ExternalitiesExternalities

Part IIIPart III

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

• Learn the nature of an externality.• See why externalities can make market

outcomes inefficient.• Examine how people can sometimes solve

the problem of externalities on their own.• Consider why private solutions to

externalities sometimes do not work.• Examine the various government policies

aimed at solving the problem of externalities.

In this Topic you will…In this Topic you will…

• Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient.

• People can develop private solutions.–Moral codes and social sanctions– Charitable organizations– Integrating different types of

businesses– Contracting between parties

• Government action is not always needed to solve the problem of externalities, which cause markets to be inefficient.

• People can develop private solutions.–Moral codes and social sanctions– Charitable organizations– Integrating different types of

businesses– Contracting between parties

PRIVATE SOLUTIONS TO PRIVATE SOLUTIONS TO EXTERNALITIESEXTERNALITIES

• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

• Private bargaining can internalize the external effects, resulting in efficient solutions.

• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

• Private bargaining can internalize the external effects, resulting in efficient solutions.

The Coase TheoremThe Coase Theorem

• In the real world bargaining does not always work.–Transactions Costs• Transaction costs are the costs that

parties incur in the process of agreeing to and following through on a bargain.

–Bargaining breaks down.

• In the real world bargaining does not always work.–Transactions Costs• Transaction costs are the costs that

parties incur in the process of agreeing to and following through on a bargain.

–Bargaining breaks down.

Why Private Solutions Do Not Why Private Solutions Do Not Always WorkAlways Work

• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .– Command-and-control policies that

regulate behaviour directly.–Market-based policies that provide

incentives so that private decisions makers will choose to solve the problem on their own.

• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .– Command-and-control policies that

regulate behaviour directly.–Market-based policies that provide

incentives so that private decisions makers will choose to solve the problem on their own.

PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES

• Command-and-Control Policies– Usually take the form of regulations: • Forbid certain behaviors.

• Require certain behaviors.

– Examples:• Requirements that all students be

immunized.• Stipulations on pollution emission levels set

by the Environmental Protection Agency (EPA).

• Command-and-Control Policies– Usually take the form of regulations: • Forbid certain behaviors.

• Require certain behaviors.

– Examples:• Requirements that all students be

immunized.

• Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES

• Market-Based Policies– Government can internalize an

externality by using taxes and subsidies to align private incentives with social efficiency.

– Pigovian taxes are taxes enacted to correct the effects of a negative externality.

• Market-Based Policies– Government can internalize an

externality by using taxes and subsidies to align private incentives with social efficiency.

– Pigovian taxes are taxes enacted to correct the effects of a negative externality.

PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES

• Why are gasoline taxes so common?• They are a Pigovian tax aimed at

correcting three negative externalities:– Congestion– Accidents– Pollution

• The tax makes the economy work better.

• Why are gasoline taxes so common?• They are a Pigovian tax aimed at

correcting three negative externalities:– Congestion– Accidents– Pollution

• The tax makes the economy work better.

CASE STUDY:CASE STUDY: Why Is Gasoline Taxed So Why Is Gasoline Taxed So Heavily?Heavily?

• Market-Based Policies– Tradable pollution permits allow the

voluntary transfer of the right to pollute from one firm to another.

– A market for these permits will eventually develop.

– A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

• Market-Based Policies– Tradable pollution permits allow the

voluntary transfer of the right to pollute from one firm to another.

– A market for these permits will eventually develop.

– A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES

• Market-Based Policies– Reducing pollution using permits is quite

similar to imposing a Pigovian tax. – In both cases it is the firm who pays its

pollution. – With Pigovian taxes, polluting firms must pay

the government.– With pollution permits, polluting firm must pay

to buy the permit. – See Figure 10-6 for an illustration of the

similarities.

• Market-Based Policies– Reducing pollution using permits is quite

similar to imposing a Pigovian tax. – In both cases it is the firm who pays its

pollution. – With Pigovian taxes, polluting firms must pay

the government.– With pollution permits, polluting firm must pay

to buy the permit. – See Figure 10-6 for an illustration of the

similarities.

PUBLIC POLICIES TOWARDS PUBLIC POLICIES TOWARDS EXTERNALITIESEXTERNALITIES

(a) Pigovian Tax (b) Pollution Permits

Price of Pollution

Quantity of Pollution

0

Pigovian Tax

P

1. A Pigovian sets the price of pollution…

2. … which together with the demand curve, determines the quantity of pollution…

Demand for pollution rights

QQuantity of

Pollution

0

Supply of pollution permits

1. … Pollution permits set the quantity of pollution…

Q

2. … which together with the demand curve, determines the price of pollution…

Demand for pollution rights

P

Figure 10-6: The Equivalence of Pigovian Figure 10-6: The Equivalence of Pigovian Taxes and Pollution Permits. Taxes and Pollution Permits.

• When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality.

• Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity.

• Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

• When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality.

• Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity.

• Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

SummarySummary

• Those affected by externalities can sometimes solve the problem privately.

• The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently.

• When private parties cannot adequately deal with externalities, then the government steps in.

• The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

• Those affected by externalities can sometimes solve the problem privately.

• The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently.

• When private parties cannot adequately deal with externalities, then the government steps in.

• The government can either regulate behavior or internalize the externality by using Pigovian taxes or by issuing pollution permits.

SummarySummary