Externalities, Environmental Policy, and Public Goods

CHAPTER
Externalities, Environmental Policy,

and Public Goods
Copyright 2015 Pearson Canada Inc.
1 of 36
CHAPTER
Externalities, Environmental Policy, and

Public Goods
Learning Objectives
5.1
Externalities and Economic Efficiency
5.2
Private Solutions to Externalities: The Coase Theorem
5.3
Government Policies to Deal with Externalities
5.4
Four Categories of Goods
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Can Government Policies Help Protect the Environment?

Government policies to reduce pollution have proven to be controversial.
In December of 2011, the federal government of Canada announced that it
was withdrawing from the Kyoto Protocol, an agreement between countries
that required rich countries to reduce their emissions of carbon dioxide (a
greenhouse gas).
On July 1, 2008, British Columbia introduced a tax on fossil fuels in order to
reduce the emissions of carbon dioxide. On July 1, 2012, the final planned
increase in the tax took effect, so that drivers in B.C. pay an extra 7 cents
per litre for gasoline.
As we will see in this chapter, economic analysis can play a significant role
in evaluating the effects of environmental policies.
AN INSIDE LOOK AT POLICY on page 150 discusses arguments for and
against such carbon tax in British Columbia.
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Economics in Your Life

Whats the Best Level of Pollution?
Policymakers debate alternative approaches for achieving the goal of reducing
carbon dioxide emissions.
See if you can answer these questions by the end of the chapter:
How do we know the best level of carbon emissions?
If carbon dioxide emissions hurt the environment, should the government take
action to eliminate them completely?
Externality A benefit or cost that affects someone who is not directly involved
in the production or consumption of a good or service.
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Externalities and Economic Efficiency
5.1 LEARNING OBJECTIVE
Identify examples of positive and negative externalities and use graphs to show
how externalities affect economic efficiency.
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The Effect of Externalities
Private cost The cost borne by the producer of a good or

service.
Social cost The total cost of producing a good or service,

including both the private cost and any external cost.
Private benefit The benefit received by the consumer of a
good or service.
Social benefit The total benefit from consuming a good or
service, including both the private benefit and any external
benefit.
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How a Negative Externality in Production Reduces Economic Efficiency

Figure 5.1
The Effect of Pollution on
Economic Efficiency
Because utilities do not bear the

cost of acid rain, they produce
electricity beyond the
economically efficient level.
Supply curve S1 represents just
the marginal private cost that the
utility has to pay.
Supply curve S2 represents the
marginal social cost, which
includes the costs to those
affected by acid rain.
If the supply curve were S2, rather
than S1, market equilibrium would
occur at price PEfficient and quantityQEfficient, the economically efficient level of output.
But when the supply curve is S1, the market equilibrium occurs at price PMarket and quantity
QMarket, where there is a deadweight loss equal to the area of the yellow triangle.
Because of the deadweight loss, this equilibrium is not efficient.
When there is a negative externality in producing a good or service, too much

of the good or service will be produced at market equilibrium.
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How a Positive Externality in Consumption Reduces Economic Efficiency

Figure 5.2
The Effect of a Positive Externality
on Economic Efficiency
People who do not consume

college educations can still
benefit from them.
As a result, the marginal social
benefit from a college education
is greater than the marginal
private benefit to college
students.
Because only the marginal
private benefit is represented in
the market demand curve D1, the
quantity of college educations
produced, QMarket, is too low.
If the market demand curve were D2 instead of D1, the level of college educations
produced would be QEfficient, which is the efficient level.
At the market equilibrium of QMarket, there is a deadweight loss equal to the area of the
yellow triangle.
When there is a positive externality in consuming a good or service, too little of

the good or service will be produced at market equilibrium.
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Externalities and Market Failure

Market failure A situation in which the market fails to produce the efficient
level of output.
What Causes Externalities?

Property rights The rights individuals or businesses have to the exclusive use
of their property, including the right to buy or sell it.
Externalities and market failures result from incomplete property rights or from
the difficulty of enforcing property rights in certain situations.
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Private Solutions to Externalities: The Coase

Theorem
Discuss the Coase theorem and explain how private bargaining can lead to
economic efficiency in a market with an externality.
Ronald Coase of the University of Chicago, winner of the 1991 Nobel Prize in
Economics, argued that under some circumstances, private solutions to the
problem of externalities will occur. To understand his argument, it is important to
recognize that completely eliminating an externality usually is not economically
efficient.
10 of 36
Making The Montreal Protocol: Reducing

the
Your Chances of Getting Skin Cancer
Connection
The Montreal Protocol led to a drastic reduction in the production of ozone-depleting

chemicals, and a reduction in the amount of ozone depleting chlorine in the
atmosphere. The second graph shows the reduction in new skin cancer cases as a
result of decreasing the damage to the ozone layer, projected to be about 60 million
fewer cases in 2020.
MyEconLab Your Turn:
Test your understanding by doing related problem 2.3 on page 153 at the end of
this chapter.
11 of 36
The Economically Efficient Level of Pollution Reduction

Figure 5.3
The Marginal Benefit from
Pollution Reduction Should
Equal the Marginal Cost
If the reduction of sulfur dioxide
emissions is at 1.0 million tonnes
per year, the marginal benefit of
$250 per tonne is greater than the
marginal cost of $175 per tonne.
Further reductions in emissions will
increase the net benefit to society.
If the reduction of sulfur dioxide
emissions is at 2.0 million tonnes,
the marginal cost of $225 per
tonne is greater than the marginal
benefit of $150 per tonne.
An increase in sulfur dioxide
emissions will increase the net
benefit to society.
Only when the reduction is at 1.5 million tonnes is the marginal benefit equal to the marginal cost.
This level is the economically efficient level of pollution reduction.
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The additional benefitthat is, the marginal benefitreceived from eliminating

another ton of sulfur dioxide declines as its emissions are reduced.
The net benefit to society from reducing pollution is equal to the difference
between the benefit of reducing pollution and the cost.
To maximize the net benefit to society, pollution should be reduced up to the
point where the marginal benefit from another ton of reduction is equal to the
marginal cost.
The Basis for Private Solutions to Externalities

Coase emphasized that when more than the optimal level of pollution is
occurring, the benefits from reducing the pollution to the optimal level are
greater than the costs.
Dont Let This Happen to You

Remember That Its the Net Benefit That Counts
Maximizing the total benefit would be an inefficient goal with less than optimal results.
this chapter.
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Figure 5.4
The Benefits of Reducing Pollution to the
Optimal Level Are Greater than the Costs
Increasing the reduction in sulphur
dioxide emissions from 1.0 million tonnes
to 1.5 million tonnes results in total
benefits equal to the sum of the areas A
and B under the marginal benefits curve.
The total cost of this decrease in pollution
is equal to the area B under the marginal
cost curve. The total benefits are greater
than the total costs by an amount equal to
the area of triangle A . Because the total
benefits from reducing pollution are
greater than the total costs, its
possible for those receiving the benefits
to arrive at a private agreement with
polluters to pay them to reduce pollution.
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Making
The Fable
Connection of the Bees
the
British economist James Meade

argued that there were positive
externalities in both apple growing
and beekeeping.
He concluded that unless the

government intervened, the market
would not supply enough apple trees
and beehives.
Some apple growers and beekeepers

make private arrangements to arrive at
an economically efficient outcome.
Steven Cheung showed, however, that

government intervention was not necessary because beekeepers and apple
growers had long since arrived at private agreements.
In Washington State, farmers with fruit orchards had been renting beehives to
pollinate their trees since at least as early as 1917, and today honeybees
pollinate more than $14 billion worth of crops annually, from blueberries in Maine
all the way to almonds in California.
this chapter.
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Do Property Rights Matter?

In discussing the bargaining between the electric utilities and
the people suffering the effects of their pollution, the victims
could not legally enforce the right of their property not to be
damaged.
Would it make any difference if the utilities were legally liable?
As Coase was the first to point out, the only difference would
be that the utilities would have an incentive to pay their
victims for the right to pollute rather than the victims having to
pay the utilities to reduce pollution.
Either way, either side would pay to reduce pollution up to the
point where the marginal benefit of the last ton of reduction is
equal to the marginal cost.
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The Problem of Transactions Costs

Transactions costs The costs in time and other resources that parties incur in
the process of agreeing to and carrying out an exchange of goods or services.
The Coase Theorem

Coase theorem The argument of economist Ronald Coase that if transactions
costs are low, private bargaining will result in an efficient solution to the
problem of externalities.
In general, private bargaining is most likely to reach an efficient outcome if the
number of parties bargaining is small.
In practice, private solutions to the problem of externalities will occur only if all
parties to the agreement have full information about the costs and benefits
associated with the externality and they are willing to accept a reasonable
agreement.
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Government Policies to Deal with

Externalities
Analyze government policies to achieve economic efficiency in a market with

an externality.
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Figure 5.5
When There Is a Negative
Externality, a Tax Can Lead to
the Efficient Level of Output
Because utilities do not bear
the cost of acid rain, they
produce electricity beyond the
economically efficient level. If
the government imposes a tax
equal to the cost of acid rain,
the utilities will internalize the
externality. As a consequence,
the supply curve will shift up,
from S1 to S2. The market
equilibrium quantity changes
from QMarket, where an
inefficiently high level of
electricity is produced, to
QEfficient, the economically
efficient equilibrium quantity.
The price of electricity will rise from PMarketwhich does not include the cost of acid rainto PEfficient
which does include the cost.
Consumers pay the price PEfficient, while producers receive a price P, which is equal to PEfficient minus the
amount of the tax.
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Solved Problem 5.3

Using a Tax to Deal with a Negative Externality
Some toilet paper plants discharge bleach into rivers and lakes, causing substantial
environmental damage. Explain how the federal government can use a tax on toilet paper
to bring about the efficient level of production. What should the value of the tax be?
Solving the Problem

Step 1: Review the chapter
material.
Step 2: Use the information
from the graph to determine
the necessary tax.
The graph shows that at the
optimal level of production, the
difference between the
marginal private cost and the
marginal social cost is $50.
Therefore, a tax of $50 per
tonne is required to shift the
supply curve up from S1 to S2.
For more practice, do related problem 3.3 on page 154 at the end of this chapter.
20 of 36
Figure 5.6
When There Is a Positive
Externality, a Subsidy Can
Bring About the Efficient
Level of Output
People who do not consume
postsecondary educations can
benefit from them. As a result,
the social benefit from a
postsecondary education is
greater than the private benefit
to postsecondary students.
If the government pays a
subsidy equal to the external
benefit, students will internalize
the externality.
The subsidy will cause the demand curve to shift up, from D1 to D2.
As a result, the market equilibrium quantity will shift from QMarket, where an inefficiently low level of
postsecondary educations is supplied, to QEfficient, the economically efficient equilibrium quantity.
Producers receive the price PEfficient, while consumers pay a price P, which is equal to PEfficient minus the
amount of the subsidy.
Pigovian taxes and subsidies Government taxes and subsidies intended to

bring about an efficient level of output in the presence of externalities.
21 of 36
Making
the
Connection
Should the Government Tax Soft Drinks?

Governments impose sin taxes on certain products.
The effect of a tax on pop is shown in the figure.
this chapter.
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Command-and-Control versus
Market-Based Approaches
Command-and-control approach An approach that involves the government
imposing quantitative limits on the amount of pollution firms are allowed to emit
or requiring firms to install specific pollution control devices.
Are Tradable Emissions Allowances Licenses to Pollute?

Some environmentalists have criticized tradable emissions allowances, arguing
that just as the government does not issue licenses to rob banks or to drive
drunk, it should not issue licenses to pollute.
But this criticism ignores one of the central lessons of economics: Resources
are scarce, and trade-offs exist.
Resources that are spent on reducing one type of pollution are not available to
reduce other types of pollution or for any other use.
Because reducing acid rain using tradable emissions allowances has cost
utilities US$870 million rather than US$7.4 billion as originally estimated,
society has saved more than $6.5 billion per year.
23 of 36
Making
the
Can a Cap-and-Trade System Reduce Global Warming?
Connection
Although CO2 emissions rose slightly during the first few years of a cap-and-trade plan set up
in Europe in 2005, they should decline over time as the number of allowances is reduced.
chapter.
Test your understanding by doing related problem 3.5 on page 154 at the end of this
24 of 36
Explain how goods can be categorized on the basis of whether they are rival or
excludable and use graphs to illustrate the efficient quantities of public goods
and common resources.
25 of 36
Rivalry The situation that occurs when one persons consuming a unit of a
good means no one else can consume it.
Excludability The situation in which anyone who does not pay for a good
cannot consume it.
Figure 5.7
Goods and services can be

divided into four categories
on the basis of whether
people can be excluded from
consuming them and
whether they are rival in
consumption.
A good or service is rival in
consumption if one person
consuming a unit of a good
means that another person
cannot consume that unit.
26 of 36
1. Private good. A good that is both rival and excludable.

2. Public good. A good that is both nonrival and
nonexcludable.
Free riding - Benefiting from a good without paying for it.
3. Quasi-public goods. Goods that are excludable but not
rival.
4. Common resource. A good that is rival but not excludable.
27 of 36
The Demand for a Public Good
Figure 5.8
Constructing the Market Demand Curve for a Private Good
The market demand curve for private goods is determined by adding horizontally the
quantity of the good demanded at each price by each consumer. For instance, in panel
(a), Jill demands 2 hamburgers when the price is $4.00, and in panel (b), Joe demands 4
hamburgers when the price is $4.00. So, a quantity of 6 hamburgers and a price of $4.00
is a point on the market demand curve in panel (c).
28 of 36
Figure 5.9
Constructing the Demand Curve
for a Public Good
To find the demand curve for a public
good, we add up the price at which
each consumer is willing to purchase
each quantity of the good.
In panel (a), Jill is willing to pay $8 per

hour for a security guard to provide 10
hours of protection.
In panel (b), Joe is willing to pay $10
for that level of protection.
Therefore, in panel (c), the price of $18
per hour and the quantity of 10 hours
will be a point on the demand curve for
security guard services.
29 of 36
Figure 5.10 The Optimal Quantity of a Public Good
The optimal quantity

of a public good is
produced where the
sum of consumer
surplus and producer
surplus is maximized,
which occurs where
the demand curve
intersects the supply
curve.
In this case, the optimal
quantity of security
guard services is 15
hours, at a price of $9
per hour.
30 of 36
Solved Problem 5.4

Determining the Optimal Level of Public Goods
Jill and Joe are in need of security guard services. Their demand schedules are as follows:
Jill
Joe
Price
(dollars per hour)
$20
18
16
14
12
10
8
6
4
2
Quantity (hours
of protection)
0
1
2
3
4
5
6
7
8
9
The supply schedule is as follows:
a. Draw a graph that shows the optimal level

of security guard services.
Be sure to label the curves on the graph.
b. Briefly explain why 8 hours of security
guard protection is not an optimal quantity.
Price
(dollars per hour)
Quantity (hours
of protection)
$20
18
16
14
12
10
8
6
4
2
1
2
3
4
5
6
7
8
9
10
Price
(dollars per hour)
Quantity (hours
of protection)
$8
10
12
14
16
18
20
22
24
1
2
3
4
5
6
7
8
9
31 of 36
Solved Problem 5.4

Determining the Optimal Level of Public Goods
Solving the Problem
Step 1: Review the chapter material.
Step 2: Begin by deriving the demand curve or
marginal social benefit curve for security guard
services.
To calculate the marginal social benefit of guard services,
we need to add the prices that Jill and Joe are willing to
pay at each quantity:
Demand or Marginal Social Benefit

Price
(dollars per hour)
$38
34
30
26
22
18
14
10
6
Quantity (hours
of protection)
1
2
3
4
5
6
7
8
9
Step 3: Answer part (a) by plotting the demand

(marginal social benefit) and supply (marginal social
cost) curves.
Step 4: Answer part (b) by explaining why 8 hours of

security guard protection is not an optimal quantity.
For each hour beyond 6, the supply curve is above the
demand curve, so the marginal social benefit received will
be less than the marginal social cost of supplying these
hours, resulting in a deadweight loss and a reduction in
economic surplus.

chapter.
For more practice, do related problem 4.1 on page 154 at the end of this
32 of 36
Common Resources
Tragedy of the commons The tendency for a common resource to be
overused.
Figure 5.11
Overuse of a Common
Resource
For a common resource
such as wood from a forest,
the efficient level of use,
QEfficient, is determined by the
intersection of the demand
curvewhich represents the
marginal benefit received by
consumersand S2, which
represents the marginal
social cost of cutting the
wood.
Because each individual tree cutter ignores the external cost, the equilibrium quantity of
wood cut is QActual, which is greater than the efficient quantity. At the equilibrium level of
output, there is a deadweight loss, as shown by the yellow triangle.
33 of 36
Is There a Way Out of the Tragedy of the

Commons?
The source of the tragedy of the commons is the same as the source
of negative externalities: lack of clearly defined and enforced
property rights.
When enforcing property rights is not feasible, though, two types of

solutions to the tragedy of the commons are possible:
1. If the geographic area involved is limited and the number of
people involved is small, access to the commons can be
restricted through community norms and laws.
2. If the geographic area or the number of people involved is large,
legal restrictions through taxes, quotas, and tradable permits on
access to the commons are required.
34 of 36
Economics in Your Life

Whats the Best Level of Pollution?
At the beginning of the chapter, we asked you to think about what the best
level of carbon emissions is. Conceptually, this is a straightforward question to
answer:
The efficient level of carbon emissions is the level for which the marginal
benefit of reducing carbon emissions exactly equals the marginal cost of
reducing carbon emissions.
In practice, however, this is a very difficult question to answer. Scientists
disagree about how much carbon emissions are contributing to climate change
and what the damage from climate change will be.
In addition, the cost of reducing carbon emissions depends on the method of
reduction used. As a result, neither the marginal cost curve nor the marginal
benefit curve for reducing carbon emissions is known with certainty, which
makes it difficult for policymakers to determine the economically efficient level
of carbon emissions and is the source of much of the current debate.
In any case, economists agree that the total cost of completely eliminating
carbon emissions is much greater than the total benefit.
35 of 36
AN
AN
INSID
INSIDE
LOOKE
Assessing Pros and Cons of a Government Carbon Tax
LOOK
With the implementation of new pollution regulations, producers would bear more of the
external cost of pollution.
36 of 36

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CHAPTER

Externalities, Environmental Policy,

Copyright 2015 Pearson Canada Inc.

Externalities, Environmental Policy, and

Externalities and Economic Efficiency

Private Solutions to Externalities: The Coase Theorem

Government Policies to Deal with Externalities

Four Categories of Goods

Copyright 2015 Pearson Canada Inc.

Can Government Policies Help Protect the Environment?

Economics in Your Life

Copyright 2015 Pearson Canada Inc.

Externalities and Economic Efficiency

5.1 LEARNING OBJECTIVE

Copyright 2015 Pearson Canada Inc.

The Effect of Externalities

Private cost The cost borne by the producer of a good or

Social cost The total cost of producing a good or service,

How a Negative Externality in Production Reduces Economic Efficiency

Because utilities do not bear the

When there is a negative externality in producing a good or service, too much

How a Positive Externality in Consumption Reduces Economic Efficiency

People who do not consume

When there is a positive externality in consuming a good or service, too little of

Externalities and Market Failure

What Causes Externalities?

Copyright 2015 Pearson Canada Inc.

Private Solutions to Externalities: The Coase

5.2 LEARNING OBJECTIVE

Copyright 2015 Pearson Canada Inc.

Making The Montreal Protocol: Reducing

Your Chances of Getting Skin Cancer

The Montreal Protocol led to a drastic reduction in the production of ozone-depleting

The Economically Efficient Level of Pollution Reduction

Copyright 2015 Pearson Canada Inc.

The additional benefitthat is, the marginal benefitreceived from eliminating

The Basis for Private Solutions to Externalities

Dont Let This Happen to You

MyEconLab Your Turn:

Copyright 2015 Pearson Canada Inc.

British economist James Meade

He concluded that unless the

Some apple growers and beekeepers

Steven Cheung showed, however, that

Do Property Rights Matter?

The Problem of Transactions Costs

The Coase Theorem

Copyright 2015 Pearson Canada Inc.

Government Policies to Deal with

5.3 LEARNING OBJECTIVE

Analyze government policies to achieve economic efficiency in a market with

Copyright 2015 Pearson Canada Inc.

Copyright 2015 Pearson Canada Inc.

Solved Problem 5.3

Solving the Problem

Pigovian taxes and subsidies Government taxes and subsidies intended to

Should the Government Tax Soft Drinks?

MyEconLab Your Turn:

Are Tradable Emissions Allowances Licenses to Pollute?