externality
A cost or benefit that
occurs when the activity
of one entity directly
affects the welfare of
another in a way that
is outside the market
mechanism.
Chapter Five
Characteristics of Externalities
1. Externalities Can Be Produced by Consumers as Well as Firms
Both consumers and firms can create externalities. For example, a person smoking in a room affects
others by reducing air quality (negative externality).
2. Externalities Are Reciprocal in Nature Externalities affect both sides. For instance, while Bart
pollutes the river with waste, Lisa increases Bart’s cost by fishing there. The impact depends on the alternatives for
both activities.
3.Public Goods as a Type of ExternalitySome actions benefit others. For example,
getting vaccinated not only protects you but also reduces the risk of spreading disease to others.
Without public action, fewer people get vaccinated than needed.
4. Public Goods as a Special Kind of Externality Public goods are like externalities but
benefit everyone equally. For example, a mosquito-killing device in your yard benefits the
community. If only a few neighbors benefit, it’s an externality.
5.1: The Externality Problem Figure 5.1 illustrates how externalities—specifically, the negative
externality of pollution—impact the socially optimal level of output in Bart's production activities. The
horizontal axis represents the quantity of output (Q) produced by Bart’s factory, while the vertical axis
measures costs and benefits in monetary terms.
1. Key Elements of the Graph
o Marginal Benefit (MB): The additional benefit Bart receives from producing
each unit of output. It decreases as output increases.
o Marginal Private Cost (MPC): The cost Bart incurs for producing each unit
(e.g., labor, materials). This cost rises with output.
o Marginal Damage (MD): The harm caused to Lisa due to pollution from
production. This increases as Bart produces more, shown by the upward slope of
the MD curve.
o Marginal Social Cost (MSC): The total cost to society, combining Bart’s
production costs (MPC) and the damage to Lisa (MD). Mathematically, MSC =
MPC + MD.
2. Bart’s Production Decision
Bart maximizes his profit by producing up to the point where MB = MPC. This occurs at
output level Q₁. However, he ignores the damage his production causes to Lisa.
3. Socially Optimal Output
Society’s efficient level of production is where MB = MSC. At this point, the total
benefit equals the total cost (including external damage). The optimal output is Q*,
which is less than Bart’s chosen level of Q₁.
4. The Problem of Overproduction
Producing at Q₁ creates excessive pollution and higher social costs because external
damages (MD) are not factored into Bart’s decision-making. Reducing output to Q*
ensures that society avoids these extra costs.
5. Conclusion
Figure 5.1 highlights the inefficiency caused by negative externalities. Bart’s focus on
private costs leads to overproduction. To correct this, policies like taxes or regulations are
needed to align private incentives with social welfare, reducing production to the socially
optimal level Q*.
Implications of Externality Analysis
1. Private Markets and Social Inefficiency
o When negative externalities exist, free markets tend to overproduce beyond the
socially efficient output level. In this case, Bart’s factory produces at Q₁, where
marginal private benefit equals marginal private cost, ignoring the external harm
caused to Lisa.
o The socially efficient output, Q*, is lower because it considers the marginal
social cost (MPC + MD) instead of just the marginal private cost (MPC).
2. Measuring the Gains from Efficiency
o Reducing output from Q₁ to Q* enhances overall social welfare.
o Bart's Loss: He loses profits represented by the area dcg in Figure 5.2, as the
difference between MB and MPC for units cut (from Q₁ to Q*).
o Lisa's Gain: Lisa benefits from reduced pollution, measured as the area abfe,
equal to the reduction in marginal damages (MD) for each unit cut.
o The total social net gain is the difference between Lisa’s gain (cdhg) and Bart’s
loss (dcg), represented by the triangular area dhg.
3. Zero Pollution is Not Efficient
o A socially optimal solution does not aim for zero pollution.
o Pollution is an inevitable by-product of most production activities. Reducing it to
zero would require halting production altogether, leading to economic
inefficiency.
o The goal is to strike a balance between the benefits of production and the costs of
pollution, finding the optimal (nonzero) pollution level at Q*.
4. Practical Challenges in Implementation
o Moving from theory to practice involves identifying the shapes and positions of
marginal damage (MD) and marginal benefit (MB) curves.
o Estimating the value of pollution damages is often complex and requires
comprehensive data on environmental and economic impacts.
o Policymakers need to address these challenges to implement efficient regulations,
such as taxes, subsidies, or permits, that align private incentives with social
welfare.
Conclusion
The analysis emphasizes the importance of internalizing externalities to achieve a socially
optimal balance between economic production and environmental protection. While the
framework provides clear theoretical insights, practical application requires careful valuation of
damages and benefits.
1. Bargaining and the Coase Theorem
The root cause of the inefficiencies associated with externalities is the absence of property rights.
When property rights are assigned, individuals may respond to the externality by bargaining with
each other.
To see how, suppose property rights to the river are assigned to Bart. Assume further that it is
costless for Lisa and Bart to bargain with each other. Is it possible for the two parties to strike a
bargain that results in output being reduced from Q1?
. দর কষাকষি এবং কোস উপপাদ্য
বাহ্যিকতার সাথে যুক্ত অদক্ষতার মূল কারণ সম্পত্তির অধিকারের অনুপস্থিতি। যখন সম্পত্তির অধিকার বরাদ্দ করা
হয়, তখন ব্যক্তিরা একে অপরের সাথে দর কষাকষির মাধ্যমে বাহ্যিকতার প্রতিক্রিয়া জানাতে পারে।
দেখার জন্য, ধরুন নদীর সম্পত্তির অধিকার বার্টকে দেওয়া হয়েছে। আরও অনুমান করুন যে লিসা এবং বার্টের জন্য
একে অপরের সাথে দর কষাকষি করা ব্যয়বহুল। দুই পক্ষের পক্ষে কি একটি দর কষাকষি করা সম্ভব যার ফলাফল Q1 থেকে
আউটপুট হ্রাস পায়?
Key Points of the Coase Theorem and Externalities
The Coase Theorem explains how private bargaining can lead to efficient solutions for externalities,
provided certain conditions are met. Here's how it works in the example of Bart and Lisa:
1. Bargaining to Resolve Externalities:
o Bart’s perspective: Willing to stop production if Lisa’s payment exceeds his
profit from producing (MB - MPC).
o Lisa’s perspective: Willing to pay Bart to reduce output if the payment is less
than the harm caused to her (MD).
o Bargaining is possible if: MD>(MB−MPC). The efficient output level (Q*),
where marginal social cost (MSC) equals marginal benefit (MB), is achieved
through negotiation.
2. Property Rights Assignment:
o If Bart owns the rights, Lisa pays him to reduce pollution.
o If Lisa owns the rights, Bart pays her to produce.
o Regardless of who owns the rights, the efficient outcome (Q* production) is
reached through bargaining.
3. Conditions for the Coase Theorem:
o Low transaction costs: Bargaining must be feasible and not too expensive.
o Clear property rights: Ownership must be well-defined and enforceable.
4. Implications:
o Externalities (e.g., pollution) can be managed efficiently if parties negotiate.
o The theorem works best in cases with few parties and clearly defined
externalities.
o It suggests practical solutions like assigning property rights to incentivize
conservation (e.g., wildlife protection).
5. Limitations:
o High transaction costs or large-scale externalities (e.g., global pollution) make
bargaining impractical.
Conclusion
The Coase Theorem shows that with well-defined property rights and low transaction costs,
private bargaining can lead to socially efficient outcomes, regardless of who owns the rights.
or Coase Theorem: Resolving Externalities through Bargaining
The Coase Theorem explains how private bargaining can lead to efficient solutions for
externalities, provided certain conditions are met. Here's how it works in the example of Bart and
Lisa:
1. Bargaining When Bart Owns Property Rights
If Bart has the right to produce, Lisa must pay him to reduce output.
Bart's Willingness: Bart will reduce production if Lisa’s payment exceeds his net profit
from producing that unit, calculated as MB− MPC (marginal benefit minus marginal
private cost).
Lisa's Willingness: Lisa is willing to pay Bart as long as the payment is less than the
marginal damage (MD) caused to her.
Bargaining is possible if: MD>(MB−MPC)
For output levels greater than the socially efficient level Q*, Lisa’s willingness to pay
exceeds Bart’s incremental gain from production, creating room for negotiation.
Total payment lies between:
o Minimum: dcg, Bart’s loss from reducing output to Q*.
o Maximum: cdhg, Lisa’s gain from reducing pollution to Q*.
Regardless of how the payment is divided, production ends at Q*.
2. Bargaining When Lisa Owns Property Rights
If Lisa has the right to a clean river, Bart must pay her for permission to produce
(pollute).
Lisa's Willingness: She will allow pollution if Bart’s payment exceeds the marginal
damage (MD) caused to her fishing business.
Bart's Willingness: Bart will pay Lisa for permission to produce if the payment is less
than his profit from that production, MB−MPC
For example:
For the first unit of output, MB−MPC is much larger than MD, leaving plenty of room
for bargaining.
As production increases, the difference narrows, and negotiation settles at Q*, where the
marginal social cost (MSC) equals the marginal benefit (MB).
3. Key Assumptions of the Coase Theorem
1. Low Bargaining Costs: The negotiation process must be simple and not overly expensive.
2. Well-Defined Property Rights: Resource ownership must be clear, and parties must be able
to identify and legally enforce damages.
When these conditions are met, the efficient output level (Q*, where MB=MSC) is achieved
regardless of who owns the property rights.
4. Practical Implications
The Coase Theorem is most relevant in scenarios with a small number of involved
parties and clearly defined externalities, like disputes between neighbors or small
firms.
For larger-scale externalities, such as air pollution or biodiversity loss, transaction costs
may be too high for bargaining to work.
5. Applications
Assigning property rights can address environmental challenges like overfishing or
species extinction.
For example, giving communities ownership of wildlife can incentivize conservation, as
they benefit from its sustainable use.
Conclusion
The Coase Theorem highlights that private bargaining, under certain conditions, can resolve
externalities efficiently. Whether Bart or Lisa owns the rights, as long as property rights are
assigned and transaction costs are low, they will negotiate to achieve the socially optimal
outcome (Q*).
MERGERS
One way to address an externality is to "internalize" it by combining the parties involved. there is
only one polluter and one pollutee, as in the Bart-Lisa scenario. In the simple case of Bart (the
polluter) and Lisa (the pollutee), the market could encourage them to merge. For example, Lisa
could buy the factory, Bart could buy the fishery, or a third party could purchase both.
Once the two firms merge, the externality is internalized—it is taken into account by the party that
generates the externality .For instance, if Bart buys the fishery, he would produce less in his
factory. This is because reducing factory output would increase the profits of his fishery business
more than it would reduce the profits from the factory. As a result, the negative impact (the
pollution) would no longer be a problem, and the market would become efficient.
Public Responses to Externalities: Taxes
When individuals cannot reach an efficient solution on their own, the government can intervene
by imposing taxes or subsidies on certain market activities.
1. Taxes
In the case of Bart’s inefficient production, the prices he pays for inputs do not reflect the social
costs, particularly because some of the inputs, like the water from the river, are priced too low. A
possible solution, suggested by economist A. C. Pigou in the 1930s, is to place a tax on the polluter. This
tax, called a Pigouvian tax, is charged for each unit of the polluter's output. The amount of the tax is
equal to the marginal damage caused by the pollution, which helps ensure that the production level
becomes more efficient.
In the graphical example (Figure 5.4), the marginal damage at the efficient output level Q* is
represented by the distance cd This is the amount of the Pigouvian tax. Bart now has to pay for
both the inputs to his production (represented by MPC) and the tax [represented by cd] for each
unit of output.
To account for this new cost, Bart’s marginal cost curve shifts upwards by the amount cd,
resulting in a new marginal cost curve MPC+cd Bart will now produce at the point where his
marginal benefit MB equals his new marginal cost MPC +cd, which happens at the efficient
output level Q*. The tax, therefore, incentivizes Bart to account for the external costs of his
production, pushing him toward the socially efficient output level.
The tax also generates revenue, which is calculated as cd×id, where id is the quantity produced at
Q*. This revenue is represented by the area of rectangle ijcd in the diagram.
While it might seem tempting to use the tax revenue to compensate Lisa, the victim of the
pollution, caution is needed. If compensation is given to those who fish in the river, some
individuals may choose to fish who otherwise wouldn’t have, potentially leading to an
inefficiently high level of fishing activity. In essence, paying the victims of pollution is not
necessary for achieving efficiency and could lead to inefficiencies.
Practical Problems
Despite the theoretical benefits of a Pigouvian tax, practical challenges exist. One of the biggest
difficulties is accurately estimating the marginal damage function, which determines the
appropriate tax rate. While it may be difficult to find the perfect rate, sensible compromises can
still be made.
For instance:
A tax based on the number of miles driven could help enhance efficiency.
A more refined tax system, varying by location and time of day, could improve efficiency
further.
A practical alternative might be a gasoline tax, which, while not perfectly efficient, could
be a significant improvement over the current status quo.
In summary, taxes like the Pigouvian tax can help internalize externalities and guide markets
toward more efficient outcomes, though implementing such systems involves practical
challenges and trade-offs.
In simple terms:
1. Subsidy for Reducing Pollution: The government can pay a polluter like Bart to reduce
production instead of charging a tax. This helps make production more efficient by
increasing Bart's cost to pollute less.
2. Bart’s Reaction: If Bart gets paid for reducing pollution, he will cut back his production
to the efficient level (Q*), where his cost of reducing pollution matches the benefit.
3. Efficient Production: The subsidy encourages Bart to produce at the most efficient level,
where the cost of reducing pollution is balanced by the benefit.
4. Income Distribution: With a subsidy, Bart receives money for reducing pollution, which
changes his income but still leads to efficient production.
5. Possible Problems: Over time, the subsidy might attract more firms to the area, causing
more pollution than before.
Explaining Cap-and-Trade vs. Emissions Fees with Uncertain Costs:
1. What’s Happening?
The government wants to reduce pollution, but it's unsure about the true cost of doing so
(marginal cost).
It predicts costs will follow MC* (its best guess).
But actual costs could be higher, like MC'.
To address pollution, the government can either:
Use a cap-and-trade system (set a limit on total pollution).
Charge an emissions fee (a price polluters pay for each unit of pollution).
2. Cap-and-Trade System
The government issues permits allowing pollution up to a fixed limit, e*, based on its
estimate of MC*.
If MC* is correct, the system is efficient.
If costs are higher (MC'), the reduction e* ends up being more than the efficient level
(e'), leading to over-reduction of pollution.
But since the marginal social benefits (MSB) of reducing pollution are inelastic (not very
sensitive to changes), the inefficiency isn’t too large.
3. Emissions Fees
The government charges a fee (f*), expecting it to reduce pollution to e*.
If costs are higher (MC'), polluters respond by reducing pollution less than the efficient
level (e').
This creates a larger inefficiency, as the pollution reduction falls far short of what is
optimal.
4. Why Cap-and-Trade is Better Here
When marginal social benefits of reducing pollution are inelastic:
o Fixing the amount of pollution (as in cap-and-trade) leads to outcomes close to
the optimal level, even if costs are uncertain.
o Emissions fees, however, allow pollution levels to vary widely with cost changes,
causing greater inefficiency.
Key Takeaway:
When benefits of pollution reduction don’t change much with levels of reduction (inelastic
MSB), cap-and-trade systems are better than emissions fees when costs are uncertain. This is
because they keep pollution reduction more stable and closer to the optimal level.
Cap-and-Trade vs. Emissions Fees: Simplified
The Problem
The government wants to reduce pollution but doesn’t know the exact cost of doing so (marginal
cost).
It predicts costs will follow MC* (its best guess).
But actual costs could be higher, like MC'.
The government has two tools to reduce pollution:
1. Cap-and-Trade: Limits total pollution by issuing permits.
2. Emissions Fees: Charges a fee for every unit of pollution.
1. Cap-and-Trade
The government sets a pollution limit, e*, based on its cost guess (MC*).
If the guess is right, pollution is reduced efficiently.
If costs are higher (MC'), the pollution reduction e* is too much, but the outcome is still
close to the efficient level because benefits of pollution reduction don’t change much
(inelastic benefits).
2. Emissions Fees
The government sets a fee, f*, expecting it to reduce pollution to e*.
If costs are higher (MC'), polluters reduce less pollution than needed (e'), creating a
bigger inefficiency because the reduction is far from the ideal level.
3. Why Cap-and-Trade is Better
When the benefits of reducing pollution don’t change much (inelastic benefits):
o Cap-and-Trade works better because it fixes the amount of pollution reduction.
o Emissions Fees allow pollution levels to vary widely with cost changes, causing
greater inefficiency
Conclusion
When benefits are inelastic, Cap-and-Trade is the better choice because it keeps pollution
reduction closer to the ideal level, even if cost estimates are wrong.
Cap-and-Trade vs. Emissions Fees with Elastic Benefits
The Problem
The government wants to reduce pollution but isn’t sure about the exact costs (marginal cost).
It estimates costs to be MC* (best guess).
Actual costs could be higher (MC').
This time, the benefits of reducing pollution are elastic, meaning the value of each extra unit of
pollution reduction changes significantly as more is cleaned up.
1. Cap-and-Trade
The government issues permits to reduce pollution by e*, based on the guess (MC*).
If the actual cost is higher (MC'), e* leads to too much pollution reduction (over-
cleaning).
This happens because cap-and-trade fixes the amount of pollution reduction,
regardless of cost changes.
When benefits are elastic, this over-cleaning creates bigger inefficiencies.
2. Emissions Fees
The government sets a fee, f*, expecting it to reduce pollution by e*.
If actual costs are higher (MC'), polluters reduce less pollution (e').
However, in this case, e' is closer to the ideal outcome compared to cap-and-trade.
3. Why Emissions Fees Work Better with Elastic Benefits
Elastic benefits mean small pollution changes have a big impact on value.
Emissions fees adjust to costs, keeping pollution reduction closer to the ideal level.
Cap-and-trade fixes pollution levels, making it less flexible and less efficient with
elastic benefits.
Conclusion
Elastic benefits: Emissions fees are better because they adjust to changes in costs.
Inelastic benefits: Cap-and-trade is better because fixing pollution reduction levels has
minimal impact.
Cap-and-Trade Made Easy:
1. What Is Cap-and-Trade?
o The government gives or sells permits allowing a certain amount of pollution.
o Each polluter (like Bart and Homer) needs a permit for every unit of pollution.
o Total permits limit pollution to the target (e.g., 80 units).
2. Does It Matter Who Gets the Permits First?
o No. It doesn’t matter how permits are initially distributed.
o This is because polluters can trade permits to minimize costs.
3. How Does Trading Work?
o Bart and Homer will trade permits until their pollution reduction costs (marginal
costs) are equal.
o Example:
Bart sells a permit if his cost to reduce pollution is less than what Homer
is willing to pay.
Homer buys a permit if it’s cheaper than his cost to reduce pollution.
o This ensures the lowest total cost for reducing pollution.
4. Efficiency and Fairness:
o Cap-and-trade ensures pollution reduction is cost-effective.
Initial allocation affects who pays more (fairness), but not efficiency.
o
5. Comparison with Emissions Fees:
o Emissions fees charge polluters for every unit of pollution.
o Both systems can achieve the same pollution reduction.
o Practical differences depend on specific situations.
In short, cap-and-trade is a flexible system where polluters trade permits to cut pollution at the
lowest cost.
1. What Is an Emissions Fee?
An emissions fee is a charge the government places on each unit of pollution. It
