Externalities

• A cost or benefit to a third party who is not involved in the transaction between producer and consumer

• External cost is also known as “negative externality”

• External benefit is also known as “positive externality”

Examples of External Costs & BenefitsExternal Costs External Benefits

Production -dumping toxic waste destroys habitats

-overfishing depletes fish stocks

-burning coal adds to global warming

-location of firm in high unemp. area increases local standards of living

-new transport built for industry encourages greater tourism

Consumption -excess alcohol intake at pub causes vandalism

-increased car use leads to delays and lost work

-improving one’s garden adds value to a neighbour’s property

-higher education improves prospects for the next generation

** you only need to be able to discuss external costs from production and external benefits from consumption**

Private Costs & Social Costs• Producers are only concerned with “private

costs” so this is all they take into account when deciding their quantity of output

• Consumers are only concerned with “private benefit” so this is all they take into account when deciding their quantity of consumption

• Social Cost = private cost + external cost

• Social benefit = private benefit + external benefit

External Costs

Cost

Quantity

MPC=S

MSC

Externality

If the negative externality were included in the “cost”, MPC would shift to MSC by the vertical amount of the negative externality. S would decrease.

External Benefits

Cost

Quantity

Externality

MPB=D

MSB

If the positive externality were included in the “demand”, MPB would shift to MSB by the vertical amount of the positive externality. D would increase.

Market Optimum vs. Socially Optimum Output

• Free market equilibrium is where marginal private cost = marginal private benefit (MPC=MPB)

• Socially optimum equilibrium is where marginal social cost = marginal social benefit (MSC = MSB)

Market Optimum vs. Socially Optimum Output

Cost

Quantity

MPC=S

MSC

MPB=MSB=D

Q free mkt

Q socially optimum

P free mkt

P socially optimum

Where there are external costs, the free market will overproduce and underprice.

Market Optimum vs. Socially Optimum Output

Cost

Quantity

MPB=D

MSB

MPC=MSC=S

P free mkt

P socially optimum

Q free mkt

Q socially optimum

Where there are external benefits, the free market will underconsume & underprice.

Welfare Loss

Cost

Quantity

MPB=D

MSB

MPC=MSC=S

P free mkt

P socially optimum

Q free mkt

Q socially optimum

- loss to society from not producing at the socially optimum output and price = area between the two curves from the free market output to the socially optimum output

WELFARE LOSS

Remedies for External Costs & Demerit Goods

• Direct Controls

• Tradable Permits

• Extending Property Rights

• Taxes

• Subsidies of Alternatives

Direct Controls

• Restriction or prohibition of production or consumption of a good

• Eg. smoking ban in public places, using cannabis is illegal, production of refrigerators using ozone-depleting chemicals is forbidden, restrictions on pollution levels

• A full ban is rational when MSC > MPB at all levels

Restriction of Output

Cost

Quantity

MPC=S

MSC

MPB=MSB=D

Q free mkt

Q socially optimum

P free mkt

P socially optimum

MPC=S1

Pros/Cons of Direct Controls

Advantages Disadvantages

-Clear limits are defined-Major offenders may be shut down (either by restriction or prohibition)

-expensive to monitor

-extra admin costs to firms

-difficult to assess the correct monetary impact of the externality (S may shift too far or not far enough)

-may lead to gov’t failure if resources end up being allocated incorrectly

Tradable Permits

1. Gov’t sets quantitative limit (quota) on the amount of an externality allowed in an industry

2. Each firm is allocated permits to produce their share of the externality

3. Firms who want to produce less than their permits allow can sell their permits to another firm who wants to produce more – everyone gets what they want

4. The total in the industry remains the same

Advantages of Tradable Permits• externality controlled by the price mechanism as

producers decide how much they are willing to pay to continue producing the externality

• permits can be ↓ over time to gradually phase out the externality (↓supply of permits →↑price of the externality → ↓quantity produced

• encourages firms to invest in going “cleaner” with revenue from selling permits

• firms producing the externality pay for it, (“internalising the externality”)

Disadvantages of Tradable Permits

• ↑ production and admin costs for firms

• ↓ pressure for offenders to clean up their act (just buy more permits!) – gives impression it’s okay

• Valuation of the correct value & quantity of permits with respect to the true social cost is difficult

• May lead to fraud/bribery/bullying by big polluting firms

Extending Property Rights

• Gov’t allocates ownership to people/organisations for certain resources (eg. air, river, sea, etc.)

• Often externalities arise due to lack of property rights (nobody owns the sea so no one minds if we dump this waste!)

• Once someone owns the resource, they can sue anyone who damages it

Pros/Cons of Extending Property Rights

Advantages Disadvantages

-enforcement is moved away from gov’t to private individuals & courts

-firms pay to change their production method or pay when they get sued – either way “internalising the externality”

-may be difficult to extend property rights in all cases (eg. which fisherman owns which piece of the sea)

-difficult to trace the source of externalities where there are multiple offenders

-may be imbalance of power between ‘big’ polluters and ‘little’ individuals

Taxes• Indirect tax imposed on offending firms to

charge them for their externality (internalise the externality)

Cost

Quantity

MPC=S

MSC

MPB=MSB=D

Q free mkt

Q socially optimum

P fm

P so

MPC=S1

tax

producer pays

consumer pays

Pros/Cons of Taxes

Advantages Disadvantages

-the offenders pay for the externality – not the 3rd party

-monetary incentive for producers or consumers of good to ↓ externality

-↑tax revenue can be used to clean up or compensate sufferers

-elastic goods may see significant reduction in demand

-difficult to measure the exact value of the externality – ie. to set the correct tax

-↑ production costs for firms

-firms may relocate to less taxed countries

-inelastic goods may not see a significant decrease in demand

Subsidies of Alternatives• Provided to encourage production and

consumption of a more socially beneficial alternative

• Eg. subsidies for construction of gas-fired power stations, subsidies for public transport, subsidies for nicorette?

Price

Quantity

SS1

D

P

P1

Q Q1

Pros & Cons of Subsidies

Advantages Disadvantages

-should ↓ use of good with negative externality or demerit good

-increase consumer surplus (shifting S outward)

-expensive for gov’t

-firms may become inefficient if relying on subsidies

-may be difficult to make people shift if demand for the demerit good is inelastic (not price sensitive)