lower level than uniform regulation
(26.7ppm vs. 30ppm) for a smaller
resource cost (25,000 vs. 35,000).