Chapter 10: Externalities and Chapter 11 Preview — Public Goods & Common Resources

Chapter 10 and 11 Notes (Externalities; Preview of Public Goods & Common Resources)

  • Overview and framing

    • Chapters 10 and 11 focus on flaws in capitalism, specifically externalities and public sector intervention.
    • Externalities are a type of market failure where the actions of buyers or sellers affect bystanders who are not part of the market transaction. Externalities can be negative or positive.
    • Recap: Chapter 7 argued that under certain assumptions markets reach efficient allocations. Externalities show those assumptions fail in the real world.
    • Key terms:
    • Externality: the uncompensated impact of one person’s action on a bystander.
    • Negative externality: detrimental impact on bystanders (e.g., pollution).
    • Positive externality: beneficial impact on bystanders (e.g., vaccination spillovers).
    • Social cost (SC): private cost + external cost. SC = PC + EC
    • Social value (SV): private value + external benefit. SV = PV + EB
    • Willingness to pay (WTP): private value or the amount buyers are willing to pay.
    • Private cost (PC): cost borne by sellers; private benefit/value (PV) is what buyers receive.

  • What is an externality? (Definition and intuition)

    • Externality occurs when a third party experiences an impact from a transaction they were not part of and are not compensated for.
    • Impacts can be negative or positive (e.g., neighbor’s noise, secondhand smoke, vaccination benefits to others, education reducing crime).

  • Negative externalities (examples and intuition)

    • Examples: Air pollution from a factory, a neighbor’s barking dog, late-night stereo blasting, health risks from secondhand smoke, risky driving from cell-phone use.
    • Focus example: Secondhand smoke. The smoker bears the private cost (and risk to themselves), but bystanders (e.g., people entering a smokey building) incur uncompensated harm. The external cost is not paid by the smoker or buyer in the market transaction.
    • Welfare recap (from welfare economics): Market equilibrium maximizes consumer and producer surplus when all costs are private. External costs shift the true (social) cost upward, leading to overproduction relative to the social optimum.
    • Graphical intuition (described in class):
    • Red curve = private supply (Private cost, PC).
    • Green curve = social cost (SC) = PC + external cost (EC).
    • An example assignment: assume per unit external cost EC = $1 per gallon of gasoline burned.
    • At the 25th gallon, private cost ≈ $2.50; social cost ≈ $3.50 (PC + EC).
    • Implication: The market overproduces gasoline because it ignores the $1 external cost to bystanders.
    • Outcome if the externality is internalized via a Pigouvian tax: A tax of $1 per gallon would shift the private supply curve upward by $1, leading to a lower quantity (e.g., 20 gallons) and a higher market price (≈ $3.00). Consumers and producers face the social cost and adjust behavior accordingly.

  • Internalizing the externality: what it means and how it works

    • Internalizing the externality means altering incentives so actors take account of external effects in their decisions.
    • In the gasoline example: impose a tax of au = $1 per gallon. Then the seller’s private cost equals the social cost: PC + au = SC.
    • Effects of higher price due to the tax:
    • Consumers cut back on gasoline use; may switch to smaller cars or drive fewer miles.
    • The broader point: the change in behavior is driven by price signals, not by a change in moral sentiment.
    • Europeans and gasoline taxes: gasoline taxes are high (e.g., between $7 and $9 per gallon), which shifts demand and vehicle choices toward smaller, more fuel-efficient cars.
    • Takeaway: Prices are powerful signals; corrective taxes induce private actors to reduce usage when social costs are high.

  • Positive externalities (examples and intuition)

    • Positive externalities occur when private actions confer benefits on bystanders.
    • Examples discussed:
    • Vaccination: protects not only the vaccinated individual but also others who might otherwise contract the disease (herd immunity-like effect).
    • Research and Development (R&D): private firms gain profits, but subsequent researchers benefit from new knowledge, boosting welfare beyond the initial buyer.
    • Education: higher education raises a population’s education level, which can reduce crime and improve governance; society benefits beyond the individual.
    • Social value vs private value for positive externalities:
    • Social value curve SV is the private value PV plus external benefit EB. SV = PV + EB
    • The market demand (private value) underestimates the true social benefit, leading to underproduction from a societal standpoint.
    • Flu vaccinations as a concrete example:
    • Private demand reflects the private benefit (PV) to the individual who buys the shot.
    • Suppose external benefit EB = $10 per shot to bystanders who avoid catching the flu.
    • The social value curve (SV) is higher than the private demand curve by $10 at each quantity.
    • Without considering the external benefit, the market might stop at 20 shots; with EB included, the socially optimal quantity is 25 shots.

  • Public policy responses to externalities (two broad categories)

    • Command and control (regulation): Government directly regulates behavior (e.g., set emission limits, require technology).
    • Examples:
      • EPA limits on pollutant quantities (e.g., no more than a certain amount of fly ash emitted).
      • Technology standards (catalytic converters on cars; emissions testing).
    • Market-based policies: Use price or incentive-based approaches to align private incentives with social welfare.
    • Corrective taxes (Pigouvian taxes) and subsidies (Pigouvian subsidies).
    • The ideal corrective tax is equal to the external cost per unit; the ideal subsidy equals the external benefit per unit.
    • Advantage: Market-based policies let firms decide how to reduce pollution efficiently based on their own abatement costs and innovations.
    • Efficiency comparison: Taxes and subsidies generally better align incentives than blunt regulations because they allow variation in abatement across firms and time, reflecting differing costs. Regulations can be blunt, one-size-fits-all, and less flexible.
    • Tradable pollution permits (cap-and-trade): A market-based approach where a cap is set on total emissions (e.g., 60 permits for 60 tons). Firms can trade permits, and the price signal motivates reductions where cheapest.
    • The Coase theorem (private solutions): If transaction costs are low and property rights are well-defined, private bargaining can internalize externalities without government intervention.
    • Limitations of private solutions: high transactions costs, stubbornness, and coordination problems can prevent efficient bargaining, especially with large numbers of affected parties.

  • Public policies: Tax vs Regulation (gasoline and environmental examples)

    • Corrective tax (Pigouvian tax) on negative externalities (e.g., gasoline pollution): The tax should equal the external cost per unit to internalize the externality.
    • Corrective subsidy for positive externalities: Subsidize activities with social benefits, like vaccines or flu shots, equal to the external benefit per unit.
    • Regulation vs taxes: Taxes typically price the externality directly; regulations specify a fixed reduction or technology. In some cases, regulation can be inefficient because different firms face different abatement costs; taxes can be more efficient because firms reduce emissions only so long as the cost is below the tax. In extreme cases, regulation may be necessary when bargaining costs are too high or when there are large numbers of affected parties (Coase theorem fails).
    • Example intuition: If a tax on gasoline rises to $5 per gallon, a soccer-mom might switch to a more fuel-efficient vehicle or shorten trips. A regulation that requires all drivers to reduce gasoline by a fixed amount may force some people to reduce more than necessary and others too little, creating inefficiency.
    • The catalytic converter example: Regulation often ensures a minimum standard (technology-based) but may not induce ongoing incentives to innovate unless the external cost is changing; price signals (taxes) encourage ongoing adaptation.
    • Summary: Corrective taxes and subsidies improve efficiency when well calibrated; public policies should reflect differences in abatement costs across firms and individuals.

  • Tradable pollution permits: a detailed look (Cap-and-Trade example)

    • Scenario: Reducing sulfur dioxide (SO2) emissions from two power plants (ACME and USE) to cut total emissions by 25% (from 80 tons to 60 tons).
    • Baseline costs: - ACME abatement cost = $100 per ton; - USE abatement cost = $200 per ton.
    • Regulation approach: Each firm must reduce by 10 tons to reach total 60 tons.
    • ACME cost: $10 imes $100 = $1,000
    • USE cost: $10 imes $200 = $2,000
    • Total cost: $3,000
    • Tradable permits approach (cap-and-trade):
    • Issue 60 permits (1 ton per permit) to emit; initial allocation: 30 permits each.
    • Total reduction target: 20 tons (80 → 60).
    • Abatement and trading option: ACME reduces by 20 tons (cost = $20 imes 100 = $2,000) and sells 10 permits to USE at $150 each (revenue = $1,500).
      • ACME’s net cost: $2,000 − $1,500 = $500
      • USE does not abate; it buys 10 permits to emit up to 40 tons (instead of reducing by 10 tons itself) at a cost of $1,500.
      • Total societal cost: $500 + $1,500 = $2,000
    • Result: The same 20-ton reduction achieved at a lower total cost ($2,000 vs $3,000) compared to regulation.
    • Mechanism: Reductions concentrate among firms with the lowest abatement costs, and permits create incentives to innovate in pollution control. The permit price signals reflect the true costs of abatement and enable cost-effective distribution of reductions.
    • Public policy takeaways from the cap-and-trade example:
    • Markets can achieve the same environmental outcome more cheaply when firms with lower abatement costs reduce more and sell permits to higher-cost firms.
    • The total price paid by consumers corresponds to the market-clearing permit price; overall welfare is improved when the cap is binding and permits are traded.
    • Some objections to this approach include ethical concerns about “buying the right to pollute.” Economists respond that the cost of pollution must be weighed against the benefits of cleaner environments; the key is achieving the social optimum at the lowest total cost.
    • Additional point: The cap-and-trade system tends to increase demand for a clean environment (a normal good), which tends to rise with income and wealth, supporting the argument that wealthier societies tend to demand more environmental quality.

  • Private solutions to externalities (Coase Theorem and practical limits)

    • Moral codes and social sanctions:
    • Littering is discouraged by moral norms and social pressure (e.g., parents admonishing children for throwing wrappers).
    • Charity-driven environmental actions exist (e.g., Nature Conservancy buying marshlands to preserve them) outside of government action.
    • Coase Theorem (Ronald Coase): If property rights are well-defined and transaction costs are low, private parties can negotiate to allocate resources efficiently and solve externalities on their own.
    • Classic example: Dick, Jane, and Spot (dog barking problem) – a private bargain could compensate the neighbor for alleviating the nuisance.
    • Why private solutions do not always work:
    • Transaction costs can be high, making bargaining impractical.
    • Some parties may be stubborn or refuse to bargain (e.g., dog owners who won’t muzzle dogs).
    • Coordination problems arise when externalities affect a large number of people (e.g., traffic impacts from a new stadium affecting thousands of drivers; bargaining with all is infeasible).
    • When government intervention is necessary:
    • Large numbers of affected parties (coordination problem) justify rules or regulations.
    • Persistent or hard-to-measure externalities may require public policy tools.

  • Preview: Chapter 11 (Public Goods and Common Resources)

    • The current discussion sets the stage for Chapter 11, which covers why some goods are non-excludable or rival in consumption, and how public goods and common resources require different policy approaches than private markets.

  • Key equations and LaTeX-ready references

    • External cost per unit (example): EC = 1 ext{ per unit (e.g., per gallon of gasoline)}
    • Social cost: SC(q) = PC(q) + EC(q)
    • Pigouvian tax (ideal): au^{*} = EC(q)
    • Internalizing: private cost with tax equals social cost: PC(q) + au = SC(q)
    • Positive externality: social value per unit: SV(q) = PV(q) + EB(q) where EB(q) > 0
    • Nobel policy terminology: Pigouvian tax (negative externality) and Pigouvian subsidy (positive externality)
    • Cap-and-trade cap: total permits = cap; each permit = 1 unit of pollution; trading price adjusts to reflect abatement costs across firms
    • Private solution caveats: transaction costs, coordination costs, and bargaining frictions can prevent efficient private bargaining under Coase

  • Quick connections to foundational principles and real-world relevance

    • Prices as signals: The central role of price in aligning private choices with social welfare (gasoline tax, permit prices, etc.).
    • Heterogeneous abatement costs across firms justify market-based policies over blunt regulations.
    • Public goods and externalities explain why some societal goals (clean air, reduced disease transmission) have to be supported by policy rather than relying solely on private markets.
    • The discussion ties to broader welfare economics: maximizing total surplus, understanding when market outcomes deviate from social optimum, and designing policies to bridge that gap.

  • Ethical, philosophical, and practical implications

    • Balancing efficiency with equity: policies like taxes and cap-and-trade may place different burdens on households and firms; distributional consequences matter for policy acceptability.
    • The moral appeal of private solutions vs regulatory mandates: debates about whether pollution rights can be priced or marketed and whether doing so commodifies nature.
    • Real-world feasibility: transaction costs, political feasibility, and enforcement costs influence which policy instruments are adopted.

  • Connections to broader topics

    • Elasticity and demand/supply behavior under externalities influence policy effectiveness.
    • The environment as a normal good: wealthier societies tend to demand cleaner environments, affecting policy design and public support for environmental programs.
    • The shift from pure laissez-faire to government intervention reflects the need to correct market failures while preserving incentives for private innovation.

  • Summary takeaways

    • Externalities create market failures by introducing private costs/benefits that diverge from social costs/benefits.
    • Negative externalities lead to overproduction; internalizing via Pigouvian taxes or other policies can restore efficiency.
    • Positive externalities lead to underproduction; subsidies or other incentives can raise social welfare to the optimal level.
    • Market-based policies (taxes, subsidies, cap-and-trade) can outperform blunt regulations by exploiting price signals and cost differentials across actors.
    • Private solutions (Coase theorem) can work in principle but may fail due to high transaction costs or coordination problems, sometimes necessitating government action.

  • Next steps

    • Chapter 11 will cover Public Goods and Common Resources to extend the study of non-market mechanisms and collective action problems.