Externalities and Market Inefficiency
Externalities: the uncompensated impact of one person’s actions on the wellbeing of a bystander
Externalities cause markets to allocate resources inefficiently
An externality that negatively effects the well being of bystanders. Ex: Pollution from an aluminum factory
The cost of society for producing a product with a negative externality is greater than the cost of the
The social cost is equal to the private costs of the producers plus the costs to those bystanders affected
by the externality
The social cost curve is always above the supply curve on the graph
The difference between the two curves shows the cost of the externality
Instead of using the equilibrium to decide how much to produce, we now use the optimum point (the point
at which the demand curve intersects with the social cost curve)
See Page 209210 for deadweight loss calculations
The deadweight loss can be calculated as the area between the demand curve and the social cost curve
between Qmarket and Qoptimum
In order to minimize or eliminate the deadweight loss, the government can impose a tax on the producers,
raising the supply curve. If the tax is equal to the cost of the externality, the supply curve and the social cost
curve will coincide making the optimum point the same as the equilibrium point
Internalizing the Externality: alter incentives so that people take account of the external effects of their
Negative externalities lead markets to produce a larger quantity than is socially desirable.
A good or service that benefits the bystanders. Ex: Education, not only does education benefit those who
are enrolled but those with an education are able to go on and help and benefit the entire community
In this case the social value curve corresponds with the demand curve, it is higher than the demand
curve. The difference between the two represents the value of the externality The optimum point is where the social value curve meets the supply curve
Positive externalities lead markets to produce a smaller quantity than is socially desirable.
To remedy the issue, the government can subsidize goods that have positive externalities.
Public Policies Toward Externalities
Governmental solutions to externalities
Command and Control Policies: Regulation
The government can remedy an externality by making certain behaviors either required or forbidden. Ex: it
is illegal to dump poisonous chemicals into the water supply
The government can put regulations on the amount of pollution a factory can emit
Market Based Policy 1: Corrective Taxes and Subsidies
Corrective Taxes: taxes enacted to correct the effects of negative externalities
Economists prefer taxes over regulations when dealing with pollution because taxes can reduce pollution
at a lower cost to society.
Corrective taxes raise revenue for the government while enhancing the economic efficiency.
Market Based Policy 2: Tradable Pollution Permits
Two firms exchange pollution permits for money, Ex: each firm is initially allowed to produce 300 glops of
pollution, one firm gives the other 100 glops for $5 million
Objections to the Economic Analysis of Pollution
Environmentalists believe that pollution permits and taxes should not be used to limit pollution because no
price can be placed on clean air and water Economists disagree because, people face tradeoffs. While clean air and water are important few people
would be willing to give up the high quality life we lead for clean air and water
Private Solutions to Externalities
Types of Private Solutions
Moral codes and social sanctions
People do not litter , not just because of the law but because it is against our moral codes
“Do to others as you wish would be done to you” a moral injunction that tells us to take account for the
affect of our actions on others.
Charities such as greenpeace make it there goal to protect the environment. Nonprofit and funded with
Colleges and universities receive gifts from alumni, corporations, and foundations as an incentive to attend.
Self interest of relevant parties
Ex: beekeeper and apple grower are right next to each other. Both benefit from the others products, but
since they do not work together the amount of bees may be to large for the amount of apple trees. They
must internalize externalities by having one firm by the other, so they can work out how many bees and
trees to keep.
Instead of buying another firm to ensure both products are at their maximum production point, two firms can
enter in a contract, an agreement to how much of their product to produce.
The Coase Theorem
The proposition that if private parties can bargain without cost over the allocation of resources, they can
solve the problem of externalities on their own
Whatever the initial distribution of rights, the interested parties can always reach a bargain in which
everyone is better off and the outcome is efficient.
Why Private Solutions Do Not Always Work Private solutions only work if both parties can easily reach an agreement, this is not always the case
Transaction Cost: the costs that parties incur in the process of agreeing and following through on a
bargain. Ex: both parties live far away and would need to pay for a plane to come up with an agreement
Bargaining fails, sometimes each party tries to hold out for a better deal. Making an agreement
The number of people interested is large. This becomes difficult because it is harder to please everyone.
When private solutions do not prevail, the government can step in. Public Goods and Common Resources 10/16/2013
The Different Kinds of Goods
Goods can be grouped according to two characteristics:
1. Is the good excludable? Can people be prevented from using the good?
2. Is the good rival in consumption? Does one person’s use of the good diminish another’s ability to use it?
Excludability: The property of a good whereby a person can be prevented from using it
Rival in Consumption: The property of a good whereby one person’s use diminishes other people’s use.
Four Types of Goods
Private Goods: Goods that are both excludable and rival.
Public Goods: Goods that are neither excludable nor rival.
Common Resources: Goods that are rival but not excludable.
Natural Monopoly: Goods that are excludable but not rival.
The FreeRider Problem
FreeRider: a person who receives the benefit of a good but avoids paying for it.
Because public goods are not excludable, the free rider problem prevents the private market from
supplying them (because they will not make any profit). The government can provide the public good and
pay for it with tax revenue if they decide the total benefits exceed the total costs.
Some Important Public Goods
National Defence Public Goods and Common Resources 10/16/2013
Once the country is defended, there is no way to prevent a citizen form enjoying the comfort of this defence.
When one person enjoys the benefit it does not prevent the benefit of another person.
General knowledge only. Specific technological knowledge can be patented making it excludable.
General knowledge cannot be excluded, for example once a mathematician proves a theory it is available to
It is also not rival, the use of the theory by one person does not prevent the use of it by another.
Firms spend a lot of money on research that can be patented and sold but none on general knowledge, in