AEC02: PRINCIPLES OF ECONOMICS

Externalities
Engr. Czarina Catherine L. San Miguel
(Instructor)
 Externality
• It is the uncompensated impact of one person’s actions on the well-being of a
bystander.

• An externality is a cost or benefit caused by a producer that is not financially

incurred or received by that producer.

• An externality can be both positive and negative and can stem from either the
production or consumption of a good or service. If the impact on the bystander is
adverse, it is called a negative externality. If it is beneficial, it is called a positive
externality.
 Externality
• 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.

• In the presence of externalities, society’s interest in a market outcome extends

beyond the well-being of buyers and sellers who participate in the market to
include the well-being of bystanders who are affected indirectly.
 Externality
• Because buyers and sellers neglect the external effects of their actions when
deciding how much to demand or supply, the market equilibrium is not efficient
when there are externalities. That is, the equilibrium fails to maximize the total
benefit to society as a whole.
Example: The Market for Aluminum
Figure 1. The Market for Aluminum

• The demand curve reflects the

value to buyers, and the supply
curve reflects the costs of sellers.

• The equilibrium quantity,

maximizes the total value to buyers
minus the total costs of sellers. In
the absence of externalities,
therefore, the market equilibrium is
efficient.
 Negative Externality
• Negative externalities occur when the product and/or consumption of a good or
service exerts a negative effect on a third party independent of the transaction.

• An ordinary transaction involves two parties, i.e., a consumer and the producer,
who is referred to as the first and second parties in the transaction. Any other
party that is not related to the transaction is referred to as a third party.
 Negative Externality
• Negative externalities commonly affect public resources where it is difficult to hold
parties accountable such as in the case of environmental pollution. Producers or
consumers may create a negative externality without worrying about lawsuits or fines.
• Example:
 Oceans are a public utility, and nobody holds private rights over them. Without
regulations, ships and boats can pollute the sea which affects other ocean users,
such as fishermen who depend on clean and productive ocean water for their
livelihood.
 Negative Externality
1. Negative Production Externalities
 Occur when the production process results in a harmful effect on unrelated third parties.
 Example: Manufacturing plants cause noise and atmospheric pollution during the
manufacturing process.
 Negative Externality
1. Negative Production Externalities
a. Air pollution
 Air pollution may be caused by factories, which release harmful gases into the atmosphere.
Some of the gases include carbon monoxide and carbon dioxide. The destructive gases cause
damage to crops, buildings, and human health.
 The high concentration of greenhouse gases in the atmosphere affects the global climate and
brings about extreme heat waves, rising sea levels, intense hurricanes, graded air quality, and
droughts. The release of toxic gases into the atmosphere adversely affects vulnerable
populations such as children, the elderly, and patients suffering from asthma and heart
diseases.
 Negative Externality
1. Negative Production Externalities
b. Water pollution
 When industrial wastes are released into public waterways it pollutes and makes it harmful to
humans, animals, and the plants that depend on them. Factory wastes often contain toxic
chemicals that cause death to aquatic animals living in the water, and it denies fishermen a
source of income.
 The contaminated water also affects plants that rely on clean water to survive. On the side of
humans, drinking water that is contaminated with industrial wastes poses a threat to human
life and can cause life-threatening diseases and even death.
 Negative Externality
1. Negative Production Externalities
c. Farm animal production
 Raising farm animals may also cause harmful effects on third parties who reside near the
farm. For example, the misuse of antibiotics can create a large pool of antibiotic-resistant
bacteria that spreads outside the farm and causes diseases to other animals.
 Also, accumulated animal wastes can leak and cause contamination of rivers and streams
and render the water unsafe for human use and consumption..
 Negative Externality
2. Negative Consumption Externalities
 Negative consumption externalities arise during consumption and result in a situation
where the social cost of consuming the good or service is more than the private benefit.
 Private benefits refer to the positive factors rewarded to the producer or the consumer
involved in a transaction.
 Social costs are negative factors impacting third parties.
 For example, when a person consumes alcohol and becomes drunk, he/she causes
social disorder, disturbing the peace of non-drinkers.
 Negative Externality
2. Negative Consumption Externalities
a. Passive smoking
 Passive smoking refers to the inhalation of smoke exhaled by an active smoker.
Inhaling other people’s smoke, also known as second-hand smoke, can cause
diseases in the non-smoking population.
 Some of the smoking-related health complications include stroke, lung cancer, heart
disease, and chronic obstructive pulmonary disease. High-risk populations such as
children and the elderly are at a higher risk of respiratory infections such as asthma
and bacterial meningitis
 Negative Externality
2. Negative Consumption Externalities
b. Traffic congestion
 When too many drivers use a road, it causes delays and slower commuting times for
all motorists. It also creates increased smog from higher idling times and increases the
likelihood of accidents.
 Negative Externality
2. Negative Consumption Externalities
b. Noise pollution
 Noise pollution caused by loud music from a casino or nightclub may also affect third
parties who are not part of the revelers dancing to the music. Loud music may be
mentally and psychologically disruptive, especially to children who are yet to adapt to
the surrounding environment.
 Also, noise pollution may cause sleep deprivation and affect the productivity of nearby
residents and businesses..
Example: The Market for Aluminum
Figure 2. Pollution and the Social
Optimum

Private marginal cost (PMC):

• The direct cost to producers of
producing an additional unit of a
good
Marginal Damage (MD):
• Any additional costs associated
with the production of the good
that are imposed on others but that
producers do not pay
Example: The Market for Aluminum
Figure 2. Pollution and the Social
Optimum

• In the presence of a negative

externality, such as pollution, the
social cost of the good exceeds the
private cost.

• The optimal quantity, , is, therefore

smaller than the equilibrium
quantity, .
 Negative Externality
• Internalizing the Externality
 Altering incentives so that people take into account the external effects of their
actions
 Negative Externality
• Remedies for Negative Externalities
• One of the solutions to negative externalities is to impose taxes to change people’s
behavior.
• The taxes can be imposed to reduce the harmful effects of certain externalities
such as air pollution, smoking, and drinking alcohol.
• An effective tax will equal the cost of the externality, and it is imposed with the goal
of discouraging activities that cause such harmful effects.
 Negative Externality
• Remedies for Negative Externalities
• Also, since most negative externalities result from the lack of property risks,
governments can introduce property rights that will help internalize the costs and
benefits.
• Putting property rights in place will create fear among would-be offenders since
they will be wary of possible legal action against them.
 WHY IS GASOLINE TAXED SO HEAVILY?
• The gas tax can be viewed as a corrective tax aimed at addressing three negative
externalities associated with driving:
1. Congestion:
If you have ever been stuck in bumper-to-bumper traffic, you have
probably wished that there were fewer cars on the road. A gasoline tax keeps
congestion down by encouraging people to take public transportation, carpool
more often, and live closer to work.
 WHY IS GASOLINE TAXED SO HEAVILY?
• The gas tax can be viewed as a corrective tax aimed at addressing three negative
externalities associated with driving:
2. Accidents:
Whenever people buy large cars or sport utility vehicles, they may make
themselves safer but they certainly put their neighbors at risk. According to the National
Highway Traffic Safety Administration, a person driving a typical car is five times as likely to
die if hit by a sport utility vehicle than if hit by another car. The gas tax is an indirect way of
making people pay when their large, gas-guzzling vehicles impose risk on others. It would
induce them to take this risk into account when choosing what vehicle to purchase.
 WHY IS GASOLINE TAXED SO HEAVILY?
• The gas tax can be viewed as a corrective tax aimed at addressing three negative
externalities associated with driving:
3. Pollution:
Cars cause smog. Moreover, the burning of fossil fuels such as
gasoline is widely believed to be the primary cause of global warming. Experts
disagree about how dangerous this threat is, but there is no doubt that the gas tax
reduces the threat by discouraging the use of gasoline.
 Positive Externality
• Positive externalities occur when there is a positive gain on both the private level
and social level.

• Research and development (R&D) conducted by a company can be a positive

externality. R&D increases the private profits of a company but also has the added
benefit of increasing the general level of knowledge within a society.
 Positive Externality
• Positive production externality:
When a firm’s production increases the well-being of others but the firm is not
compensated by those others.

Example: Beehives of honey producers have a positive impact on pollination and

agricultural output
 Positive Externality
• Positive consumption externality:
When an individual’s consumption increases the well-being of others but the
individual is not compensated by those others.

Example: Beautiful private garden that passers-by enjoy seeing

 Positive Externality
• Although some activities impose costs on third parties, others yield benefits.
• Example: Education
To a large extent, the benefit of education is private: The consumer of education
becomes a more productive worker, and thus reaps much of the benefit in the form
of higher wages. Beyond these private benefits, however, education also yields
positive externalities.
One externality is that a more educated population leads to more informed voters,
which means better government for everyone.
 Positive Externality
• Example: Education
Another externality is that a more educated population tends to result in lower
crime rates.
A third externality is that a more educated population may encourage the
development and dissemination of technological advances, leading to higher
productivity and wages for everyone.
Because of these three positive externalities, a person may prefer to have
neighbors who are well educated.
Example: Education
Figure 3. Education and the Social
Optimum

• In the presence of a positive

externality, the social value of the
good exceeds the private value.

• The optimal quantity, , is, therefore,

larger than the equilibrium quantity,
.
 Private Solutions to Externalities
a. The Types of Private Solutions
1. Moral codes and social sanctions
2. Charities
3. Relying on the self-interest of the relevant parties
4. Interested parties to enter into a contract
 Private Solutions to Externalities
b. The Coase Theorem
• Developed by British American economist Ronald Coase
• It is the proposition that if private parties can bargain without cost over the allocation of
resources, they can solve the problem of externalities on their own.
• The Coase Theorem is applied when there are conflicting property rights.
• The Coase Theorem states that under ideal economic conditions, where there is a
conflict of property rights, the involved parties can bargain or negotiate terms that will
accurately reflect the full costs and underlying values of the property rights at issue,
resulting in the most efficient outcome.
 Private Solutions to Externalities
b. The Coase Theorem
• Coase Theorem (Part I): When there are well-defined property rights and
costless bargaining, then negotiations between the party creating the externality
and the party affected by the externality can bring about the socially optimal
market quantity.

• Coase Theorem (Part II): The efficient quantity for a good producing an
externality does not depend on which party is assigned the property rights, as
long as someone is assigned those rights.
 Private Solutions to Externalities
b. The Coase Theorem Example
1. Individuals own the river:
If the river is owned by individuals then individuals can charge firms for
polluting the river. They will charge firms the marginal damage (MD) per unit
of pollution.
Why price pollution at MD? If the price is above MD, individuals would want to
sell an extra unit of pollution, so the price must fall. MD is the equilibrium
efficient price in the newly created pollution market.
 Private Solutions to Externalities
b. The Coase Theorem Example
1. Firms own river:
2. If the river is owned by firms then firms can charge individuals for polluting
less. They will also charge individuals the MD per unit of pollution reduction.
 Private Solutions to Externalities
Problems with Coasian Solution
In practice, the Coase theorem is unlikely to solve many of the types of
externalities that cause market failures.
1. The assignment problem:
• In cases where externalities affect many agents (e.g. global warming), assigning
property rights is difficult)
• Coasian solutions are likely to be more effective for small, localized externalities than
for larger, more global externalities involving a large number of people and firms.
 Private Solutions to Externalities
Problems with Coasian Solution
In practice, the Coase theorem is unlikely to solve many of the types of
externalities that cause market failures.
2. The holdout problem:
• Shared ownership of property rights gives each owner power over all the
others (because joint owners have to all agree to the Coasian solution)
• As with the assignment problem, the holdout problem would be amplified with
an externality involving many parties
 Private Solutions to Externalities
Problems with Coasian Solution
In practice, the Coase theorem is unlikely to solve many of the types of
externalities that cause market failures.
3. Transaction Costs and Negotiating Problems:
• The Coasian approach ignores the fundamental problem that it is hard to negotiate
when there are large numbers of individuals on one or both sides of the negotiation.
• This problem is amplified for an externality such as global warming, where the
potentially divergent interests of billions of parties on one side must be somehow
aggregated for a negotiation.
 Private Solutions to Externalities
• Ronald Coase’s insight that externalities can sometimes be internalized was useful.
• It provides the competitive market model with a defense against the onslaught of
market failures.
• It is also an excellent reason to suspect that the market may be able to internalize
some small-scale, localized externalities.
• It won’t help with large-scale, global externalities, where only a “government” can
successfully aggregate the interests of all individuals suffering from externality
 Public Policies toward Externalities
• The government can respond to externalities in one of two ways.

1. Command-and-control policies regulate behavior directly.

2. Market-based policies provide incentives so that private decision-makers will

choose to solve the problem on their own
Public Policies toward Externalities
1. Command-and-Control Policies: Regulation.
• Command and control is a type of environmental regulation that allows
policymakers to specifically regulate both the amount and the process by which
a firm should maintain the quality of the environment.
Public Policies toward Externalities
1. Command-and-Control Policies: Regulation.
• Example:
• the National Pollution Control Decree of 1976
• the Toxic Substances and Hazardous and Nuclear Wastes Control Act of 1990
• the Philippine Mining Act of 1995
• the Clean Air Act of 1999
 Public Policies toward Externalities
2. Market-Based Policy 1: Corrective Taxes and Subsidies
• The government can internalize the externality by taxing activities that have negative
externalities and subsidizing activities that have positive externalities.

• Taxes enacted to deal with the effects of negative externalities are called corrective
taxes. They are also called Pigovian taxes after economist Arthur Pigou (1877–1959), an
early advocate of their use.

• An ideal corrective tax would equal the external cost from an activity with negative
externalities, and an ideal corrective subsidy would equal the external benefit from an
activity with positive externalities.
 Public Policies toward Externalities
3. Market-Based Policy 2: Tradable Pollution Permits
• Tradable pollution permits are so-called cap and trade schemes. They give companies a legal
right to pollute a certain amount per fixed time span. Firms that pollute less can then sell their
leftover pollution permits to firms that pollute more.

• Advantage of allowing a market for pollution permits:

• The initial allocation of pollution permits among firms does not matter from the standpoint of
economic efficiency. Those firms that can reduce pollution at a low cost will sell whatever
permits they get, while firms that can reduce pollution only at a high cost will buy whatever
permits they need. As long as there is a free market for pollution rights, the final allocation
will be efficient regardless of the initial allocation.
Why is it important to consider externalities?

Therefore, the importance of externalities in resource allocation is crucial if it is

to be optimal and it is the observation that gives cost-benefit analysis some of
its justification as it is necessary to measure those created by activities and to
intervene to correct them.
 Self-Assessment Test
Which of the following is an example of a positive externality?
a. Dev mows Hillary’s lawn and is paid $100 for performing the service
b. While mowing the lawn, Dev’s lawnmower spews out smoke that Hillary’s
neighbor Kristen has to breathe
c. Hillary’s newly cut lawn makes her neighborhood more attractive.
d. Hillary’s neighbors pay her if she promises to get her lawn cut on a regular
basis.
 Self-Assessment Test
The Coase theorem does NOT apply if
a. there is a significant externality between two parties
b. the court system vigorously enforces all contracts
c. transaction costs make negotiating difficult
d. both parties understand the externality fully
 Assignment
Give an example of a negative externality and a positive externality. Explain
why market outcomes are inefficient in the presence of these externalities.
(Deadline of submission: April 30, 2022 (Saturday), 11:59PM)