Externalities and Environmental Policy

Chapter 5

Externalities

1. Hubbard, p.138: “Externality- A cost or benefit that affects someone who is not directly involved in the production, or consumption of a good or service. Negative externality- the impact is adverse

(smoking). Positive externality- the impact is beneficial

(Immunization).

Private Versus Public Cost or Benefit)

2. A private cost is incurred by the individual seller taking part in some economic activity.

A private benefit realized by the individual buyer taking part in some economic activity.

For example, you realize (incur) either a benefit or a cost when you buy a pizza for lunch.

The benefit occurs when your hunger is satisfied and the cost is incurred when you pay for it.

Public Benefits Versus Public Costs

3. Public ( social) benefits or costs are the sum of the benefits realized or costs incurred by all members of society.

Public(social) benefits = private benefit + external benefit (Education)

Public (social) cost = private cost + External cost (Cigarette consumption)

Externalities

4. External costs = social costs – private costs External costs in production External cost in consumption

External benefits= social benefits – private benefits

External benefits in production External benefits in consumption

5. Negative Externality in the Production of Aluminum

Price ofAluminum

Cost of pollution Marginal Social cost =MSC

MarginalPrivate

cost=MPC

opt Tons of aluminum

Q Q

D=MPB=MSB

p

5. Negative Externality in Consumption

Qty of alcohol

Price of Alcohol Cost of

alcohol

MSB

MPB

optQ Q

MPC=MSC

p

5. External Benefit in Production

Price of Robot

Value of technology spillover MSC

MPC

opt Qty of robotsQQ

MPB=MSB

p

Positive Externality in Consumption

Qty of Education

Price of Education Benefits of

education

MSB

MPB

optQQ

MPC=MSC

p

Public policies Toward Externalities

Regulation The Clean Air Act, 1970 and amended in 1977 and 1990 The Clean Water Act, 1972 and amended in 1977

Taxes and subsidies Tax Polluters Subsidize pollution abatement

Create tradable pollution permits (emission trading or cap and trade which is a form of carbon pricing right to emit pollutants)

Note: (Coase Theorem- The argument that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities p. 141).