Topic 14 – Externalities
(Jan 17 -19 )
2. Pollution: Negative Production Externality
2.2. Social versus Private cost
2.3 Inefficiency of Market Outcome
2.4 Emissions charge (tax) to achieve efficiency
4. Alcohol: Negative Consumption Externality
5. Other externalities
6. The Coase Theorem
Motivational Example: Lumber Industry Perfect Competition
1. The Lumber Industry is in perfect competition;
2. Lumber mills dump toxic waste into the nearby lake, therefore decreasing the recreational value of the
3. Lumber mills are not required to compensate the users of the lake for the decline of the recreational
quality of the lake.
1. In this industry, will the price paid by consumers: too high; too low?
2. Is the market going to the set the price at the correct level?
3. Will the market for lumber produce an allocatively efficient level of output?
There are third party effects.
Externality: Transaction between buyer and seller affects third party
Production externality: process of producing goods/services affects third party, both for the better/worse)
Consumption externality: consuming of the goods/services affect third party, both for better/worse
Pollution: Negative Production Externality
Market for Aluminum
1. Pre-externality: Price($25) and Quantity (Q ) C
Price result in allocative efficiency because the value to
SS – Social Cost buyers of the last unit sold equals to the cost to
SS - Private Cost producers;
$25 2. Assume health economics determine that for
each ton of Aluminum produced, the cost to society
DD (smoke) is $10/ton;
(Private Value = Social Value)
Q AE QC Quantity 3. With externality: the market outcome is no longer
in allocative efficiency. -- Note: SS = sum of marginal costs for individual firms = private marginal costs;
-- Social cost = private marginal costs + externality cost (cost to society as a whole)
-- Social cost differs from private costs only when externality is present;
-- What are the criteria of allocative efficiency if there is an externality?
Allocatively efficient level of output, with the presence of externality, occurs not at “P=MC”, but
A perfectly competitive market produces too high a level of output, while consumers confront too low a
Government Intervention: Tax
SS’ – Private Cost
(= Social Cost because of the tax)
SS - Private Cost
$30 $10 tax
(Private Value = Social Value)
Q AE QC Quantity
-- In the presence of externalities, when private markets get it wrong (i.e. market failure), there exists the
potential for the government to intervene in such a way as to improve the market outcome.
-- Once the government imposes a tax that’s precisely equal to the amount of external cost, the level of
output is allocatively efficient.
-- If the government proposes to impose a $10 tax per unit, typically the firm will advise the government
not to intervene, what they would do is to argue with the fact that employment would fall Alcohol: Negative Consumption Externality
-- Not the product of alcohol that’s harmful, but the consumption of it is. Hence the name “consumption
-- Usually when we have a consumption externality, there is no production externality, and vice versa;
-- Another definition of Allocative Efficiency:
DD =SS :SWe are producing at the allocatively efficient level when social demand curve equals to the
social supply curve.
Market of Alcohol
-- Negative consumption externality: $5