Lecture 5: Theory of Externalities

Prepared by
Fahmida Sultana
Associate Professor
Department of Development Studies
University of Dhaka
 Lecture Outline
• Definition
• Classifications
• Consequences
• Private Solutions to Externalities
• Public Solutions to Externalities
 Definition
• Also known as spillover Effects/Neighboring Effects/Third
Party Effects
• An externality is an effect of a purchase or use decision by one
set of parties on others who did not have a choice and whose
interests were not taken into account.
• In economics, an externality is an indirect cost or benefit to an
uninvolved third party that arises as an effect of another
party's activity. Externalities can be considered as unpriced
goods involved in either consumer or producer market
transactions.
• Externalities occur in an economy when the production or
consumption of a specific good or service impacts a third
party that is not directly related to the production or
consumption of that good or service.
 Classifications of Externalities
• Externalities can be classified into two
categories
– Positive Externalities
– Negative Externalities
 Positive Externality
• Positive Externality: One individual’s action
confers a benefit upon others.
– Example : the emphasis on education is a positive
externality. Investment in education leads to a
smarter and more intelligent workforce. Companies
benefit from hiring employees who are educated
because they are knowledgeable. This benefits
employers because a better-educated workforce
requires less investment in employee training and
development costs.
– Consequence: Undersupply of goods generating
positive externalities
Positive Production Externality
Positive Consumption Externality
 Negative Externality
• Negative Externality: One individual’s action
imposes a cost on others.

– Example: pollution, generated by some productive

enterprise, and affecting others who had no
choice and were probably not taken into account.
– Consequence: Overproduction of goods
generating negative externalities
 Negative Externality
• Negative production externalities are the side-effects of production
activities. As a result an individual or firm making a decision does
not have to pay the full cost of the decision. Pollution created by
firms due to production activities is an example of negative
production externality.
• In an unregulated market, producers don't take responsibility for
external costs that exist--these are passed on to society. Thus
producers have lower marginal costs than they would otherwise
have and the supply curve is effectively shifted down (to the right)
of the supply curve that society faces. Because the supply curve is
increased, more of the product is bought than the efficient amount-
-that is, too much of the product is produced and sold. Since
marginal benefit is not equal to marginal cost, a deadweight welfare
loss results.
Negative Production Externality
 Negative Externality
• The diagram in the previous slide illustrates negative
production externality.
• The supply curve given by MPC reflects the firm’s private
costs of production and the marginal social cost curve given
by MSC represents the full cost of production to society.
The vertical difference between MPC and MSC represents
negative externality. Therefore for each level of output, Q1,
social costs given by MSC are greater than the firm’s private
costs by the amount of externality.
• The optimal production quantity is Q*, but the negative
externality results in production of Q1. The deadweight
welfare loss is shown in blue.
Negative Consumption Externality
 Non-market external Effects/Market
external Effects
• If the third party to which the benefit or cost goes
cannot be identified and hence cannot be charged or
compensated, that is non market external effect
• And if the third party can be identified and thus can
be charged or compensated that will be market
external effect.

• Example
 Pecuniary externalities
• Externality in monetary term, other than having a direct resource
effect as in real externality.

• If the demand for housing by students increases the price of the

housing for nonstudents, that is known as pecuniary externality as
the effect comes through price.

• Under complete markets, pecuniary externalities offset each other.

For example, if someone buys drugs and this raises the price of
drugs, the other consumers of drugs will be worse off and the
producers of drugs will be better off. However, the loss to
consumers is precisely offset by the gain to producers; therefore
the resulting equilibrium is still Pareto efficient. As a result, some
economists have suggested that pecuniary externalities are not
really externalities and should not be called such.
 Consequences of Externalities
• Overproduction of goods generating negative
externalities
• Undersupply of goods generating positive
externalities
 Tragedy of the Commons/ Common
Resource Problem
• The case where because the property rights
are not defined properly, the same source of
consumption is overused/ over consumed and
for that the marginal benefit becomes much
less, is known as the Tragedy of the
Commons/Common Resource Problem.

• Example: Grazing cows on a given piece of

land which is not owned by anybody, fishing in
a lake etc.
 Private Solutions to Externalities
• Internalizing externality (by forming economic units
of sufficient size so that most of the consequences of
any action occurs within the unit)
– Collective action taken by the flat owners to maintain the
property
• Assigning Property Rights (Property rights assign to a
particular individual, the right to control some assets
and to receive fees for the property’s use)
– Coase Theorem
• Using the Legal System
 The Coase Theorem
• The situation where the property rights to a common
resource are not assigned to a single individual, but
there are externalities, the parties involved can get
together and make some arrangements by which
externality is internalized and efficiency is ensured, is
referred to as the Coase Theorem.

• Examples: Collective decision of the flat owners for

maintenance of the facilities for all of them.
 Failures of Private solutions for
Externalities
• Public Good (free Rider) Problems
• Compounded by imperfect information problems
– How much does the individual need to be
compensated for externality?
– Incentive not to reveal truth
• Transaction Costs
• Additional Problems with Litigation
– Uncertainty about outcomes
– Differential access
 Public Solutions to Externalities
In order to correct negative externality of production and to bring
down the production to the optimal level, government can
intervene through the following options:
• Taxes are one solution to overcoming externalities. To help reduce
the negative effects of certain externalities such as pollution,
governments can impose a tax on the goods causing the
externalities. The tax, called a Pigovian tax—named after economist
Arthur C. Pigou, sometimes called a Pigouvian tax—is considered to
be equal to the value of the negative externality. This tax is meant
to discourage activities that impose a net cost to an unrelated third
party. That means that the imposition of this type of tax will reduce
the market outcome of the externality to an amount that is
considered efficient.
 Public Solutions to Externalities
Government may impose a tax on the firm either on per unit
of production or per unit of pollutants emitted. These will
lead to a shift of MPC curve upwards towards the MSC curve
and thus reducing output and bringing it closer to socially
optimal level i.e. Q*. The diagram on the next slide shows the
impact of taxes .
Public Solutions to Externalities
 Public Solutions to Externalities
• Subsidies can also overcome negative externalities by
encouraging the consumption of a positive externality. One
example would be to subsidize orchards that plant fruit trees
to provide positive externalities to beekeepers.

• Governments can also implement regulations to offset the

effects of externalities. Regulation is considered the most
common solution. The public often turns to governments to
pass and enact legislation and regulation to curb the negative
effects of externalities. Several examples include
environmental regulations or health-related legislation.
 Public Solutions to Externalities
• These legislations will lower the quantity of goods produced
and bring it closer to the optimal quantity Q* by shifting the
MPC curve upward towards the MSC curve. It might include
legislations to
– Limit the emission of pollutants by setting limits to the extent of
pollutants produced by a firm.
– Limit the production to a certain level.
– Force polluting units to install technologies which reduce emissions.
 Basic References

• Rosen
• Stiglitz
• Bhatia