MICROECONOMICS

LEARNING GUIDE-PROBLEM SET

CHAPTER II: (Some) Market Failures

Unit 5: Externalities

PROFESSOR: DR. ALFONSO BÁRCENA

STUDENT:
Microeconomics- Unit 5: Externalities

CHAPTER II: (Some) Market Failures

Unit 5 Externalities

5.1 Externalities I: Types.

5.2 Externalities II: Analysis
5.3 Solutions: Public and Private.

Index

1. LEARNING OUTCOMES ................................................................................................................................. 3

2. KEY POINTS ................................................................................................................................................... 3
3. KEY WORDS / CONCEPTS.............................................................................................................................. 3
4. CHAPTER OUTLINE & KEY CONCEPTS REVIEW............................................................................................. 4
5. ACTIVITIES: CASE STUDY ............................................................................................................................ 10
6. QUESTIONS FOR REVIEW ........................................................................................................................... 10
7. PROBLEM SET............................................................................................................................................. 12
Microeconomics- Unit 5: Externalities

1. LEARNING OUTCOMES

● Understand what an externality is and how it affects market efficiency.

● Understand the different types of externalities.
● Understand the different, both public and private, solutions.

2. KEY POINTS

1. When a transaction between a buyer and seller directly affects a third party, that 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.

2. Those affected by externalities can sometimes solve the problem privately. For instance, when one
business confers 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.

3. When private parties cannot adequately deal with external effects, such as pollution, the government
often steps in. Sometimes the government prevents socially inefficient activity by regulating behavior.
Other times it internalizes an externality using corrective taxes. Another way to protect the
environment is for the government to issue a limited number of pollution permits. The end result of
this policy is largely the same as imposing corrective taxes on polluters.

3. KEY WORDS / CONCEPTS

Externality
Internalizing the externality
Corrective tax
Coase Therem
Transaction costs
Microeconomics- Unit 5: Externalities
4. CHAPTER OUTLINE & KEY CONCEPTS REVIEW

Read Carefully Presentation PPT U5 in Classlife

KEY CONCEPTS REVIEW OF 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.

C. In either situation, decisionmakers 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.

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).

B. Negative Externalities

Example: An aluminum firm emits pollution during production.

1. 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.
Microeconomics -Unit 5 Externalities

2. 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.

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.

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

4. This negative externality could be internalized by a tax on producers for each

unit of aluminum sold.

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

people take account of the external effects of their actions.

C. Positive Externalities

1. Example: education
2. Education yields positive externalities because better-educated voters lead to
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.

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

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

5
Microeconomics -Unit 5 Externalities

I. 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.

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).

6
Microeconomics -Unit 5 Externalities

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

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.

II. 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 decisionmakers will

choose to solve the problem on their own.

B. Command-and-Control Policies: Regulation

1. Externalities can be corrected by making certain behaviors either required or

forbidden.

2. In the United States, it is the Environmental Protection Agency (EPA) that

develops and enforces regulations aimed at protecting the environment.

7
Microeconomics -Unit 5 Externalities

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

of a particular technology to reduce emissions.

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

decisionmakers 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
decisionmakers to take into account the cost of all of the resources being
used when making decisions.

3. In the News: Conservin g Fuel

a. Some auto executives have suggested that fuel consumption should be

reduced by increasing the tax on gasoline, rather than regulating the
production of more fuel-efficient cars.

b. This is an article from The New York Times that discusses the reasoning
behind the viewpoints of these auto executives.

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.

8
Microeconomics -Unit 5 Externalities

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.

Price ce
Supply of
Pollution Permits

Tax

Demand for Demand for

Pollution Rights Pollution Rights

Q* Quantity Q* Quantity

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.

5. In the News: Controlling Carbon

a. To combat global warming, European nations regulate carbon emissions

with a system of permits.

b. This is an article from The Financial Times that describes the effects of a
cold snap on the price of these permits.

E. Objections to the Economic Analysis of Pollution

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

2. These people fail to understand that the United States has limited ability to
eliminate pollution and such elimination would come at a high opportunity cost.

9
Microeconomics -Unit 5 Externalities

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

5. ACTIVITIES: CASE STUDY

A1. Case Study: Technology, Spillovers, Industrial Policy and Patent

Protection

Instructions: Reply in groups to the following questions

1. When a technology spillover occurs and how it can be measured?

2. What it is a patent and how it is used?

A2. Case Study: Why is Gasoline Taxed so Heavily?

Instructions: Discuss and reply to the following questions in groups:

1 . Why is Gasoline Taxed so Heavely?

2. What types of externalities is correcting?

6. QUESTIONS FOR REVIEW

1. Give an example of a negative externality and an

example of a positive externality.
2. Draw a supply-and-demand diagram to explain the
effect of a negative externality that occurs as a result of
a firm’s production process.
3. In what way does the patent system help society solve
an externality problem?
4. What are corrective taxes? Why do economists prefer
them to regulations as a way to protect the environment from pollution?
5. List some of the ways that the problems caused by
externalities can be solved without government
10
Microeconomics -Unit 5 Externalities

intervention.
6. Imagine that you are a nonsmoker sharing a room
with a smoker. According to the Coase theorem, what
determines whether your roommate smokes in the
room? Is this outcome efficient? How do you and your
roommate reach this solution

11
Microeconomics -Unit 5 Externalities

7. PROBLEM SET
7.1) Do you agree with the following statements? Why or why not?
a. “The benefits of corrective taxes as a way to reduce pollution have to be weighed against the
deadweight losses that these taxes cause.”
b. “When deciding whether to levy a corrective tax on consumers or producers, the government
should be careful to levy the tax on the side of the market generating the externality.

7.2) . There are three industrial firms in Happy Valley

Firm Initial Pollution Level Cost of Reducing Pollution by 1

Unit
A 70 units $20
B 80 units $25
C 50 units $10

The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution
permits.
a. Who sells permits and how many do they sell? Who buys permits and how many do they buy?
Briefly explain why the sellers and buyers are each willing to do so. What is the total cost of
pollution reduction in this situation?
b. How much higher would the costs of pollution reduction be if the permits could not be traded

7.3) Ringo loves playing rock-’n’-roll music at high volume. Luciano loves opera and hates rock-’n’-
roll. Unfortunately, they are next-door neighbors in an apartment building with paper-thin walls.
a. What is the externality here?
b. What command-and-control policy might the landlord impose? Could such a policy lead to an
inefficient outcome?
c. Suppose the landlord lets the tenants do whatever they want. According to the Coase theorem,
how might Ringo and Luciano reach an efficient outcome on their own? What might prevent them
from reaching an efficient outcome?

7.4) It is rumored that the Swiss government subsidizes cattle farming and that the subsidy is larger
in areas with more tourist attractions. Can you think of a reason this policy might be efficient?

12