2. • 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…
3. • 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 TOPRIVATE SOLUTIONS TO
EXTERNALITIESEXTERNALITIES
4. • 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
5. • 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 NotWhy Private Solutions Do Not
Always WorkAlways Work
6. • 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 TOWARDSPUBLIC POLICIES TOWARDS
EXTERNALITIESEXTERNALITIES
7. • 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 TOWARDSPUBLIC POLICIES TOWARDS
EXTERNALITIESEXTERNALITIES
8. • 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 TOWARDSPUBLIC POLICIES TOWARDS
EXTERNALITIESEXTERNALITIES
9. • 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 SoWhy Is Gasoline Taxed So
Heavily?Heavily?
10. • 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 TOWARDSPUBLIC POLICIES TOWARDS
EXTERNALITIESEXTERNALITIES
11. • 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 TOWARDSPUBLIC POLICIES TOWARDS
EXTERNALITIESEXTERNALITIES
12. (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
Q
Quantity 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 PigovianFigure 10-6: The Equivalence of Pigovian
Taxes and Pollution Permits.Taxes and Pollution Permits.
13. • 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
14. • 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
