Chapter 10- Externalities
- Negative externality: any negative spillover cost stemming from a production activity that is
imposed on a party other than the decision maker
o Decision maker does not face the external cost
- a crack house operating next to a day care centre
- a pulp and paper mill upstream from a fishery
Positive externality: any positive spillover benefit stemming from a production activity that is imposed
on a party other than the decision maker
- The decision maker does not reap the external benefit
o OC transpo and stores near the transitway
o textbook case: beekeeper and orchard
- Both + and - externalities cause market failure in the form of an INefficient level of output:
o Reminder: this means that Qs = Qd at the level of output
o Equivalently, the marginal benefit, which is the consumer’s willingness to pay for the
last unit, does not equal the suppliers’ valuation of the last unit, which is the cost of
o Equivalently, total surplus is maximized at the efficient level of production
Pollution - negative externality:
What is the optimal level of output for a polluting firm?
- Zero say the environmentalists
- NOT zero, say the economists
o How can that possibly be?
- Typically, the polluting firm produces something that is valued by consumers, so some output,
and therefore some pollution as a byproduct, should be produced
o since automobiles cause air pollution, why not immobilise all motor vehicles?
- The polluting firm doesn’t care about the costs that it is imposing on others, as these costs are
EXTERNAL to its decision making process
o it makes its choices based on its MB and the costs that it faces
- The costs that it imposes on others are included in the social cost (SC) of production *SC = PC + damages imposed on others
*The following two graphs are essentially the same (see fig 10.2, pg.2)
- Because SC > PC (private cost) at the free market rate of output, the polluting firm is over-producing
from a social point-of-view.
o Assumes that the polluter has the (property) right to produce as it pleases, and that the
affected parties do not have the (property) right to stop it.
- The intersection of the demand curve and the social-cost curve determines the optimal output
o The socially optimal output level is less than the market equilibrium quantity.
- From the point of view of society, we are over-producing at the market level of output
*See Fig 10-3 (page 3)
Calculation of deadweight loss:
- Deadweight loss is loss in total surplus stemming from the pollution
o i.e. since we are producing at the market equilibrium rather than the socially optimal
- Avoid pages 209 (starting at paragraph 3) and page 210 like the plague.
o Worst part of the entire textbook
o All that stuff with the triangles and trapezoids
- Start reading again at the top of page 211 for the general idea
- At the market quantity, where we would produce without intervention, the private cost curve
intersects the demand curve, thus ensuring that the consumers’ willingness to pay is aligned at
the margin with the producers’ costs
- At the market quantity, where we would produce without intervention, the social cost curve lies
above the demand curve, so that the consumers’ willingness to pay is less than the full social
cost of production at the margin
- Any units greater that the socially optimal Q ought not to be produced
- Over these units of excess production, the discrepancy between the total social cost of
production, as represented by the height of the social cost curve, and the benefits received from
consumption, as represented by the demand curve, represents a net loss in total surplus, which
we call deadweight loss
o That is represented by triangle ‘H’
How to achieve the socially Optimal Output:
- Decree by law that the level of output cannot exceed Q optimum
o The quota approach
that approach is difficult to administer It is not efficient in that both high cost and low cost producers have to reduce
- The government can internalize an externality by imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable quantity.
- Make the polluting producer assume not only the private costs but also the social costs of
- This situation can be rectified with emission charges assessed on the polluter for each unit of
o The effluent charge will INTERNALISE the externality. Now that the polluter faces these
costs that it imposes on others, it will take them into account when setting its output.
- If the effluent charge = the damages imposed on others, SC = PC, and the socially optimal
equilibrium is reached
o Called a Pig