1. Externalities
Spillover Costs
and Benefits

2. Market Failures
—Caused by either externalities (spillover) or
information problems
√ Externalities failures: (cost or benefit
accruing to an individual or group—a third
party—which is external to the market
transaction)
• Failure of the market to bring about the
allocation of resources that best satisfies the
wants of society.
• Results in either overallocation or
underallocation of resources dedicated to the
production of a particular good or service.

3. When there are NO
externalities involved:
• No benefits or costs beyond
those to consumer
• Qe is efficient allocation
equilibrium, so MB=MC.

4. OPTIMAL AMOUNT OF A PUBLIC GOOD
P
$9 S=MSC
7
The public good’s
5
marginal Cost
as shown by the
3
Supply Curve
1 D=MSB
0 1 2 3 4 5 Q

5. OPTIMAL AMOUNT OF A PUBLIC GOOD
P
$9 S=MSC
7 Yields the
optimum amount
5 of the public good
3 MB = MC
1 D=MSB
0 1 2 3 4 5 Q

6. Cost-benefit Analysis
Marginal Cost = Marginal Benefit Rule
Externalities
Spillover Costs
Overallocation
Spillover Benefits
Underallocation

7. Spillover Costs And Benefits
P
Spillover S=MSC
costs
S=MPC
D=MB
Overallocation
Q0 Qe Q
0

8. Overallocation of resources
√ when external costs are present and
suppliers are shifting some of their costs onto
the community, making their marginal costs
lower.
√ The supply does not capture all the costs
with the MPC curve understating total
production costs.
√ This means resources are overallocated
to the production of this product.
√ By shifting costs to the consumer, the
firm enjoys MSC curve and Qo (optimum
output ).

9. Spillover Costs And Benefits
P
Spillover S=MSC
costs
S=MPC
D=MB
Overallocation
Q0 Qe Q
0

10. Spillover Costs And Benefits
P
S=MC
Spillover
Benefits
D=MSB
D=MPB
Underallocation
Qe Q0 Q
0

11. Underallocation of resources
√ when external benefits are present
and the MPB curve reflects only the
private benefits understating the total
benefits, at Qe.
√ The output at Qo is optimum and
reflects the MSB curve and the S curve.
√ External positive benefits will
accrue to society from the consumption
of this product.

12. Spillover Costs And Benefits
P
S=MC
Spillover
Benefits
D=MSB
D=MPB
Underallocation
Qe Q0 Q
0

13. Correcting Spillover Costs
Individual Bargaining
Coase Theorem
Liability Rules and Lawsuits
Government Intervention
Direct Controls
Specific Taxes
Subsidies and Government
Provision

14. Correcting Spillover Costs
S=MSC
P Spillover
costs S=MPC
TAX
Overallocation D=MB
Corrected
Q0 Qe Q
0

15. Correcting for Spillover Benefits
Subsidy to:
• Buyer to “lower” the price;
more units will be sold.
• Seller to “lower” the marginal
cost of producing. More units
will be produced and sold.

16. Correcting for Spillover Benefits
P Correcting by Subsidy to Consumers
S=MC
Subsidy to
consumer
increases
demand
D=MSB
Underallocation D=MPB
Corrected
Qe Q Q
0 0

17. Correcting for Spillover Benefits
P Correcting by Subsidy to Producers
S=MPC
S=MSC
Subsidy to
producers
increases
supply
D=MB
Underallocation
Corrected
Qe Q0 Q
0

18. Problem Resource Ways to Correct
allocation
Spillover Overallocation •Individual
Costs of Resources Bargaining
Negative •Liability rules and
External lawsuits
-ities •Tax on Producers
•Direct Controls
•Market for
Externality rights

19. Problem Resource Ways to
Allocation Correct
Spillover Underallocation •Individual
Benefits of Resources Bargaining
Positive •Subsidy to
Externalities consumer
•Subsidy to
producer
•Government
Provision

20. Market for Externality Rights:
D 2002 S = Supply
√ Determine
Price per pollution right
of
“rights” (supply is
$200
pollution
fixed)
rights
√ Demand is
$100
D 2012 downsloping;
500 750 1000
demand will
increase over time
Quantity of pollution rights
as human and
Equilibrium price for business
“rights” will be intersection populations
of demand and supply. increase.

21. Market for Externality Rights:
D 2002 S = Supply
Price per pollution right
Firms are either
of encouraged to
$200
pollution reduce or
rights eliminate it based
$100
D 2012 on their costs and
500 750 1000
the price of the
Quantity of pollution rightsright to pollute.
Pollution Rights can be bought and sold;
conservation groups can “buy” up rights
to control spillover costs.

22. Society’s Optimal Amount Of
Externality Reduction
MC
Society’s marginal benefit and marginal
Socially optimum
cost of pollution abatement
amount of
pollution
abatement
MB
0 QO Amount of pollution abatement