Chapter 5

Externalities
Problems and Solutions

Jonathan Gruber
Public Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

 Introduction
 Externalities arise whenever the actions of one
party make another party worse or better off, yet the
first party neither bears the costs nor receives the
benefits of doing so.
 As we will see, this represents a market failure for
which government action could be appropriate and
improve welfare.
 Introduction
 Externalities can be negative or positive:
 Acid rain, global warming, pollution, or a neighbor’s
loud music are all negative externalities.
 Research and development or asking good questions
in class are positive externalities.
 Introduction
 Consider global warming, a negative externality.
Many scientists believe this warming trend is caused
by human activity, namely the use of fossil fuels.
 These fuels, such as coal, oil, natural gas, and
gasoline produce carbon dioxide that in turn traps
heat from the sun in the earth’s atmosphere.
 Figure 1 shows the trend in warming over the last
century.
 This table shows the global
Figure 1 temperature during the 20th century.

Global Average Temperature Over Time

58.5

58
Global average temperature

There has been a distinct trend

upward in temperature
57.5

57

56.5

56
1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000
Year
 Introduction
 Although this warming trend has negative effects
overall on society, the distributional consequences
vary.
 In much of the United States, warmer temperatures
will improve agricultural output and quality of life.
 In Bangladesh, which is near sea-level, much of the
country will be flooded by rising sea levels.
 If you’re wondering why you should care about
Bangladesh, then you have identified the market
failure that arises from externalities.
 From your private perspective, you shouldn’t!
 EXTERNALITY THEORY
 Externalities can either be negative or positive, and they can
also arise on the supply side (production externalities) or the
demand side (consumption externalities).
 A negative production externality is when a firm’s
production reduces the well-being of others who are not
compensated by the firm.
 A negative consumption externality is when an
individual’s consumption reduces the well-being of others
who are not compensated by the individual.
 The basic concepts in positive externalities mirror those in
negative externalities.
 Economics of Negative Production
Externalities
 To understand the case of negative production
externalities, consider the following example:
 A profit-maximizing steel firm, as a by-product of its
production, dumps sludge into a river.
 The fishermen downstream are harmed by this activity, as the
fish die and their profits fall.
 This is a negative production externalities because:
 Fishermen downstream are adversely affected.
 And they are not compensated for this harm.

 Figure 2 illustrates each party’s incentives in this situation.

 SMC = PMC +
Price MD S=PMC
of steel TheThe
yellow
steeltriangle
firm sets
is the
consumer
PMB=PMC andto producer
find
The its firmoptimal
steel
socially overproduces
level of
privately
surplus
optimal
at Q 1profit
. society’s
from
production viewpoint.
is at Q2, the
p2 This maximizing
Theframework output,
marginal damage
does notQ1. of SMC and SMB.
intersection
curve
capture (MD)
therepresents
harm donethe to The red triangle is the
The social marginal cost deadweight
is loss from the
fishery’s harm
the fishery, per unit.
however.
the sum of PMC and MD, and private production level.
p1
represents the cost to society.
MD

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 2 Negative Production Externalities

 Economics of Negative Production
Externalities
 The steel firm’s privately optimal production solves:

PMB  PMC
 This yields a quantity of steel Q1 at a price of P1.
 Economics of Negative Production
Externalities
 The steel firm’s emits pollution causing damage to
the fishery. This is represented by the marginal
damage curve. Ideally, the fishery prefers:

MD  0
 This would yield zero steel production, which is
obviously not in the steel firm’s best interests.
 Economics of Negative Production
Externalities
 The social marginal cost accounts for both the
direct costs to the steel firm and the indirect harm
to the fishery:

SMC  PMC  MD
 We find the socially optimal quantity of steel Q2 at a
price of P2, by solving:

SMC  SMB
 Economics of Negative Production
Externalities
 The socially optimal quantity entails less production
of steel. By doing so, the steel firm would be worse
off but the fishery would be better off.
 Graphically, this triangle in between the PMB and
PMC curves from Q2 to Q1.
 The damage to the fishery is reduced as well.
 Graphically, this is the area under the MD curve
from Q2 to Q1.
 Economics of Negative Production
Externalities
 The deadweight loss from the original production
level Q1 is graphically illustrated as the triangle in
between the SMC and SMB curves from Q2 to Q1.
 Note that the SMB equals the PMB curve in this
case.
 Negative Consumption Externalities

 We now move on to negative consumption

externalities. Consider the following example:
 A person at a restaurant smokes cigarettes.
 That smoking has a negative effect on your
enjoyment of the restaurant meal.
 In this case, the consumption of a good reduces the
well-being of someone else.
 Figure 3 illustrates each party’s incentives in the
presence of a negative consumption externality.
Price of S=PMC=SMC
cigarettes The The
yellow
smoker
triangle
setsis the
surplus
PMB=PMC to thetosmokers
find his
privately
(and producers)
optimal quantity
at Q1.
The
ThisThe
MD of cigarettes,
framework
curve
social does Q
represents
marginal 1.benefit is
not
the nonsmoker’s
capture
the the harmharm
difference done per
to PMB
between The red triangle is the
non-smokers,
pack of cigarettes.
however.
and MD. deadweight loss from the
p1
The
The socially
smoker private
optimalproduction
consumes of level.
leveltoo
manysmoking
cigarettes from
is at Q2,society’s
the MD
p2 intersection viewpoint.
of SMC and SMB.

D=PMB
SMB=PMB-MD

0 Q2 Q1 QCIGARETTES

Figure 3 Negative Consumption Externalities

 Negative Consumption Externalities

 The smoker’s privately optimal quantity solves:

PMB  PMC
 This yields a quantity of cigarettes Q1 at a price of
P1. The surplus is the same as before.
 Negative Consumption Externalities

 The smoker’s consumption causes damage to the

other restaurant patrons. They would prefer:

MD  0
 This would yield zero cigarette smoking, which is
detrimental to the smoker.
 Negative Consumption Externalities

 The social marginal benefit accounts for both the

direct benefit to the smoker and the indirect harm
to the other patrons:

SMB  PMB  MD
 We find the socially optimal quantity of cigarettes
Q2 at a price of P2, by solving:

SMC  SMB
 Negative Consumption Externalities

 The socially optimal quantity entails less smoking.

By doing so, the cigarette smoker is worse off, but
the other patrons are better off. The surplus to the
smoker (and tobacco companies) falls.
 Graphically, this is the triangle in between the PMB
and PMC curves from Q2 to Q1.
 The harm to other restaurant patrons is reduced as
well.
 Graphically, this is the area under the MD curve
from Q2 to Q1.
 Negative Consumption Externalities

 The deadweight loss from the original consumption

level Q1 is illustrated graphically as the triangle in
between the SMC and SMB curves from Q2 to Q1.
 Note that the SMC equals the PMC curve in this
case.
 The Externality of SUVs
 Consider a real-life example: the use of sport utility
vehicles (SUVs). They create three sorts of
externalities:
 Environmental externalities: They consume a lot of
gasoline and create more pollution.
 Wear and tear on roads: SUV drivers do not bear the
costs that result from their vehicles.
 Safety externalities: When SUVs are in accidents, the
other drivers are often more severely injured.
 Positive Externalities
 Positive externalities can occur in production or
consumption.
 A positive production externality is when a firm’s
production increases the well-being of others, but the firm is
not compensated by those others.
 Research and development is a production externality.
 A positive consumption externality is when an individual’s
consumption increases the well-being of others, but the
individual is not compensated by those others.
 Nice landscaping could be a consumption externality.
 Positive Externalities

 Let’s consider positive production externalities.

Consider the following example:
 A policeman buys donuts near your home.
 As a consequence, the neighbors are safer because of
the policeman’s continued presence.
 In this case, the production of donuts increases the
well-being of the neighbors.
 Figure 4 illustrates each party’s incentives in the
presence of a positive production externality.
Price of S = PMC
donuts The
Thedonutyellowshop
triangle
setsisPMB
the
=consumer
PMC to find anditsproducer
privately
optimal surplus
profit at
maximizing
Q 1.
This
The red triangle theoutput,
Theframework
external
is Q1.not
marginal
does
benefit
capture
deadweight loss from (EMB)
the
thebenefit
represents
to the The The donut
socially
shopoptimal
underproduces
level of
the
private productionneighbor’s
neighbors, benefit.
level. however. fromissociety’s
donuts SMC
at Q2, the = PMC -
viewpoint.
intersection
p1
of SMC andEMB SMB.
EMB
p2
The social marginal cost
subtracts EMB fromDPMC.
= PMB =
SMB

0 Q1 Q2 QDONUTS

Figure 4 Positive Production Externalities

 Positive Externalities

 The donut shop’s privately optimal production

solves:

PMB  PMC
 This yields a quantity of donuts Q1 at a price of P1.
 Positive Externalities

 The shop creates positive externalities to the

neighbors through the presence of police. This is
represented by the external marginal benefit.
Ideally, the neighbors prefer:

EMB  0
 This would yield much more donut production,
which is obviously not in shop’s best interests.
 Positive Externalities

 The social marginal cost accounts for both the

direct costs to the donut shop and the indirect
benefit to the neighbors:

SMC  PMC  EMB

 We find the socially optimal quantity of donuts Q2
at a price of P2, by solving:

SMC  SMB
 Positive Externalities

 The socially optimal quantity entails more

production of donuts. By doing so, the donut shop
would be worse off but the neighbors would be
better off. The consumer and producer surplus fall.
 Graphically, this triangle is between the PMC and
PMB curves from Q1 to Q2.
 The benefit to the neighbors is increased as well. It
goes up.
 Graphically, this is the area under the EMB curve
from Q1 to Q2.
 Positive Externalities

 The deadweight loss from the original donut

production level Q1 is graphically illustrated by the
triangle in between the SMB and SMC curves from
Q1 to Q2.
 Note that the SMB equals the PMB curve in this
case.
 Positive Externalities

 Finally, there can be positive consumption

externalities.
 A neighbor’s improved landscape is a good example
of this.
 The graphical analysis is similar to negative
consumption externalities, except that the SMB
curve shifts outward, not inward.
 Positive Externalities

 The theory shows that when a negative externality is

present, the private market will produce too much
of the good, creating deadweight loss.
 When a positive externality is present, the private
market produces too little of the good, again
creating deadweight loss.
 The Solution (Coase Theorem)

 The Coase Theorem: When there are well-defined

property rights and costless bargaining, then
negotiations between the parties will bring about the
socially efficient level.
 Thus, the role of government intervention may be
very limited—that of simply enforcing property
rights.
 The Solution (Coase Theorem)

 Consider the Coase Theorem in the context of the

negative production externality example from
before.
 Give the fishermen property rights over the amount
of steel production.
 Figure 5 illustrates this scenario.
 SMC = PMC +
Price This bargaining processMD will S = PMC
of steel
Thecontinue
The gain
gain until theissocially
to society
to society this is area,
this area,
the efficient
difference
the difference level.
betweenbetween(PMB(PMB - -
PMC)
PMC) andandMDMD for for
thethe
firstsecond
unit. unit.
p2
The
If the
reason
fisheryishad
because
property
any
rights,
steel itproduction
would initially
makesimpose
the
p1 zero
fishery
steelworse
production.
off.
MD

Thus,
Thus,While
ButitThere
While
there
is itthe
is possible
is
fishery
the
possible still
room
fishery
room
for suffers
toforbargain.
the suffers
to
thebargain.
only
steelsteelthe
firm firm
toThe
a The to steel
“bribe”
modest
same
steel“bribe”
the
amount
damage
firmfirmthe
fishery
getsof fishery
gets
as
damage.
a lot
fromofinthe
ainbit less D = PMB
order
order surplus
surplus
to to produce
produce from
fromfirst
the
the the
the
unit.
first
second
firstnext
unit.
unit.unit.
unit. SMB

0 1 2 Q2 Q1 QSTEEL

Figure 5 Negative Production Externalities and Bargaining

 The Solution (Coase theorem)

 Through a process of bargaining, the steel firm will

bribe the fishery to arrive at Q2, the socially optimal
level.
 After that point, the MD exceeds (PMB - PMC), so
the steel firm cannot come up with a large enough
bribe to expand production further.
 The Solution (Coase Theorem)

 Another implication of the Coase Theorem is that

the efficient solution does not depend on which
party is assigned the property rights, as long as
someone is assigned them.
 The direction in which the bribes go does depend
on the assignment, however.
 Now, let’s give the property rights to the steel firm
over the amount of steel production.
 Figure 6 illustrates this scenario.
 SMC = PMC +
Price MD S = PMC
of steel
This bargaining process will
The gain gain to society is this
is area, the
continueThe until thetosocially
society this area,
If the
Thissteel
levelfirm
difference of production
had property
between MD and MD (PMB -
p2 the difference
efficient
While While
the level.
steel
the steel
firmbetween
firm
suffers
suffers
a and
rights,
maximizes it would
PMC) the
byinitially
consumer
cutting choose
and unit.
another
(PMB-PMC)
only
larger
a modest
loss byloss
in cutting
profits. back 1 unit.
in profits.
producer Q surplus.
1 .

p1

MD

The
Thus,The
Thus,
fishery
it is
fishery
itpossible
gets
is possible
gets
the for
same
a lot
the
forofthe
fishery
fishery
surplus toas“bribe”
surplus to “bribe”
cutting
from the the
steel
cutting
back steel
firmfirm
from
back
D=PMB=SMB
to
steel
cutthe
production
back first
toanother
cut
unit.
back.
by unit.
one unit.

0 Q2 Q1 QSTEEL

Figure 6 Negative Production Externalities and Bargaining

 The Solution (Coase Theorem)

 Figure 6 shows that even though the bargaining

process is somewhat different, the socially efficient
quantity of Q2 is achieved.
 Problems with Coasian Solutions

 There are several problems with the Coase

Theorem, however.
 The assignment problem
 The holdout problem
 The free rider problem
 Transaction costs and negotiating problems
 Problems with Coasian Solutions

 The “assignment problem” relates to two issues:

 It can be difficult to truly assign blame.
 It is hard to value the marginal damage in reality.
 Problems with Coasian Solutions

 The “holdout problem” arises when the property

rights in question are held by more than one party.
 The shared property rights give each party power
over all others.
 This could lead to a breakdown in negotiations.
 Problems with Coasian Solutions

 The “free rider” problem is that when an investment

has a personal cost but a common benefit,
individuals will underinvest.
 For example, if the steel firm were assigned property
rights and you are the last (of many) fishermen to
pay, the bribe is larger than the marginal damage to
you personally.
 Problems with Coasian Solutions

 Finally, it is hard to negotiate when there are large

numbers of individuals on one or both sides.
 Problems with Coasian Solutions

 In summary, the Coase Theorem is provocative, but

perhaps not terribly relevant to many of the most
pressing environmental problems.
 PUBLIC-SECTOR REMEDIES FOR
EXTERNALITIES
 Coasian solutions are insufficient to deal with large
scale externalities. Public policy makes use of three
types of remedies to address negative externalities:
 Corrective taxation
 Subsidies
 Regulation
 Corrective Taxation

 The government can impose a “Pigouvian” tax on

the steel firm, which lower its output and reduces
deadweight loss.
 If the per-unit tax equals the marginal damage at the
socially optimal quantity, the firm will cut back to
that point.
 Figure 7 illustrates such a tax.
 SMC=PMC+MD
Price S=PMC+tax
S=PMC
of steel
The socially optimal level of
production, Q2, then maximizes
p2
profits.
The steel firm initially produces
at QImposing
1, the intersection
Imposing aatax of PMC
taxequal
shifts to
thethe
PMC
MD
p1 shifts
curveand
the PMB.curve
upward
PMC and reduces
such that
steel
it equals
production.
SMC.

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 7 Pigouvian Tax

 Corrective Taxation

 The Pigouvian tax essentially shifts the private

marginal cost.
 The firm cuts back output, which is a good thing
when there is a negative externality.
 Corrective Taxation

 The steel firm’s privately optimal production solves:

PMB  PMC  tax

 When the tax equals MD, this becomes:

PMB  PMC  MD  SMC

 But this last equation is simply the one used to
determine the efficient level of production.
 Subsidies

 The government can impose a “Pigouvian” subsidy

on producers of positive externalities, which
increases its output.
 If the subsidy equals the external marginal benefit at
the socially optimal quantity, the firm will increase
production to that point.
 Figure 8 illustrates such a subsidy.
Price of S = PMC
donuts The donut shop initially
choosesProviding a subsidy equal
Q1, maximizing shifts
the
its to PMC
EMB curve
profits. shifts downward.
the PMC
curve downward to SMC.

The socially optimal level of

SMC=PMC-EMB
p1 donuts, Q2, is achieved by such
a subsidy.

p2

D = PMB =
SMB

0 Q1 Q2 QDONUTS

Figure 8 Pigouvian Subsidy

 Subsidies

 The subsidy also shifts the private marginal cost.

 The firm cuts expand output, which is a good thing
when there is a positive externality.
 Subsidies

 The donut shop’s production solves:

PMB  PMC  subsidy

 When the subsidy equals EMB, this becomes:

PMB  PMC  EMB  SMC

 But this last equation is simply the one used to
determine the efficient level of production.
 Regulation

 Finally, the government can impose quantity

regulation, rather than relying on the price
mechanism.
 For example, return to the steel firm in Figure 9.
 SMC = PMC + MD
Price S = PMC
of steel

p2
The
Yet firm
the government
has an incentive
couldto
simply require
produce
it toQproduce
1. no
p1 more than Q2.

D = PMB =
SMB

0 Q2 Q1 QSTEEL

Figure 9 Quantity Regulation

 Regulation

 In an ideal world, Pigouvian taxation and quantity

regulation give identical policy outcomes.
 In practice, there are complications that may make
taxes a more effective means of addressing
externalities.
 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 The key goal is, for any reduction in pollution, to
find the least-cost means of achieving that
reduction.
 One approach could simply be to reduce output.
 Another approach would be to adopt pollution-
reduction technology.
 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 The models we have relied on so far have examined
reductions in output. Thus, we will modify this.
 Our basic model now examines pollution reduction,
rather than say, steel production.
 Figure 10 illustrates its features.
 PR Since
While
it pays
it faces
for increasing
the pollution
Pollution reduction
reduction,
marginal the has
costsSMCa price
fromisreducing
the same
associated with it. level.
its pollution
as PMC. S=PMC=SMC
S=PMC

The optimal
While level of
the benefit of pollution
pollution
reduction is therefore R*.
reduction is zero the firm,
society benefits by MD.

MD =
The steel firm’s private
Thus,
At some
the x-axis
levelalso measuresSMB
of pollution
marginal benefit from reduction,
pollutionthe
pollution levels
The firm ashas
good wethat
achieved
move
is being created
On
Such
its an
own,
reduction action
the steel
maximizes
is zero. company
fulltoward itsthe
pollution isreduction.
origin.
“pollution reduction.”
would set Qprofits.
R=0 and Q Steel =Q 1 .
D=
PMB
0 R* RFull QR
PFull P* 0
More pollution

Figure 10 Model of Pollution Reduction

 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 As Figure 10 shows, the private market outcome is
zero pollution reduction, while the socially efficient
level is higher.
 In the figure, the optimal tax would simply be MD–
the firm would reduce pollution levels to R*,
because its MC is less than the tax up until that
point, but no further.
 Quantity regulation is even simpler–just mandate
pollution reduction of R*.
 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 Assume now there are two firms, with different
technologies for reducing pollution.
 Assume firm “A” is more efficient than firm “B” at
such reduction.
 Figure 11 illustrates the situation.
 PR PMCB ToWhile Firmthe
get B
Firm
has A’s
total is more
relatively
For any given
PMCefficient. output
marginal inefficient
cost,A
we Bpollution
sum
level, PMC >PMCA. S = PMCA + PMCB =
reduction
horizontally. technology.
Efficient SMC
PMCB If,regulation
Quantity
instead, is got more
regulation
we in this
where thereduction
marginal
way costTheof SMB curve is the
The efficient level ofis clearly
from inefficient,
Firm
same
A, we
as before.
pollution reduction
since
could Firm
lower Bfor
theis “worse”
total at
social
pollution reduction is
each firm equals
reducing SMB.
cost.
pollution.
the same as before.
PMCA
MD=SMB
Quantity regulation could
Imposing
involve equal reductions in a Pigouvian tax
pollution by bothequal
firms,to MD induces these
such that R1 + R2 = R*.levels of output.

0 RB RA,RA R* QR
RB

Figure 11 Two Firms Emit Pollution

 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 Figure 11 shows that price regulation through taxes
is more efficient than is quantity regulation.
 A final option is quantity regulation with tradable
permits. Idea is to:
 Issue permits that allow firms to pollute
 And allow firms to trade the permits
 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 As in the previous figure, initially the permits might
be assigned as quantity regulation was assigned.
 This means that initially RA = RB.
 But now Firm B has an interest in buying some of
Firm A’s permits, since reducing its emissions costs
PMCB (>PMCA). Both sides could be made better
off by Firm A selling a permit to Firm B, and then
Firm A simply reducing its pollution level.
 This trading process continue until PMCB=PMCA.
 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 Finally, the government may not always know with
certainty how costly it is for a firm to reduce its
pollution levels.
 Figure 12 shows the case when the social marginal
benefit is “locally flat.”
 In
Butaddition,
it is possible
imagine for that
the
PR PMC
Then
Suppose
therethe
is large
true firm’s
the government’s
costs to be best2.2
PMC
deadweight
costs are PMCloss. guess of costs is PMC1.
2. PMC1
This results in a
much smaller DWL,
and much less If, instead, theFirst,
This could
assume be the
pollution reduction. government levied
SMBa
caseisfor
downward
global
tax, it would equal sloping,
warming,but for
fairly
MD at QR = R1. example. flat.

MD =
SMB
Regulation
mandates R1.

0 R3 R1 RFull QR
PFull 0
More pollution

Figure 12 Model with Uncertainty and Locally Flat Benefits

 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 Figure 13 shows the case when the social marginal
benefit is “locally steep.”
 In
Butaddition,
it is possible
imagine for that
the
PR PMC
Then
Suppose
therethe
is small
true firm’s
the government’s
costs to be best2.2
PMC
deadweight
costs are PMC
loss. guess of costs is PMC1.
2. PMC1
This results in a
larger DWL, and
much less pollution If, instead, the
reduction. government levied a
tax, it would equal
MD at QR = R1.
First,
This could
assume
be the
SMB
caseisfor
downward
nuclear
sloping,
leakage,
andfor
fairly
Regulation example.
steep.
mandates R1.
MD =
SMB

0 R3 R1 RFull QR
PFull 0
More pollution

Figure 13 Model with Uncertainty and Locally Steep Benefits

 DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
 These figures show the implications for choice of
quantity regulation versus corrective taxes.
 The key issue is whether the government wants to
get the amount of pollution reduction correct, or to
minimize firm costs.
 Quantity regulation assures the desired level of
pollution reduction. When it is important to get the
right level (such as with nuclear leakage), this
instrument works well.
 However, corrective taxation protects firms against
large cost overruns.
 Recap of Externalities:
Problems and Solutions
 Externality theory
 Private-sector solutions
 Public-sector solutions
 Distinctions between price and quantity approaches
to addressing externalities