University of Pacific-Economics 53

Lecture Notes #16

I. Externalities

A. Introduction

An externality is defined as a cost or benefit related to the production or consumption of some

good that is imposed on second or third parties (people not participating in the market
transaction). When producers fail to take into account the social costs and benefits the amount
of output produced will either be overproduced or underproduced. Likewise, when consumers
fail to take into account the costs and benefits of their actions too much or too little output will
be consumed vs. what is socially optimal.

As societies get more urbanized, the presence of externalities becomes more commonplace.
With more people, the likelihood that actions be decision makers will have a greater chance of
affecting others increases. Externalities are fairly common in our society. Here are some
examples:

• Air pollution (negative production externality)

• Second-Hand Smoking (negative consumption externality)
• Bee Keepers and Pollination (positive production externality)
• Vaccinations (positive consumption externality)

B. Definitions

It’s important to be clear about certain terms and definitions before we can go forward with a
more in-depth analysis of externalities.

• Private Benefit: The increase in consumer happiness from the consumption of one more
unit of a good or service. This is equivalent to our usual demand curve.
• Private Cost (Marginal Cost): The increase in a firm’s costs when it produces one
more unit of a good or service. This is equivalent to the usual supply curve.

The word private is used to emphasize the fact that there are two main actors in a transaction in
the output market: the buyer of a good or service (the households) and sellers of a good or
service (the firms). When we talk about private benefits or private cost we are discussing the
costs and benefits that apply only to the direct participants in a transaction in the output market.

The term social is used to emphasize the fact that in some transactions the entire society (and
not just a household or a firm) is affected by a market transaction.
• Social Benefit: The total benefit gained by society from the consumption of a good. It
includes any private benefit and any consumption externality that might exist.
• Social Cost: The total cost from the production of a good, including both the private cost
and any production externality.
When there is NO externality on the production side then: Social Cost = Private Cost
Where there is NO externality on the consumption side then: Social Benefit = Private Benefit

Economic Efficiency will always occur when social costs = social benefits

When there is no externalities on either the production or consumption side, then economic
efficiency will occur when private costs = private benefits. As we have seen already, private cost
is just the marginal cost curve facing a firm.
Private costs = MC

What about private benefits? What is the benefit to you from consuming one more unit of a
good? We’ve seen already that the benefit has to be at least the price of the good. If the benefit
you would get from consuming one more unit of a good is less than the price you are willing to
pay for the good then you would not purchase it. If however, the benefit you would get is greater
than the price of the good than you will certainly purchase the good.

Thus private benefits = P

Since we stated that economic efficiency occurs where private costs= private benefits. Then
when there is no externalities a firm will produce here P = MC.

This is illustrated in Figure 1 for a perfectly competitive firm.

Figure 1: Perfectly Competitive Firm with (o Externalities

When externalities occur, then society will want to produce at a point where social benefits is
equal to social costs. When this statement is saying is that the benefits to society (both private
and social) from producing 1 more unit of a good must b equal to the cost to society (both private
and social). If social benefits were greater than social costs, then society would be better off if
the firm produced one more unit of the good. On the other hand if social costs were greater than
the social benefits, the society would be better off if the firm produced less of the good because
the social resources needed to produce the good is greater than the social benefits gained from
consuming the good.

In general, we assume that producers and consumers only take into account their own private
costs and benefits. They will ignore the social costs and benefits. As a result, when there is a
negative externality, the market will end up producing too much of a good than what is socially
optimal. When there is a positive externality, the market will end up producing too little of a
good than what is socially optimal. In the next section, we’ll look at two examples

C. Examples of Externalities

1. (egative Production Externality

In a negative production externality, the producer does not face the entire cost of production. For
example, an oil refinery generates air pollution in its production of oil. The presence of air
pollution makes the community around the oil refinery worse off due to diminished health or due
to diminished ability to view a clear blue sky, etc…

Refer to Figure 2. The firm will only take into account their own private costs and thus will
produce where private benefits = private costs. Which is equivalent as saying where supply
equals demand. The oil refinery would produce at Point A where (Quantity = Q1; Price = P1).
However, there are social costs (the air pollution) to the production of oil, which the oil refinery
ignores. The social cost curve must be higher (to the left) of the private cost curve. At the
original level of production, social costs are higher than social benefits and thus this quantity is
not efficient and we have market failure. The reason for market failure is that the market
participants do not factor in the full social costs of their harmful economic activities. There is a
divergence between social costs and private costs which is the negative externality. Note that
there is no externality on the consumption side, so private benefit = social benefit (the demand
curve will be the same). We know that when externalities exists, economic efficiency will only
occur when social benefit is equal to social cost. In this case, economic efficiency will be at
Point B. The shaded area is the area in which social costs exceeded social benefit that results
from overproduction. This is the deadweight loss. Society would be better off if the economy
was at Point B rather than at Point A. Note that at Point B, the efficient solution is not to reduce
the harmful activity to 0. As long as the firm has the ability to compensate the damaged parties
fully and still have profits left over, then pollution is “worth it” to society. It would be inefficient
for the oil refinery to stop polluting. Notice that if the quantity produced were below Q2, the
benefits gained from society would have been greater than the social costs. Society would be
better off if they produce more of the polluting product.
Figure 2

2. Positive Consumption Externality

Consider the market for flu shots. Flu shots are an example of a positive consumption
externality. The more people who get flu shots, the less likely any person who has not received
the shot will become ill with the flu. Thus, in this case, there is a clear benefit to society if one
gets the flu shot. However, you don’t get compensated by society for this benefit (in fact in
some cases you have to pay to get a flu shot). Therefore, you will only consider your private
benefit in determining whether or not to get a flu shot. This will be a case where the social
benefit will differ from the private benefit. The social benefit curve for a positive consumption
externality will be to the right of the private benefit curve. This is the case, because at every
price, society would benefit more from flu shots. There is no externality on the production side,
therefore the social and private costs are the same.

Refer to Figure 3. We know that the market equilibrium is where the private costs=private
benefits at Point A. However, Point A cannot be efficient since at that quantity the social
benefits exceed the social costs. Economic efficiency will only be reached when social costs =
social benefits at Point B. The shaded area is the positive externality that is realized as we
produced the good. The deadweight loss is the shaded area between Q1and Q2. It is the loss to
society by not producing enough of the good.

Figure 3

D. Solutions to Externalities
There are several ways we can achieve an efficient level of production in the presence of
externalities.

(1) Taxes and Subsidies: The government can be used to “internalize: the externality that
will force the market participants to see the full economic consequences of their actions.
In the case of a negative externality this can be done using a tax. If the tax is set to the
amount of the externality cost, then it will have the effect of shifting the curves in the
right direction and the efficient amount will be produced. For example in the case of the
negative production externality. The government can charge a tax on production of the
good equal to the externality. The tax will shift the S1 curve to S2 and the firm will
produce at the efficient amount Point B. In the case of a positive externality this can be
done using a subsidy (government paying producers to produce or consumers to
consume). There is the obvious difficultly of the government’s ability to correctly
measure the externality.
(2) Private Solutions (Bargaining and (egotiation): Consider the case of the polluting oil
refinery. The victims of the pollution can either bribe the polluters not to pollute, or the
polluters could compensate the victims of pollution to allow them to pollute. This is
 known as Coase Theorem. The theorem states that if basic rights at issue are
understood, transaction costs are low, and if few parties are involved, private parties will
find an efficient solution to the problem of externalities. Often, however, transaction
costs are not low since there are many people involved in the externality. Thus private
solutions to an externality are generally not feasible.
(3) Legal Rules and Procedures: When externalities generate damage to society, courts
and the law can be employed to limit the damage costing action. An injunction is a
court order forbidding the continuation of behavior that leads to damages. If the damages
have already occurred, the court can issue liability rules which requires the damaging
party to compensate for the harm committed. As a result of injunctions and liability
rules, the decision makers have an incentive to weigh all the consequences.
(4) Selling or Auctioning Pollution Rights: Another method to control pollution is to issue
“permits” to firms to pollute and allow firms to trade these permits in a market setting
thereby resulting in an efficient level of pollution. This system is called a “cap and trade”
approach. The Clean Air Act of 1990 is an example of a law that used the cap and trade
system.
• Emissions from each factory was limited to a certain level. Each firm
plant was issued permits to emit only that level of production.
• Permits could be used to emit air pollution or they could be traded to
another firm.
• Firms who had clean technology and were able to produce output at
emission levels lower than the federal mandate would sell its unused
permits to firms with dirtier technology. The socially desirable level of
pollution would thus be generated using this method.
• Environmental groups could also purchase these permits in the market and
choose not to use them, thereby reducing emissions even further.

Table 1 shows a hypothetical permit trading scenario

Units of MC of TC of Units of MC of TC of
Pollution Reducing Reducing Pollution Reducing Reducing
Reduced by Pollution Pollution for Reduced by Pollution for Pollution for
Firm A for Firm A Firm A Firm B Firm B Firm B
1 $5 $5 1 $8 $8
2 $7 $12 2 $14 $22
3 $9 $21 3 $23 $45
4 $12 $33 4 $35 $80
5 $17 $50 5 $50 $130

Table 1 shows the costs for two firms (Firm A and Firm B) to reduce pollution. For
example to reduce 1 unit of pollution will cost Firm A $5. To reduce pollution one more
unit will cost Firm A $7 extra. The total cost therefore of reducing pollution by 2 units is
$12. As you can see in the table the cost for reducing pollution is cheaper for Firm A
than for Firm B. Firm A is using a cleaner technology which makes it cheaper for Firm
A to reduce its emissions.
 Suppose that both firms are currently emitting 5 units of pollution. The government has
now mandated that firms in this industry can only emit 2 units of pollution. The result is
both firms have to cut their emissions by 3 units. Both Firm A and Firm B get 2 permits
each. Each permit allows the firm to emit 1 unit of pollution. Both firms have to reduce
its emissions by 3 units.

The total cost to Firm A to reduce its emissions by 3 units is $21, while the total cost to
Firm B to reduce its emissions by 3 units will be $45. Firm A could go further and
reduce its emission by 1 more unit so that it emits only 1 unit of emission. The extra cost
for Firm A would be $12. If Firm A spent an additional $12 it would produce only 1 unit
of pollution and will have an unused permit.

Firm A can then sell that permit to Firm B. Firm B would then have 3 permits allowing
it to produce 3 units of pollution. Thus Firm B only has to reduce its emissions by 2
units. Thus it saves $23 in costs from not having to reduce from 2 to 3 units.

Note that the cap and trade approach allows the economy to achieve the desired level of
emissions at a lower cost than if both firms reduced their emission levels equally.

(5) Direct Regulation of Externalities

All of the forms of controlling externalities that we have discussed so far are indirect.
That is they are designed to encourage firms to internalize the cost and benefits of their
actions, but they are not mandatory. Some externalities, however, are too dangerous to
society that they require a more direct means of control. Direct regulation involves
explicit control over the actions that lead to externalities. Violators of the regulations not
only face a monetary cost, but also criminal penalties and sanctions. Direct regulation
ensures that firms and households completely weigh the costs of their actions.

II. Public Goods

A. Characteristics of Public Goods

Public goods have the following two characteristics:

(1) It must be non-rival in consumption
(2) The benefits must be non-excludable

There two characteristics make it difficult for private firms to produce the optimal quantity of
public goods (or to provide it at all). The provision of public goods often requires the assistance
of government.

A rival good is a good that once it is consumed, no one else can consume it. A nice juicy steak
at Outback Steak House is a good example. Once I finish the steak, no one else can eat it. A
good is non-rival if the consumption of the good by one party does not interfere with another
party’s consumption of that good. For example, if Bill enjoys the police protection of the city
that does not prevent Susan from also enjoying police protection.
A good is considered excludable if anyone who doesn’t pay for the good cannot consume it. If I
want a nice juicy steak at Outback Steakhouse, I’ll need to pay for it. If I don’t have the money,
I won’t be able to get the steak. Most public goods are non-excludable. Once the good is
produced, it is difficult if not impossible to prevent people from consuming the good or enjoying
the service. It’s not feasible to deny people fire or police services even if they don’t pay taxes to
pay for the service.

Other types of goods:

Private Goods are goods that are excludable and rival
Quasi Public Goods are goods that are excludable and non-rival
Common Resources are goods that are non-excludable and rival.

These two characteristics of non-rivalry and non-excludability make it very difficult for private
firms to produce public goods. As an example, suppose during George Bush’s administration he
tried to privatize national security and wanted to hire the firm Blackwater to provide national
security. Blackwater would run into immediate problems in providing national security. First,
would be the fact that payment would be voluntary. Blackwater cannot withhold its services for
people who don’t pay. Everyone would benefit if they invaded a foreign country for “national
security” whether or not they had paid. People have a clear incentive not to contribute if they
know they will enjoy the benefits even if they don’t contribute. This is known as the free-rider
problem. Another example, would be if you really enjoyed a program on PBS. Public
television such as PBS have frequent fundraisers to pay for programming. This is a clear
example of a free-rider problem. Whether you pick up the phone and make a pledge to PBS will
not affect your ability to enjoy your favorite show on PBS. You might contribute because it’ll
make you feel better about yourself, but there is no economic incentive to make you want to
contribute.

Another issue Blackwater would face in providing national security is the drop-in-the bucket
problem. The budget for the Defense Department last year was $400 billion dollars. Thus it
would cost Blackwater $400 billion to provide national security. Suppose that Blackwater could
raise this money if each individual in America voluntarily contributed $150. However, the
problem is that each individual contribution is so small relative to total cost of providing the
service, that if one individual withholds their contribution it will not affect the level of service.
The amount of public good provided would not depend on whether an individual paid or not,
thus there is no incentive for an individual to pay.

Both the free-rider problem and drop in the bucket problem explain why government has to get
involved to provide the optimal level of public goods.

B. Public Provision of Public Goods (Optimal Level)

One of the big problems facing governments is deciding what is the optimal level of public good
that should be provided. For example with national defense, an individual such as Dick Cheney
would probably want a lot of soldiers, airplanes and missiles, while a anti-war hippie from
Berkeley would probably want very little national defense. Given these varying preferences
among individuals, how does the government choose the efficient level of public goods?
One theory put forth by Paul Samuelson (hence the name Samuelson’s Theory) argues that the
optimal production of a pubic good depends on society’s willingness to pay for the public good.
To illustrate this point, let us go back to Chapter 3 and recall how a market demand curve for a
private good was derived. Figure 4 shows how market demand curves are determined
Figure 4: Market Demand Curves

Suppose there was a simple economy with only 2 individuals: A and B. A’s demand curve is
shown in the far left hand graph in Figure 4, while B’s demand curve is shown in the middle
graph.
We can see from the figure if the price of the good was $1 then A will demand 9 units of the
good, while B would demand 13 units of the good. The total market demand when the price is
$1 will be 22 units of good (A’s demand + B’s demand). If the price of the good increased to $3
then A will demand only 2 units of output, while B will demand 9 units of output. The total
market demand at $3 will be 11 units of output.

With private goods, there exists a price mechanism that reveals what people are willing to pay
for goods. Thus the firms are willing to produce only those goods that people want at a certain
price. To determine market demand for a private good we add the quantity demanded by each
individual at each price level.

The difference between a public good and a private good is that there can only be one level of
output that can be produced for a public good. The job of the government is to determine what
that level should be. Samuelson’s Theory argues that the government can produce the efficient
level of output if they could ask each individual what they would be willing to pay at each level
of output produced. In essence, the government is trying to find the market demand curve for
the public good.

Figure 5 illustrates how the market demand curve is derived for a public good.
Figure 5: Market Demand Curve for Public Goods

To simplify things let us assume a simple

economy with only 2 individuals. Figure
5 shows the demand curve for individuals
A and B for a certain public good. The
government has sent out a survey to A
and B and asked each what they would be
willing to pay if the amount of public
good produced was X1 units. We can see
from the graphs that Individual A would
be willing to pay $6 for that level of
output, while Individual B would be
willing to pay $3 for that level. Thus if
the government could collect the
donations from A and B they know that
they could get $9 if they produced X1
units. They next asked A and B what
they would be willing to pay for X2 units.
We see that both A and B would both be
willing to pay $2 each. So if the
government produced X2 units, then they
could possibly get $4. We thus see how
the market demand curve is derived in the
case of a public good. We add the
amounts that each individual is willing
to pay at each potential level of output.
The optimal production of a public good occurs where the society’s wiliness to pay (represented
by the market demand curve) is equal to the marginal cost of providing the public good
(represented by the supply curve).
Figure 6 illustrates this.

Market demand curve is DA+B while the supply curve is the marginal cost. The efficient level of
output is going to be at X1 and the price charged will be $9.

The obvious problem with this method is that it requires the government being able to determine
the preferences for every individual and their willingness to pay. If people knew that their
responses would somehow determined how much they would be taxed to provide for the public
good they would simply lie about their willingness to pay. The solution depends on the type of
political system set up in the economy. In dictatorships, the optimal amount of public good is
determined by one individual, the dictator. In representative democracies, the decision for
provision of public goods can be determined by representatives, while in true democracies the
voters can decide the level of public goods.

C. Tiebout Hypothesis
One theory proposed by Charles Tiebout (Tiebout hypothesis) states that efficient amount of public
goods can be produced at the local level. The idea is that people who prefer a higher level of public good
will reveal that preference by paying higher housing price and/or taxes. Suppose that a community
spends a lot of money on law enforcement with the result of very low crime rates. Those households that
value safety and are willing to pay for it, will want to move to this community. Those who don’t value
the police service will not move to the community. Does the town is able to provide the efficient level of
output of public goods.

D. Mixed Goods
Some goods have characteristics consistent with both private and public goods. A good example
is college education. College education has aspects that are consistent with private goods.
College education is certainly excludable. If you don’t pay your student fees you will be
prevented from enrolling in classes. However, college education does provide benefits that are
nonexcludable. All members of society benefit when people go to college. A college educated
society will have a lower crime rate, higher productivity and higher wages. Some mixed goods
such as education produces a positive externality.

III. Social Choice

As we have seen one of the problems with public goods is determining what society wants.
Public officials and elected representatives cannot know the preferences of everyone concerning
public goods such as roads, national defense and clean air and water. Thus we have to rely on
imperfect social choice mechanisms to determine public good allocation. Social choice is the
problem of deciding what society wants. It is done by adding up individual preferences to make
a choice for society as a whole.

A. Majority Voting and the Voting Paradox

The most common form of social choice in democratic societies is majority voting, where
societies’ wants are determined by the majority of voters. However, even in this simple public
choice mechanism problems arise. Consider the following example:

Suppose that the Brady Family-Mike (the Dad), Carol (the Mom) and Greg (the sole surviving
son of a horrific car accident that killed 5 other siblings) are deciding where to take their family
vacation.

The choices are: London, Orlando and New York.

Given the choices each of the family members have certain preferences:
Mike’s 1st choice would be New York, his 2nd choice would be London and his 3rd Orlando.
Carol’s 1st choice would be London, her 2nd choice would be Orlando and her 3rd New York.
Greg’s 1st choice would be Orlando, his 2nd New York and his 3rd choice would be London.

If the choice was between New York and London, the Brady family would go to New York,
since Mike and Greg would outvote Carol.
If the choice was between London and Orlando, the Brady family would go to London, since
Mike and Carol would choose London over Orlando.

Thus we would expect that since the Brady Family prefers New York to London, and prefers
London to Orlando it must be the case that the Brady family will prefer New York to Orlando. Is
this true?
Well looking at the family preferences, we see if the choice was between Orlando and New
York, Orlando would win out! Greg and Carol would both choose Orlando over New York and
thus the Bradys would go to Orlando.

This contradiction is called the voting paradox. The paradox shows that majority rule voting
can lead to contradictory and inconsistent results.

Majority voting has other problems as well.

• Logrolling
In Congress, bills must be passed by a majority vote. However if a piece of legislation
would only benefit the West Coast, it might have difficultly gaining the votes necessary
to pass. One solution is to engage in logrolling where Congressional people agree to
help get each other by trading votes to get legislation passed. In our example, suppose
there was another bill pending in Congress that only would benefit the South. The
Western congressmen would offer their support for the Southern bill so it can pass the
House. In exchange the southern congressmen would support the western bill.
Logrolling can lead to inefficient “pork-barrel” legislation.
• Incentive for Voters to (ot Be Well Informed
Another problem for voting to determine social choice is that voters have little incentive
to be well informed. There is little chance that your vote will matter (unless you were in
Florida in 2000), but aside from that is the fact that costs or benefits from your vote will
be spread out among the entire voting population. If you voted for a bond measure that
ended up costing the state billions of dollars, it will end up costing you only a small
fraction of that amount personally.

Even if social choice decisions are not made directly by voters but by public officials there will
be problems with that mechanism as well. Public sector agencies have little incentive to be
efficient. Unlike private business firms who will go out of business if they are not efficient,
public agencies will still be around even if they are inefficient. It is hard to punish or fire a
public official, thus there is little incentive for the public official to make the best decision
possible. Some on the right side of the political spectrum have argued that private firms might
be able to provide the same service at a lower cost.