This is a comprehensive and detailed note on externalities and efficiency for Econ 102.
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Externalities and Efficiency
• External costs are called negative externalities.
• External benefits are called positive externalities.
Externalities:
External costs or benefits that fall on bystanders.
External cost:
A cost paid by people other than the consumer or the producer.
Private cost:
A cost paid by the consumer or the producer.
Social cost:
The cost to everyone; private cost plus external cost.
Social surplus:
Consumer surplus plus producer surplus plus everyone else’s surplus.
Externalities and Efficiency
• A market equilibrium maximizes consumer and producer surplus (trade gains).
• A market with externalities does not maximize social surplus (consumer + producer +
everybody else’s surplus).
Efficient equilibrium:
The price and quantity maximize social surplus.
Efficient quantity:
The quantity that maximizes social surplus. Who bears the cost is irrelevant for efficient quantity.
External Costs
• A tax on an ordinary good increases deadweight loss.
• A tax on a good with an external cost reduces
deadweight loss and raises revenue.
• Economist Arthur C. Pigou first focused attention on externalities and how they might be
corrected with taxes.
Pigouvian tax:
A tax on a good with external costs.
External benefit:
A benefit received by people other than the consumers or producers trading in the market.
, Example: being vaccinated
When there are external benefits, the market output is too low.
• A subsidy equal to the external benefit:
– Shifts the demand curve up
– Makes market equilibrium = efficient equilibrium
• A Pigouvian subsidy therefore:
– Reduces deadweight loss
– Increases social surplus
Pigouvian subsidy:
A subsidy on a good with external benefits.
Internalizing an externality:
Adjusting incentives so that decision-makers take into account all the costs and benefits of their
actions, both private and social.
The market can handle externalities when:
– Transaction costs are low.
– Property rights are clearly defined.
Transaction costs:
All the costs necessary to reach an agreement. The costs of identifying and bringing buyers and
sellers together, the bargaining, and the drawing up of a contract are all transaction costs.
Coase theorem:
If transaction costs are low and property rights are clearly defined, private bargains will ensure
that the market equilibrium is efficient even when there are externalities.
Conditions of the Coase theorem are often unlikely to be met.
– Transaction costs for many externalities are high.
– Property rights are often not clearly defined.
Tradable allowances
• Under the Clean Air Act of 1990, the EPA distributes pollution allowances to generators of
electricity.
• Congress sets the total amount of allowances.
• The EPA monitors emissions so firms can’t pollute
beyond their allowances.
• Firms can trade or bank allowances for future use.
Costs and Profit Maximization Under Competition
Every producer must answer three questions:
– What price to set?
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