Marginal social cost MSC is the sum of marginal private cost MC and marginal

							Externalities   CHAPTER   10
CHAPTER CHECKLIST

When you have completed your study of this
chapter, you will be able to

1 Explain why negative externalities lead to inefficient
  overproduction and how property rights, pollution
  charges, and taxes can achieve a more efficient
  outcome.
2 Explain why positive externalities lead to inefficient
  underproduction and how public provision, subsidies,
  vouchers, and patents can achieve a more efficient
  outcome.
EXTERNALITIES IN OUR DAILY LIVES

 An externality is a cost or a benefit that arises from:
    • Production that falls on someone other than the
      producer
    • Consumption that falls on someone other than the
      consumer
 A negative externality is a production or
 consumption activity that creates an external cost.
 A positive externality is a production or consumption
 activity that creates an external benefit.
 EXTERNALITIES IN OUR DAILY LIVES
EXTERNALITIES IN OUR DAILY LIVES

  Four types of externalities:
     •   Negative production externalities
     •   Positive production externalities
     •   Negative consumption externalities
     •   Positive consumption externalities
 EXTERNALITIES IN OUR DAILY LIVES
EXTERNALITIES IN OUR DAILY LIVES

Negative Production Externalities
  Pollution is the major example of this type of
  externality.
  Others are noise and congestion.
Positive Production Externalities
  Example: Orchards provide positive production
  externalities to honey producers, who in turn provide
  positive production externalities to orchards.
 EXTERNALITIES IN OUR DAILY LIVES
EXTERNALITIES IN OUR DAILY LIVES


Negative Consumption Externalities
  Smoking tobacco in a confined space
  Noisy parties
Positive Consumption Externalities
  A flu vaccination
  Restoration of an historic building
  Education and research
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Private Costs and Social Costs
  Marginal private cost is the cost of producing an
  additional unit of a good or service that is borne by the
  producer of that good or service.
  Marginal external cost is the cost of producing an
  additional unit of a good or service that falls on people
  other than the producer.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

  Marginal social cost is the marginal cost incurred by
  the entire society—by the producer and by everyone
  else on whom the cost falls.
  Marginal social cost (MSC) is the sum of marginal
  private cost (MC) and marginal external cost.
            MSC = MC + Marginal external cost
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

Figure 10.1 shows the
relationship between
cost and output.

When output is 4,000 tons
of chemicals a month:
1. Marginal private
  cost is $100 a ton.
2. Marginal external
  cost is $125 a ton.
3. Marginal social cost is
  $225 a ton.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Production and Pollution: How Much?
  When an industry is unregulated, the amount of
  pollution it creates depends on the market equilibrium
  price and the quantity of the good produced.
  If the industry creates an external cost, the market
  equilibrium is inefficient. Too much of the good is
  produced.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.2 shows
inefficiency with an
external cost.
1. The market is in
   equilibrium at a
   price of $100 a ton
   and 4,000 tons of
   chemical a month
   is inefficient.
2. Marginal social
  cost exceeds ...
3. Marginal benefit.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION


4. The efficient
  quantity is 2,000
  tons of chemical,
  where marginal
  social cost equals
  marginal benefit.
5. The gray triangle
   shows the dead-
   weight loss created
   by the pollution
   externality.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Property Rights
  Property rights are legally established titles to the
  ownership, use, and disposal of factors of production
  and goods and services that are enforceable in the
  courts.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION
Figure 10.3 shows
how property
rights achieve an
efficient outcome.
1. With property
  rights, the MC
  curve that
  excludes the cost
  of pollution shows
  only part of the
  producers’
  marginal cost.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

2. The marginal
  private cost
  curve includes
  the cost of
  pollution, and
  the supply curve
  is S = MC.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION
3. Market
   equilibrium is
   at a price of
   $150 a ton and
   a quantity of
   2,000 tons of
   chemical a
   month and is
   efficient
   because…
4. Marginal social
  cost equals
  marginal benefit.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

The Coase Theorem
  Coase theorem is the proposition that if property
  rights exist, only a small number of parties are involved,
  and transactions costs are low, then private
  transactions are efficient and the outcome is not
  affected by who is assigned the property right.
  Transactions costs are the opportunity costs of
  conducting a transaction.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Application of the Coase Theorem
 • If factories own homes and river, the rent people
   willingly pay decreases as the amount of pollution
   increases.
 • If homeowners own the river, factories must pay
   homeowners for any pollution, and the more they
   pollute, the more they pay.
 • Regardless of who owns the river, so long as someone
   owns it, the factories bear the cost of pollution, and the
   quantity of production and pollution are efficient.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

Government Actions in the Face of External
 Costs
  The three main methods that governments can use to
  achieve a more efficient allocation of resources in the
  presence of external costs are:
     • Emission charges
     • Marketable permits
     • Taxes
10.1 NEGATIVE EXTERNALITIES: POLLUTION

  Emission Charges
  Emission charges confront the producers with the
  external cost of pollution and provide an incentive to
  seek technologies that are less polluting.

  To work out the emission charge that achieves
  efficiency, the regulator needs a lot of information about
  the industry, which is generally not available.
10.1 NEGATIVE EXTERNALITIES: POLLUTION

  Marketable Permits
   A marketable permit assigns to each producer in an
   industry an emission limit.
   Producers can buy and sell permits in the market.
   Producers with a low marginal cost of reducing
   pollution will sell permits and producers with a high
   marginal cost of reducing pollution will buy.
   Producers will buy and sell permits until their marginal
   cost of pollution equals the market price of a permit.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

Taxes
Figure 10.4 shows
the effects of a
pollution tax.

1. A pollution tax is
  imposed that is
  equal to the
  marginal external
  cost arising from
  pollution.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION

The supply curve
becomes the marginal
private cost curve,
MC, plus the tax—the
curve labeled
S = MC + tax.

Because the tax
equals the marginal
external cost, the MSC
curve becomes the
supply curve.
 10.1 NEGATIVE EXTERNALITIES: POLLUTION


 2. Market equilibrium
   at a price of $150 a
   ton and 2,000 tons
   of chemical a month
   is efficient
   because…
3. Marginal social cost
  equals marginal
  benefit.
10.1 NEGATIVE EXTERNALITIES: POLLUTION


4. The government
  collects tax
  revenue shown by
  the purple
  rectangle.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Private Benefits and Social Benefits
  Marginal private benefit is the benefit of an
  additional unit of a good or service that the consumer of
  that good or service receives.
  Marginal external benefit is the benefit of an
  additional unit of a good or service that people other
  than the consumer of the good or service enjoy.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

  Marginal social benefit is the marginal benefit
  enjoyed by society—by the consumers of a good or
  service and by everyone else who benefits from it.
  Marginal social benefit (MSB) is the sum of marginal
  private benefit (MB) and marginal external benefit.
          MSB = MB + Marginal external benefit
 10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Figure 10.5 shows an
external benefit.
When 15 million students
attend college:
1. Marginal private benefit
  is $10,000 per student.

2. Marginal external benefit
  is $15,000 per student.

3. Marginal social benefit is
  $25,000 per student.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Figure 10.6 shows
inefficiency with an
external benefit.
1. Market equilibrium
  is at a tuition of
  $15,000 a year and
  7.5 million students
  and is inefficient
  because …
2. Marginal social
  benefit exceeds …
3. Marginal cost.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE



4. The efficient
  number of students
  is 15 million.

5. The gray triangle
  shows the
  deadweight loss
  created because
  too few students
  enroll in college.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

Government Actions In the Face of External
 Benefits
  Four devices that governments can use to achieve a
  more efficient allocation of resources in the presence of
  external benefits:
     •   Public provision
     •   Private subsidies
     •   Vouchers
     •   Patents and copyrights
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

  Public provision is the production of a good or
  service by a public authority that receives the bulk of its
  revenue from the government.
  A subsidy is a payment that the government makes to
  private producers to cover part of the costs of
  production.
  A voucher is a token that the government provides to
  households that can be used to buy specified goods or
  services.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Public provision
Figure 10.7(a) shows how
public provision can achieve
an efficient outcome.
1. Marginal social benefit equals
   marginal cost with 15 million
   students enrolled in college.
2. The efficient quantity.
3. Tuition is $10,000 per year.
4. The taxpayers cover the
   remaining $15,000 of
   marginal cost per student.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Private Subsidies
Figure 10.7(b) shows
how a subsidy
achieves an efficient
outcome of 15 million
students.
1. A $15,000 subsidy
   per student shifts
   the supply curve to
    S = MC – subsidy.
2. The dollar price is
  $10,000 a student.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

3. The market
  equilibrium is
  efficient with 15
  million students
  enrolled in college.

4. Marginal social
  benefit equals
  marginal cost.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
Vouchers
Figure 10.8 shows
how vouchers can
achieve an efficient
outcome.
The MSB curve
becomes the demand
curve because…
1. With vouchers,
   buyers are willing to
   pay MB plus the
   value of the voucher.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE
2. Market equilibrium is
   efficient with 15
   million students
   enrolled.
3. Price, marginal
   social benefit, and
   marginal cost are
   equal.
4. Tuition equals the
   dollar price of
   $10,000 plus the
   value of the voucher.
10.2 POSITIVE EXTERNALITIES: KNOWLEDGE

  Intellectual property rights are the property rights of
  the creators of knowledge and other discoveries.
  A patent or copyright is a government-sanctioned
  exclusive right granted to the inventor of a good,
  service, or productive process to produce, use, and sell
  the invention for a given number of years.