CHAPTER FOUR

4 BEC 310: Public

Finance

Government and Managerial Policy:

Externalities
 In this chapter……

■ Introduction
■ Types of Externalities (Read on Optimization in externalities)
■ Negative Externalities
■ Positive Externalities
■ Pecuniary and Non-pecuniary

■ Towards Social Optimum

■ Merger
■ Assigning Property Rights
■ Pigouvian Taxation

■ The Tragedy of the Commons (Read about Rent Seeking)

■ Global Externalities and International Agreements

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 Introduction

■ Externalities are the effects of production and

consumption activities not directly reflected in the
market.
■ An externality exists when the consumption or
production choices of one person or firm enter the
utility or production function of another entity without
that entity’s permission or compensation.
■ Externalities occur in many everyday interactions.

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 Introduction

■ Sometimes they are localised and small:

1. Impact on your roommate if you play your stereo too loudly.
2. Impact on your neighbours if your dog uses their garden as a
bathroom.
■ Externalities also exist on a much larger scale, such as
global warming or acid rain.
■ The most important question of public finance is when
is it appropriate for the government to intervene?

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 Types of Externalities

■ The two broad categories of externalities are positive

and negative externalities.
■ The concept of externalities is very much related to the
one of public goods.
■ This is because the decision to supply a public good or
to contribute to its provision affects not only the utility
of the contributor, but also the utility of all other
people in the economy.
■ In this sense, providing public goods generates a
particular positive externality.
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 Types of Externalities

■ A positive externality occurs when other people who

are affected receive a positive utility change from a
higher provision of the public good.
■ Some authors distinguish between public goods and
positive externalities based on the following:
1. If the provision of the good in question is made
consciously, then it is called a public good.
2. If the good arises as a by-product of some other activity,
then it is called an externality.

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 Types of Externalities

■ Negative externalities are those that arise when the

activity of one individual decreases the utility of other
individuals in the economy.
■ Examples:
1. The production process pollutes the environment, thus
decreasing the utility of other individuals.
2. Individuals who have a higher risk of illness as a
consequence of a firm's pollution.
3. A steel plant dumping waste in the river as it makes
steel imposes cost on fishermen.
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Types of Externalities

■ Negative Externality
■ When a negative externality exists, the price of a good
or service does not reflect the full marginal social cost
of resources allocated to its production.
■ It is important to remember that there is no malice
intended from a negative externality.
■ In this case, the sellers or producers of the good do not
consider the costs to third parties.
■ Let us consider an example of a negative externality.

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Types of Externalities

■ Negative Externality
■ Environmental Pollution
■ Here, we will show the result of the unregulated
outcome where, as a by-product of its production
process, factory A pollutes a river.
■ This pollution causes harm to the fishing firm B.
■ There are additional costs not internalised by private producers; these are
externalities.
■ Producers do not pay these costs.

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Types of Externalities

■ Negative Externality
■ Environmental Pollution
■ For simplicity, assume that there is nothing that A
can do to prevent pollution, except for reducing its
production.
■ That is, pollution is an increasing function of the
quantity produced.
■ The market price for the product produced by A is
given by p in Figure 5.1.

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Types of Externalities

■ Negative Externality
■ Environmental Pollution
Figure 5.1

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Types of Externalities

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Types of Externalities

■ Negative Externality
■ Environmental Pollution
■ As said, A's production causes pollution that leads to
a marginal damage given by the MD curve in Figure
5.1.
■ When we add A's marginal cost curve MC and the
marginal damage curve MD, we get the social
marginal cost curve MSC.
■ That is to say MSC=MD+MC.

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Types of Externalities

■ Negative Externality
■ Environmental Pollution
■ Hence, the social cost of production includes all costs
associated with production.
■ In this case, the price of a good or service does not
reflect the full marginal social cost of resources
allocated to its production.
■ It does not matter whether they are costs that A pays
directly or costs that accrue as damages for other members
of the society (like B here).
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Types of Externalities

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Types of Externalities

than

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Types of Externalities

■ Negative Externality
■ Environmental Pollution
■ What have we seen?
1. When a negative externality exists, too much output is
produced and sold in a competitive market relative to the
efficient amount.
2. When we move away from the social efficiency-maximizing
quantity, we create a deadweight loss for society.
3. This is because units are produced and consumed for which
the cost to society (MSC) exceeds the social benefits (SMB).

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Types of Externalities

■ Positive Externalities
■ We have covered an example of negative externalities
and have shown that the unregulated outcome results
in output that is too high from a social point of view.
■ We now want to look at the opposite case of a positive
externality, in which another agent benefits from that
action.

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Types of Externalities

■ Positive Externalities
■ Suppose that a firm researches some way to decrease
its costs but they discover that this is not patentable.
■ This means that other firms can imitate the findings and
reduce their own costs.
■ Suppose, for example, that the research is not for
some technology, but rather is looking for an optimal
way to organise production with the existing
technology.

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Types of Externalities

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Types of Externalities

■ Positive Externalities
Figure 5.5

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Types of Externalities

■ Positive Externalities
■ The ways to deal with positive externalities very much
mirror the possibilities to deal with negative
externalities.
■ While a Pigou tax is used to reduce the amount of
negative externalities, the government can subsidise the
positive externality generating activity.
■ The government often subsidises private companies
doing research and also research in universities.

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Towards Social Optimum
■ We now discuss several options of how the social
optimum can be restored in the case of either negative
and positive externalities.
■ 1. Merger
■ The first option is a merger between A and B, that is,
one firm takes over the other.
■ The combined firm “internalises" the externality:
■ This is because when the merged firm maximises profits, it
will choose the socially efficient level of output, since it now
faces all costs and benefits of its actions.

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Towards Social Optimum

■ 1. Merger
■ Mergers or private contracts are a useful solution to
deal with externalities as long as the number of
parties affected by the externality is low.
■ If, instead, many agents are involved, then the merger
solution appears very impractical.

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Towards Social Optimum

■ 2. Assigning Property rights

■ The next possible solution to the externality problem
is similar to the merger solution in that it does not
require an active involvement by the government.
■ This is referred to as the private solution to the
externality problem.
■ Let us propose two individuals involved in a river
externality problem (water pollution).

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Towards Social Optimum

■ 2. Assigning Property rights

■ Property right here means that B has the right to
prevent A from using the river at all for the
production waste, unless B agrees to this usage.
■ As the effective “owner" of the river, B can now sell
the right to emit a certain level of pollution to A.
■ In general, A and B can write a contract that specifies how many
units of pollution A is allowed, and the payment that A has to give
to B in exchange.

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Towards Social Optimum

■ 2. Assigning Property rights

■ We could also assign the property rights for the river in
a different way where A has the right to pollute the
river.
■ This arrangement may seem a bit odd, but we will
show that it also leads to an efficient outcome.
■ This method of internalising an externality is contained
in the Coase Theorem.

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 Towards Social Optimum

■ 2. Assigning Property rights

■ The Coase Theorem states that:
■ If property rights are clearly assigned to one party, can
be enforced when transactions costs of bargaining are
zero, then the efficient level of the externality
generating activity will be realised.
■ For this, it does not matter who (A or B) receives the
property rights.

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Towards Social Optimum

■ 2. Assigning Property rights

■ Some remarks concerning the Coase Theorem are in order:
■ First, there are only some situations in which externalities can be
corrected through private negotiations.
■ The example presents a very simple case of an externality, because there are only two
parties involved but in realistic pollution examples, there are many polluters and
many people who suffer from pollution.
■ For large groups, it will be much more difficult to reach an efficient agreement
through multilateral bargaining.
■ Second, the Coase theorem does not state that both property
assignments are equivalent, only that efficiency will be achieved in
both arrangements.
■ There are clear distributional differences between the two assignments.

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Externalities

■ Assignment 3:
■ Identify and explain the problems with the Coasian
solutions in your own words.

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Towards Social Optimum

■ Pigou Taxes
■ In many cases of negative externalities with many
participants, the government corrects the externality by
charging a Pigou tax on the activity that creates the
negative externality.
■ For example, most governments tax gasoline at a higher rate than
other products, because the operation of cars often causes negative
externalities.
■ These include pollution and congestion and therefore, should be
discouraged in order to implement the social optimum.

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Towards Social Optimum
■

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Towards Social Optimum

■ Pigou Taxes
■ The tax forces A to internalise his external effect on B.
■ In this regard, A will choose its profit maximising
output level such that:
■ Its marginal cost plus the Pigou tax that has to be paid for
every unit of output together equal the price that A gets
for one unit of output.

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Towards Social Optimum

Figure 5.4

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Towards Social Optimum

■ Pigou Taxes
■ A final word of caution concerns the use of Pigou
taxes to achieve efficiency in cases where:
1. Private solutions like mergers are possible or
2. Property rights are well established and only few parties are involved.

■ In this case, using Pigou taxes is not a good idea

because:
1. Both the private solutions will already reduce the level of pollution to the
optimal level, and
2. Using Pigou taxes on top of that will lead to a level of pollution that is too
low.

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Towards Social Optimum

■ Pigou Taxes
■ In practice, Pigou taxes or subsidies are therefore
applied to correct for externalities that:
1. Affect a large number of agents.
2. Would be very difficult to internalise through private
contracts.

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Resources with Non-Excludable Access: The
Tragedy of the Commons
■ This type of externality is known as the tragedy of the
commons.
■ The commons refers to common ownership or absence
of private ownership.
■ In the case of fishing, absence of property rights to the
fish in the stream makes the river a common.
■ The tragedy is the depletion of the common resource
and here, it is the fish.
■ The people fishing impose negative externalities on one another because they
are competing for the same fish.
■ Together, they may overfish the river thereby not allowing a sustainable future
stock of fish to persist.
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Resources with Non-Excludable Access: The
Tragedy of the Commons
■ Today, we refer to resources as “commons" if the
access is non-excludable, but rival.
■ Private ownership encourages conservation whereas
common access encourages depletion.
■ Modern day examples for commons include fishing in
the world's oceans and farmer’s keeping of cows.

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Personal Interactions that are not
Externalities
■ Not all personal interactions involve externalities.
■ Example 1:
■ When two people are in the desert and there is only enough water for one to
survive, one person drinking the water does not create a negative externality.
■ Externalities involve inefficiencies.
■ One person drinking the water is a Pareto-efficient outcome:
■ It is impossible to make one person better off without making someone else

worse off by changing the behaviour of the person drinking the water.
■ Two people in the desert might see a water bottle ahead and set off running
to reach it, the person who reaches the bottle first drinks the water.
■ There has been a contest that someone has won and another person has lost.
■ We do not associate winning and losing a contest with externalities.

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Personal Interactions that are not
Externalities
■ Example 2:
■ More people may come to the beach than an ice-cream
vendor had expected.
■ The vendor realises that demand is higher than was anticipated and
increases the price of ice cream.
■ Through the increased price of the ice cream, people have now
affected one another by their decision to come to the beach.
■ Although the increase in price is directly due to the decision of
people to come to the beach, the increased price of the ice cream is
not a case of an externality.
■ There is no externality because the market has internalised the
increased demand through the increase in the market price.
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Personal Interactions that are not
Externalities
■ Note:
1. If people compete for space at the beach or kick sand
onto one another, there is an externality.
2. Yet some people may prefer a crowded beach
whereas others prefer personal space.
3. Whether an externality is present, therefore, is
subjective.

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Global Externalities and International
Agreements
■ Global externalities affect the world at large.
■ 1. Global warming and climate change
■ These are as a result of emissions of carbon dioxide,
sulphur dioxide, methane and nitrous oxide and the
destruction of rain forests.

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Global Externalities and International
Agreements

■ Biodiversity
■ Elephants are hunted for the ivory from their tusks.
■ Rhinos are hunted because people in some parts of the
world believe that their horns, when ground up and
ingested, are aphrodisiacs.
■ Other species of the world’s largest mammals, the
whales, have been hunted to near extinction.
■ International agreements attempt to preserve wildlife and
biodiversity, but not all governments have the same will
or incentive to participate in the agreements or to
comply.
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Global Externalities and International
Agreements
■ The Ozone Layer
■ Emissions of manmade chlorofluorocarbons and other
substances (halons, carbon tetrachloride, and methyl
chloroform) have been identified as the cause of a hole
in the earth’s ozone layer over the continent of
Antarctica.
■ The ozone layer provides protection from ultraviolet radiation due to rays of the
sun.
■ A diminished ozone layer increases the incidence of skin cancer and is also
harmful to agricultural crops.
■ International agreement on eliminating emissions of chlorofluorocarbons was
reached when the extent of the damage to the earth’s ozone layer became
known.
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Global Externalities and International
Agreements
■ Climate Change
■ Climate change has been described as a problem of
monumental magnitude.
■ Climate change is a case of the tragedy of the
commons.
■ The commons is the global atmosphere in which a
stock of greenhouse gases accumulates.

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Global Externalities and International
Agreements
■

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 END
Thank you!

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