Economics 2 Emmanuel Saez

Fall 2024

LECTURE 9
Externalities and Climate Change
I. OVERVIEW
 Market Failure
• When markets do not lead to an efficient outcome

• First example was monopoly—a profound lack of

competition.

• This lecture is about externalities, an important

source of market failures.

• Economic activity can create external harm

(external means not taken into account by the
market participants).
 Externality
• An externality arises whenever the actions of one
economic agent directly affect another economic
agent outside the market mechanism

• A power plant that pollutes a river used for

recreation is an externality

• A power plant that increases its price of electricity

because of a shift in demand is NOT an externality
(as this is a market mechanism)
 SUV Externalities Example
• Example: negative externalities of driving a gas
powered large Sport Utility Vehicle:
– 1. Environmental externality: carbon emissions and
global warming

– 2. Infrastructure externality: Larger cars wear down the

roads more

– 3. Safety externality on other drivers: The odds of

having a fatal accident increase if hit by a bigger car

– 4. Congestion externality: driving a car adds to traffic

which increases travel time for others
 Quiz:
Question: Which of these is NOT a negative externality?

• A. Cigarette smoking that damages your future health.

• B. Texting while driving which increases accident risk.

• C. Pesticide runoff from farms that pollutes land/water.

• D. Noise related to a construction project.

• E. All are negative externalities

 Quiz
Example: Suppose you have a beehive in your garden
to produce homemade honey you sell to fellow
students. Does this produce externalities?
A. Yes, a negative externality if neighbors get stung by
your bees.

B. Yes, a positive externality as the bees help with

pollination in the organic farm next door.

C. Yes, a positive externality because fellow students love

to stop by and discuss my beehive hobby.

D. All of A, B, and C
 Quiz
Example: suppose you are still talking when I start
lecturing. Is this an externality as economists define
it? Only 1 answer is correct.
A. No, because this has nothing to do with markets

B. No, because I was engrossed in the conversation and

did not even notice class had started

C. Yes, but only if the background noise makes it harder

for the students to understand the lecture.

D. No, because many students were also talking so my

talking does not make any difference.

E. Yes, because the rule is to be quiet when class starts

II. NEGATIVE EXTERNALITIES
 Atmospheric CO2 Concentration

Source: Scripps Institution of Oceanography: Keeling Curve, Hawaii Observatory

https://keelingcurve.ucsd.edu/
Atmospheric CO2 concentration is the cumulative CO2 emissions since
industrialization because CO2 lasts 300 to 1000 years in atmosphere
Temperature gains are approximately proportional to atmospheric CO2
 Negative Externality Econ Modeling
• There are negative effects on agents outside the
market mechanism

• These negative effects can be measured in $ costs

(for economists, anything that matters can be
measured in $ costs, a strong assumption)

• Negative externalities can result from either the

consumption or the production of a good
– Consumption negative externality: emitting CO2 when
driving a gas powered car

– Production negative externality: emitting CO2 when

producing electricity in coal power plant
Market for Coal Powered Electricity
P S1, MC1

P1

D1, MB1
Q1 Q
 Some Terminology
• “Private” refers to the people participating in the
market (the buyers and sellers, and the
government if there is a tax or a subsidy).

• “Social” includes effects on people both in the

market and outside the market.
 Market for Coal Powered Electricity
P S1,PMC1

P1

D1,PMB1
Q1 Q
PMC is the private marginal cost (we used to call this MC)
PMB is the private marginal benefit (we used to call this MB)
 Total Private Surplus
• Sum of consumer surplus and producer surplus
(plus government revenue and minus government
expenditure).
 Review of Welfare Analysis
P S1,PMC1

P1

D1,PMB1
Q1 Q
PMC is the private marginal cost; PMB is the private marginal benefit.
 Market produces economic surplus for
participants: consumers and producers
P Sum of S1,PMC1
Consumer
& Producer
Surplus

P1

D1,PMB1
Q1 Q
PMC is the private marginal cost (we used to call this MC)
PMB is the private marginal benefit (we used to call this MB)
 More Terminology
• External Marginal Cost: The additional cost to
people outside the market when one more unit is
produced and consumed (sometimes called
marginal damage)

• Social Marginal Cost: Private marginal cost plus

external marginal cost.
Negative Production Externality
(Market for Coal Powered Electricity)
P
S1,PMC1

Private
P1 Economic
Surplus

D1,PMB1
Q1 Q
 Negative Production Externality
(Market for Coal Powered Electricity)
P SMC1
S1,PMC1

External MC
P1

D1,PMB1=SMB1
Q1 Q
External MC is the $ measure of the external cost of producing 1
extra unit of coal powered electricity (e.g. global warming)
 Negative Production Externality
(Market for Coal Powered Electricity)
P SMC1
S1,PMC1

Private External MC
Economic
P1 Surplus

D1,PMB1=SMB1
Q1 Q
External MC is the $ measure of the external cost of producing 1
extra unit of coal powered electricity (due to climate change)
 Total Social Economic Surplus
• Total private economic surplus plus external
benefits minus external costs.

• It includes the welfare (measured in $) of both

people in the market and outside the market.
 Negative Production Externality
(Market for Coal Powered Electricity)
P SMC1
S1,PMC1

External MC
P1

Total External Cost

D1,PMB1=SMB1
Q1 Q
Dark blue area is the total external cost of producing Q1:
sum of external MC from 0 to Q1
 Negative Production Externality
(Market for Coal Powered Electricity)
P SMC1
S1,PMC1

Social External MC
Economic
P1 Surplus Negative Social Economic Surplus

D1,PMB1=SMB1
Q1 Q
Social Economic Surplus at Q1 is the light blue area minus the dark
blue area
 Efficient Quantity with Externality

P SMC1
S1,PMC1

Social External MC
Economic
Surplus

D1,PMB1,SMB1
Q* Q1 Q
Efficient quantity that maximizes social economic surplus is Q*
(where SMC and SMB intersect)
 Negative Production Externality
(Market for Coal Powered Electricity)
P SMC1
S1,PMC1

External MC
P1 Deadweight loss

D1,PMB1,SMB1
Q* Q1 Q
Efficient quantity is Q* but market equilibrium quantity is Q1:
Deadweight loss: triangle starting at Q1 and pointing to Q*
Welfare Analysis of a Negative Production Externality
P SMC1
S1,PMC1

a
External MC
d
c
b

D1,PMB1,SMB1
Q* Q1 Q
Q1 Q*
Consumer and Producer Surplus a+b+c a+b
External Costs −(b+c+d) −b
Total Social Surplus a−d a
Deadweight Loss d
 Deadweight Loss
• The total social surplus is largest at the quantity
(Q*), where SMB=SMC.

• Why is this the case?

• Any shortfall from the largest total social surplus is

the deadweight loss.
 Whenever There Is a Negative Production
Externality:
• The SMC curve lies above the PMC curve.

• The people in the market will choose to produce

where PMC=PMB (or supply is equal to demand).

• But total social economic surplus higher if the

market produced and consumed less (where
SMC=SMB).
 Some Points about the Welfare Analysis of a
Negative Externality
• The total social surplus includes producers and
consumers in the market as well as all agents
affected by the externality

• Even with a negative externality, some production

may still be desirable (if SMC and SMB intersect).

• When there is no externality, SMB and PMB are

the same, and SMC and PMC are the same.

• Negative Consumption Externalities work the

same by shifting down the PMB into the SMB
 Negative Consumption Externality
(Market for Gasoline)
P
S1,PMC1

P1 Deadweight loss

External MC
D1,PMB1
SMB1
Q* Q1 Q
Efficient quantity is Q* but market equilibrium quantity is Q1:
Deadweight loss: triangle starting at Q1 and pointing to Q*
 Quiz:
Question: Gasoline consumption generates a climate
change negative externality. The market outcome is
inefficient. Who is at fault?

• A. Consumers who don’t take into account that

gasoline contributes to global warming

• B. Producers who don’t take into account that

gasoline contributes to global warming

• C. Both consumers and producers

• D. Nobody is at fault
III. POSITIVE EXTERNALITIES
 Positive Externality
• The effects on those outside the market are good.

• There is an external benefit.

• Positive externalities can result from either the

consumption or the production of a good (or
both).
 More Terminology
• External Marginal Benefit: The additional benefit
to people outside the market when one more unit
is produced and consumed.

• Mathematically: external marginal benefit is like a

negative external marginal cost

• Social Marginal Cost: Private marginal cost minus

external marginal benefit if positive externality in
production

• Social Marginal Benefit: Private marginal benefit

plus external marginal benefit if positive
externality in consumption
 Positive Production Externality
(Beehive honey production that helps crops)
P
S1,PMC1

SMC1= PMC1-
External MB
P1
Deadweight loss

D1,PMB1,SMB1
Q1 Q* Q
Efficient quantity is Q* but market equilibrium quantity is Q1:
Deadweight loss: triangle starting at Q1 and pointing to Q*
 Positive Consumption Externality
(Market for Vaccines)
P S1,PMC1,SMC1

Deadweight loss
P1 External MB

SMB1
D1,PMB1
Q1 Q* Q
Efficient quantity is Q* but market equilibrium quantity is Q1:
Deadweight loss: triangle starting at Q1 and pointing to Q*
 Other Examples of Positive Externalities?
• Technology spillovers: Firms constantly invent
better production processes that can then be
copied and drive long-run economic growth

• Education and research: Fundamental knowledge

taught and created also has spillovers on industry
(e.g., Stanford and Silicon Valley)

• Mundane example: Planting flowers in your yard

that neighbors enjoy. Almost everything not
market mediated has externalities!
 Whenever There Is a Positive Externality:
• The SMC curve lies below the PMC curve.

• The people in the market will choose to produce

where PMC=PMB (or supply is equal to demand).

• But society would be better off if the market

produced and consumed more (where SMC=SMB).
IV. REMEDIES FOR EXTERNALITIES
 Remedies for Externalities
• Private Solution:
• Negotiation and compensation
• Social sanctions

• Government Regulation
• Some externality generating actions are
regulated or prohibited

• Taxes and Subsidies

• Taxes can discourage negative externalities and
subsidies encourage positive externalities
Tax Remedy for a Negative Producer Externality

P SMC1,
S1,PMC1

External MC
P1

D1,PMB1,SMB1
Q* Q1 Q
 Tax Remedy for a Negative Producer Externality

P SMC1,S2
S1,PMC1

External MC,
P2c
P1 Tax
P2p

D1,PMB1,SMB1
Q2= Q* Q1 Q
A tax on producers equal to the external MC shifts PMC up to SMC and
moves equil. from Q1 to Q2=Q*. P2c is consumer price, P2p producer price
Tax Remedy for a Negative Consumption Externality

P
S1,PMC1

P1

External MC
D1,PMB1
SMC1
Q* Q1 Q
Tax Remedy for a Negative Consumption Externality

P
S1,PMC1

P2c
P1 Tax

External MC
D1,PMB1
SMC1
Q2= Q* Q1 Q
A tax on consumers equal to the external MC shifts PMB down
to SMB and moves equilibrium from Q1 to Q2=Q*.
 Quiz:
Question: Suppose the externality is on consumer
side (like gasoline for driving). Which tax remedy
works?

• A. A gas tax on consumers

• B. A gas tax on producers

• C. Both A. and B.

• D. None
 Quiz:
Question: Gasoline consumption generates a climate
change negative externality with marginal cost $2
per gallon. What is the correct remedy?

• A. $2 tax per gallon charged on consumers

• B. $2 tax per gallon charged on producers

• C. Either A. or B.

• D. Phase-out gas cars

 Tax Remedy for Negative Externality
• A tax per unit equal to the external MC moves the
market equilibrium to efficiency.

• It does not matter whether the tax is charged to

consumers or producers (see earlier lecture)

• It does not matter whether the externality is

created by producers or consumers

• If external MC varies with Q: The right tax is the

marginal external effect at the socially efficient
point
 Tax Remedy for Negative Externality
with non constant MC
P SMC1 S2
S1,PMC1

External MC
P2c
P1 Tax

D1,PMB1,SMB1
Q2= Q* Q1 Q
A tax per unit equal to the external MC at Q* shifts PMC up and
moves equilibrium from Q1 to Q2=Q*
Remedy for a Positive Externality (Subsidy)
P S1,PMC1,SMC1

P1 External MB

SMB1
D1,PMB1
Q1 Q* Q
 Remedy for a Positive Externality (Subsidy)
P S1,PMC1,SMC1

P2
P1 External MB,
Subsidy

SMB1,D2
D1,PMB1
Q1 Q*=Q2 Q
A producer subsidy equal to the external MB shifts PMB up to SMB
and moves equilibrium from Q1 to Q2=Q*
 Quiz:
Question: Gasoline consumption generates a climate
change marginal external cost of $2 per gallon. But
suppose gasoline consumption is completely
inelastic to price. What is the correct remedy for
efficiency?

• A. A $2 tax per gallon

• B. Nothing

• C. Either A. or B.

• D. Phase-out gas cars

 Tax Remedy with inelastic demand
(Tax and externality on producer side for visibility)
P SMC1 =PMC1 +Tax = S2
S1,PMC1
P2c
P1 Tax = external MC

D1,PMB1

Q2= Q* Q1 Q
With inelastic demand, Q1 is very close Q2=Q* (identical with totally
inelastic demand). Corrective tax does not change Q. It just reduces
consumer surplus and is not needed.
 Quiz:
Question: Suppose ag industry invent a powerful new pesticide
that helps grow coffee in poor countries more cheaply but is
toxic. Marginal damage is $10/unit as locals are poor (would be
$100/unit in the US). What is the correct remedy?

• A. A $10 tax per unit

• B. A $100 tax per unit

• C. Nothing

• D. The pesticide should be entirely prohibited

 Corrective (or Pigouvian) Taxes/Subsidies
• Named after economist Arthur Pigou (1877-1959)

• The idea to make economic agents internalize the

externality by incorporating it in the price

• For a negative externality: charge you a per-unit tax equal

to the amount that others suffer from your action

• For a positive externality: award you a per-unit subsidy

equal to the amount that others benefit from your action

• If you get the amount of the tax or subsidy right, this

brings private incentives in line with social incentives

• The right amount is the amount of marginal external effect

at the socially efficient point
 Do taxes/subsidies work in practice?
• Examples where the idea is currently used:
• Gas tax: in the US, gas taxes are earmarked for
road maintenance (deals with the wear and tear
externality only, not global warming)

• Congestion pricing: some cities have imposed

taxes on cars coming in crowded cities (London
£15 daily) to fight congestion externalities

• Research and Development (R&D) tax credits for

firms: subsidy to encourage innovation (but not
tied explicitly to size of positive externality)
Impact of London congestion charge starting in March 2003 (Leape 2006)
 Quiz:
Question: The state of Texas funds roads with its gas
tax—to correct for wear and tear produced by
driving. What is the correct tax policy for electric
vehicles (EVs) for Texas?

• A. No tax as EVs don’t use gas

• B. An extra specific tax as EVs also use the road

• C. A subsidy as EVs mitigate global warming

• D. Texas should phase out gas cars like California

 How do we deal with externalities in practice?

• Most common response is regulation:

• Products/actions that generate negative externalities are
forbidden by law (Harmful pollutants, dangerous
consumer goods, littering, speeding, criminal behavior)
• The penalty starts with a fine: economically equivalent to
a tax but psychologically/socially very different [goal is to
prohibit not price externality]
• Limit (=allowance) on pollutant emissions. Example:
smog check for gas cars in California

• Issue with regulation (for economists):

• Issue: cheap to reduce pollutant in some cases but not

others. Example: electric cars exist but not electric planes =>
CO2 allowance could kill high value aviation industry
Taxes and regulation combination: Cap&Trade
• Emission permits and trading (=cap&trade):
– Pollutant emitters are given emission permits

– Pollutant emitters can trade their emission allowances.

– Price of emissions is the same for all. If total allowances

set such that price=external MC then efficient

• Cap&trade has been used in transitions:

– SO2 emissions creating acid rain, CFCs depleting ozone
layer: costly to prohibit immediately as time is needed
to develop substitutes

– phased-out over years through cap&trade system with

shrinking allowances
 Quiz:
Question: Suppose the US adopts a cap&trade policy
for carbon emissions where each industry gets
permits equal to 50% of their 2024 emissions. What
would happen to aviation industry?

• A. Aviation industry would shrink a lot as they

can’t fly planes without fossil fuels

• B. Aviation industry would buy permits from other

industries and just charge the extra cost on flyers.

• C. Aviation industry would invent quickly E-planes.

• D. All of A, B, C.
IV. DEALING WITH GLOBAL WARMING
 Main Costs of Global Warming
Great variation across areas and economic development. Pace
of change is what makes adaptation particularly daunting:

• Extreme weather makes many populated places less

livable (sea rise, heatwaves, droughts, smoke from fires)

– Could lead to mass migration movements that are disruptive

in our world of independent nations

• Agricultural production disruptions and food security risks:

– demand for food inelastic in the short-run. Spikes in prices if

agricultural output falls => Famines in low-income countries

• Impact on bio-diversity (mass extinctions)

 Quiz:
Question: Suppose extreme weather shock reduces
vegetables production globally by 20% which makes prices
go up 200%. Which mitigating policy is most efficient?

• A. Nothing: Let poor people in poor countries starve and let

others pay more for food

• B. Regulation: Prohibit meat so that everybody can survive

with vegetarian diet.

• C. Tax: Impose a high tax on meat to discourage wasteful use of

cereals to grow meat.

• D. Universal basic income so that everybody can afford food

funded by tax on rich people/countries
 Carbon tax: Economists’ Narrow Solution
• CO2 emissions impose a global warming externality ⇒
Solution is to impose a carbon tax equal to the marginal
damage of CO2 [economists carbon tax letter]

• But what is the marginal damage of CO2? Costs hard to

evaluate and depend greatly on how you discount the
future as most of the damage is (used to be) in the future

§ If future is discounted heavily (individual humans are

impatient), CO2 damage cost is small and it is desirable to let
global warming happen and civilization collapse!

§ If future not discounted heavily, then big but unpopular

carbon tax is called for

• Economists have probably slowed down the process on net

by underestimating costs (comparing Florida to Minnesota)
 Gas taxes are generally very unpopular

Gas taxes are the go-to solution for economists. In practice, many gas
users are inelastic and low income and get upset. Gas taxes tend to
generate “tax revolts” as in the Yellow Vest movement in France in 2022.
 Broader View on Reducing Emissions
• Massive CO2 emissions pose existential civilizational risk
(like CFCs destroying vital ozone layer)

• Solution is to decarbonize as a social choice and we

need to do it fast (within decades not centuries)

• Economists’ obsession about estimating the Marginal

Cost of CO2 emissions is a distraction. Shows the
limitation of marginal analysis dear to economists:

– Getting the exact price/quantity right at the margin is 2nd

order

– The 1st order problem is to decarbonize

 Broader View on Reducing Emissions: Solutions
• Costs of climate change have already surpassed the
cost of transition, we moved too slowly.

• Decarbonization is within sight: renewable electricity

(solar/wind) + grid + big batteries could replace most
fossil fuels. Renewable energy cost dropping fast.

• Could be done without killing economic growth and

without huge short-term disruptions. COVID response
likely cost more

• Economists’ useful point: some sectors are cheaper to

decarbonize than others (cars easier than planes):
tradeable allowances can make sense in a transition
 Tools actually used for decarbonization
• Government support for (a) fundamental research in clean
energy, (b) clean energy industry subsidies (for producers
or consumers: e.g., EV credits in the US)

• Government development of infrastructure for clean

energy: clean energy power plants, grid, etc.

• Government regulations to decarbonize: phase-out coal

power plants and gas powered-cars, land management, ..

• Carbon tax (or equivalent cap-and-trade carbon emission

pricing) has been at best a minor tool, because it raises
prices of energy and generates protests

• 2022 Inflation Reduction Act is largest US federal response

to climate change to date and has no carbon tax
 Quiz:
Question: Would you support spending more through
government to decarbonize the economy for good in coming
decades?

• A. Yes, that’s the right thing to do for humanity

• B. No, because future generations get most of the benefit

while current generation would pay the cost

• C. No, because I am upset previous generations did not do it

already (don’t want to pay to clean up their mess)

• D. No, because there are more pressing issues to address with

government spending than climate change

• E. No, because markets on their own will do best to invent the

new clean technologies of the future
 International Coordination
• From one country perspective, decarbonizing is costly and
benefit is modest (as global emissions is what matters)

• Economists: countries need to make a coordinated binding

agreement to decarbonize together

• Reality: Series of international agreements: Kyoto 1997, …,

Paris 2015 where countries make non-binding pledges

• Reality: leader countries can have dramatic impact:

– Provide model that others can follow later on: California has 100%
renewable electricity mandate by 2045, no new gas cars by 2035

– Rich countries want to develop and control future renewable tech

(US, EU vs. China competition for renewables is good)
 Quiz:
Question: Richer countries (US+Europe) produced 2/3 of
emissions to date. What seems the best moving forward?

• A. Richer countries should invent and adopt the new

technologies, and help other countries adopt them.

• B. Richer countries should lead but also force other countries to

transition with carbon content tariffs or sanctions.

• C. An international agreement where countries with the highest

benefits from preventing climate change contribute the most.

• D. Let each country chart its own course and do what’s best for
its own national interest.

• E. We just need a global carbon tax equal to marginal damage.

 References
• CORE-The Economy, Chapters 12 and 20.

• Principles of Economics, Chapter 11.

• Leape, Jonathan, The London Congestion Charge,

Journal of Economic Perspectives—Volume 20,
Number 4—Fall 2006