What externalities are and why they can lead to inefficiency and government intervention in the market The difference among negative, positive, and network externalities The importance of the Coase theorem, which explains how private individuals can sometimes remedy externalities Why some government policies to deal with externalities, like emissions taxes, tradable emissionspermits, or Pigouviansubsidies, are efficient, and others, like environmental standards, are not What makes network externalities an important feature of high–tech industries To Video To First Active Learning What you will learn in this chapter 1 EXTERNALITIES Externalities (spillovers): the impact on third parties of a transaction between others. If fracking pollutes drinking water sources, it is an external cost (“negative externality”). Back to Table of contents 2 Image credit: Associated Press, MCT via Getty Images The extra safety your neighbor might have because everyone else in the area has purchased burglar alarms is a(n): private cost. external cost. private benefit. external benefit. To Next Active Learning LEARN BY DOING: PRACTICE QUESTION Back to Table of contents 3 EXTERNALITIES Examples of external costs: air and water pollution texting while driving chemical runoff that affects fish stocks Examples of external benefits: education beehives next to almond orchards preserved farmland Back to Table of contents All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified 4 FOR INQUIRING MINDS: TEXTING 1 in 4 accidents (250,000 per year) are caused by cell phone use (National Safety Council, 2012) 43 states have banned it… because of the negative (fatal) externalities. Back to Table of contents Image: Steve Debenport/Getty Images 5 IS THE MARKET ALWAYS EFFICIENT? Market failure: free-market equilibrium not providing the socially optimal amount of a good. Left to itself, a market economy will typically generate too much pollution because polluters have no incentive to take into account the costs they impose on others. Back to Table of contents All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified 6 COSTS AND BENEFITS OF POLLUTION The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution. Acid rain, smog, contaminated water, etc. The marginal social benefit of pollution is the additional gain to society as a whole from an additional unit of pollution. Goods and services, jobs, etc. The socially optimal quantity of pollution is the quantity society would choose if all costs and benefits were fully accounted for. Back to Table of contents 7 SO HOW DO YOU MEASURE THE MARGINAL SOCIAL COST OF POLLUTION? It’s the sum of the willingness to pay among all members of society to avoid that unit of pollution. It may be hard to estimate, so society often underestimates it.

1. What externalities are and why they can lead to inefficiency and
government intervention in the market
The difference among negative, positive, and network
externalities
The importance of the Coase theorem, which explains how
private individuals can sometimes remedy externalities
Why some government policies to deal with externalities, like
emissions taxes, tradable emissionspermits, or
Pigouviansubsidies, are efficient, and others, like environmental
standards, are not
What makes network externalities an important feature of high–
tech industries
To Video
To First
Active Learning
What you will learn in this chapter
1
EXTERNALITIES
Externalities (spillovers): the impact on third parties of a
transaction between others.

2. If fracking pollutes drinking water sources, it is an external cost
(“negative externality”).
Back to Table of contents
2
Image credit: Associated Press, MCT via Getty Images
The extra safety your neighbor might have because everyone
else in the area has purchased burglar alarms is a(n):
private cost.
external cost.
private benefit.
external benefit.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents
3
EXTERNALITIES
Examples of external costs:
air and water pollution
texting while driving

3. chemical runoff that affects fish stocks
Examples of external benefits:
education
beehives next to almond orchards
preserved farmland
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
4
FOR INQUIRING MINDS: TEXTING
1 in 4 accidents (250,000 per year) are caused by cell phone use
(National Safety Council, 2012)
43 states have banned it… because of the negative (fatal)
externalities.
Back to Table of contents
Image: Steve Debenport/Getty Images
5
IS THE MARKET ALWAYS EFFICIENT?
Market failure: free-market equilibrium not providing the
socially optimal amount of a good.
Left to itself, a market economy will typically generate too

4. much pollution because polluters have no incentive to take into
account the costs they impose on others.
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
6
COSTS AND BENEFITS OF POLLUTION
The marginal social cost of pollution is the additional cost
imposed on society as a whole by an additional unit of
pollution.
Acid rain, smog, contaminated water, etc.
The marginal social benefit of pollution is the additional gain to
society as a whole from an additional unit of pollution.
Goods and services, jobs, etc.
The socially optimal quantity of pollution is the quantity
society would choose if all costs and benefits were fully
accounted for.
Back to Table of contents
7
SO HOW DO YOU MEASURE THE MARGINAL SOCIAL
COST OF POLLUTION?
It’s the sum of the willingness to pay among all members of

5. society to avoid that unit of pollution.
It may be hard to estimate, so society often underestimates it.
Back to Table of contents
8
HOW MUCH DOES YOUR ELECTRICITY REALLY COST?
A 2011 study estimated the cost of 10,000 pollution sources--
and compared the Total External Cost (TEC) to society to its
TVC (Total Value Created)
ECONOMICS
IN ACTION
Back to Table of contents
Image Denis Pepin/Shutterstock
9
SO HOW DO YOU MEASURE THE MARGINAL SOCIAL
BENEFIT OF POLLUTION?
It’s the highest willingness to pay for the right to emit that unit
measured across all polluters.
Back to Table of contents

6. 10
THE SOCIALLY OPTIMAL QUANTITY OF POLLUTION
Marginal social cost, marginal social benefit
Quantity of pollution
emissions (tons)
QOPT
0
$200
Marginal social cost of pollution
O
Socially optimal quantity of pollution
Socially optimal point
Marginal social benefit of pollution
The socially optimal amount of pollution is not zero.
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
WHY A MARKET ECONOMY PRODUCES TOO MUCH

7. POLLUTION
QMKT
QH
QOPT
0
$400
300
200
100
O
Marginal social benefit at QMKT
Market-determined quantity of pollution
Marginal social cost of pollution
The market outcome is inefficient: marginal social cost of
pollution exceeds marginal social benefit.
Marginal social cost, marginal social benefit
Quantity of pollution emissions (tons)
Marginal social cost at QMKT
Marginal social benefit of pollution

8. In a market economy without government intervention, those
who benefit from pollution—like the owners of power
companies—decide how much pollution occurs.
Socially optimal quantity of pollution
Back to Table of contents
PRIVATE SOLUTIONS TO EXTERNALITY PROBLEMS
In certain situations the private sector can resolve externalities.
Solving problems requires time and effort.
Transaction costs: all of the costs to individuals of making a
deal.
Back to Table of contents
13
PRIVATE SOLUTIONS TO EXTERNALITIES
In an influential 1960 article, the economist Ronald Coase
pointed out that in an ideal world, the private sector could
indeed deal with all externalities.

9. According to the Coase theorem, even in the presence of
externalities an economy can always reach an efficient solution
provided that the transaction costs are sufficiently low.
Back to Table of contents
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FreeImages.com unless otherwise specified
14
PRIVATE SOLUTIONS TO EXTERNALITIES
Coase’s analysis argues that individuals have an incentive to
find a way to make mutually beneficial deals that lead them to
“internalize the externality”: take externalities into account
when making decisions.
Example: a family agrees to stop playing loud music during
their next-door neighbor child’s naptime in exchange for use of
the lawnmower.
Back to Table of contents
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15
Nobel prize–winner James Meade argued that the production of
honey by beekeepers produced a positive externality for farmers

10. in the form of pollination, and thus pollination would be
underprovided in a free market. It turns out, however, that
pollination is a $15 billion industry in the United States and
beekeepers regularly truck their colonies around the country to
sell pollination services to farmers. Click here to watch. (5:55
minutes)
http://www.youtube.com/watch?v=YZCoX9tsT1E
Back to Table of contents
LEARN BY DOING: APPLICATION VIDEO
http://www.youtube.com/watch?v=YZCoX9tsT1E
16
In reality, the Coase theorem is unlikely to work because:
most people don’t care if they are affected by an external cost.
externalities are rare and difficult to identify.
transaction costs are often high, making negotiations difficult.
prices will increase as a result of ending the externality.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents
17

11. POLICIES FOR POLLUTION
Environmental standards: rules that protect
the environment by
specifying actions
by producers and
consumers.
If the market won’t solve its own externality problems, then
what?
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
18
POLICIES FOR POLLUTION
An emissions tax: cost depends on the amount of pollution a
firm produces.
Pigouvian taxes: taxes designed to reduce external costs.
Example: an emissions tax designed to reduce coal production.
Tradable emissions permits: licenses to emit limited quantities
of pollutants; the licenses can be bought and sold by polluters.
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified

12. 19
POLICIES FOR POLLUTION
Which is the best?
Environmental standards?
Inflexible and don’t allow reductions in pollution to be achieved
at minimum cost.
Emissions tax?
Emissions tax ensures that the marginal benefit of pollution is
equal for all sources of pollution (unlike environmental
standards).
Back to Table of contents
20
EMISSIONS TAXES CAN SOLVE EXTERNALITY
PROBLEMS
QMKT
QH
QOPT
0
$400
300
200
100
O

13. Marginal social cost of pollution
Marginal social cost, marginal social benefit
Quantity of pollution emissions (tons)
Socially optimal quantity of pollution
Optimal Pigouvian tax on pollution
Marginal social benefit of pollution
Back to Table of contents
ENVIRONMENTAL STANDARDS VS. EMISSIONS TAXES
(b) Emissions tax
(a) Environmental standard
0
600
400
200
$600

14. 200
0
600
300
$600
150
300
MBB
MBB
MBA
MBA
TA
SA
S B
TB

15. Emissions
tax
Environmental standards force both plants to cut emission by
half.
Without government action, each plant emits 600 tons.
Marginal benefit to individual polluter
Marginal benefit to individual polluter
Quantity of emissions (tons)
Quantity of emissions (tons)
Plant A has a lower marginal benefit so reduces emissions by
400 tons.
Plant B has a higher marginal benefit so reduces emissions by
only 200 tons.
Back to Table of contents
ECONOMIC GROWTH AND GREENHOUSE GASES IN SIX
COUNTRIES
Canada and the U.S. pollute more absolutely… bot not
compared to their GDP
Back to Table of contents
23
TRADABLE EMISSIONS PERMITS

16. Since 1994, the United States has had an SO2 cap-and-trade
system, and acid rain has been reduced by 50%— relatively
cheaply.
The EU has a mandatory, comprehensive CO2 cap-and-trade
scheme on track for 21% reduction in greenhouse gases by
2020.
Back to Table of contents
Image © 2014 TerraPass, Inc.
24
CAP AND TRADE
The US caps (and then allows trade in) Sulfur Dioxide
(responsible for acid rain) emissions
The EU caps and trades Carbon Dioxide (responsible for
greenhouse gases)
The good:
Major pollution reduction at low cost
The bad:
Politicians often bow to industry pressure and create too many
permits (eliminating the cap)
Doesn’t work for localized pollutants like mercury
ECONOMICS
IN ACTION
Back to Table of contents

17. Photo credit: AP Photo/Kin Cheung
25
Suppose a government decides to issue a limited number of
tradable pollution permits.
Which of the following statements is true?
Firms that can easily and at low cost reduce their level of
pollution will find it beneficial to purchase these tradable
pollution permits.
When the government issues these tradable pollution permits, it
effectively creates a market for the right to pollute.
Firms that sell their tradable pollution permits do not fully
understand the costs they will incur when they try to reduce the
level of pollution they create.
None of the statements is true.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents
26
POSITIVE EXTERNALITIES
The marginal social benefit of a good or activity is equal to the
marginal benefit that accrues to consumers plus its marginal
external benefit.
Education creates benefits for students—and the society they
live in.

18. Back to Table of contents
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FreeImages.com unless otherwise specified
27
THE IMPECCABLE ECONOMIC LOGIC OF EARLY-
CHILDHOOD INTERVENTION PROGRAMS
Breaking the cycle of poverty? Separate studies by The RAND
Corporation, University of Pittsburgh and others find $4-17
benefit for each dollar spent.
ECONOMICS
IN ACTION
Back to Table of contents
Image fatihhoca/istockphoto/Getty Images
28
EXTERNAL BENEFITS AND EFFICIENCY
Sometimes a market includes benefits that bystanders receive.
External benefit: a benefit received by people other than the
consumers or producers trading in the market.
Do motorcycle riders provide an external benefit to those
waiting for an organ transplant?

19. Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
29
When the consumption of a good generates positive external
benefits, the market tends to produce:
too much of the good, since there are positive external benefits
from the consumption of the good.
too little of the good, since the market does not take into
account the positive external benefits from the consumption of
the good.
To Next
Active Learning
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents
30
THE SOCIALLY OPTIMAL AMOUNT OF FARMLAND
Marginal social cost, marginal social benefit

20. Quantity of preserved farmland
QOPT
0
10,000
Marginal social cost of preserved farmland
O
Socially optimal quantity of preserved farmland
Socially optimal point
Marginal social benefit of preserved farmland
The market will preserve less than the socially optimal amount
of farmland.
The market outcome (no preserved farmland) is inefficient:
marginal social benefit of farmland preservation exceeds
marginal social cost.
$20,000
Back to Table of contents
All photo credits unless otherwise noted from Freeimages.com
(Formerly Stockxchange) or Morguefile.com
PIGOUVIAN SUBSIDY
A Pigouvian subsidy: a payment designed to encourage
activities that yield external benefits.

21. The socially optimal quantity can be achieved by a Pigouvian
subsidy equal to the marginal social benefit at the optimal
quantity.
Back to Table of contents
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FreeImages.com unless otherwise specified
32
With a partner, decide: Do car alarms do any good?
Since they frequently go off for no apparent reason, do they
create any negative externalities? What are they?
Police argue that they can “shatter the sense of civility that
makes a community safe.” As one of the “signs that no one
cares,” car alarms “invite both further disorder and serious
crime.”-Police Strategy No. 5, New York Police Department,
1994
Click here for a See blog post on the subject.
Back to Table of contents

22. LEARN BY DOING: DISCUSS
See the following article for more details and discussion:
http://www.nytimes.com/2003/12/11/opinion/11FRED.html
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
33
TECHNOLOGY SPILLOVERS
A technology spillover is an external benefit that results when
knowledge spreads among individuals and firms.
Silicon valley: a giant technology spillover
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
34
NETWORK EXTERNALITIES
A good is subject to a network externality when the value of the
good to an individual is greater when a large number of other
people also use the good.
Examples include:
communication systems, e.g., telephones, telegraphs, fax
machines.
railway systems.
hub-and-spoke air travel.

23. Back to Table of contents
35
NETWORK EXTERNALITIES
A good is subject to positive feedback when success breeds
greater success and failure breeds failure.
The more popular Windows is, the more software is made for it
and the more popular it becomes.
Back to Table of contents
All image credits courtesy of Morgue File and/or
FreeImages.com unless otherwise specified
36
For most pollutants, the socially efficient level of pollution is
zero.
True
False
LEARN BY DOING: PRACTICE QUESTION
Back to Table of contents

24. 37
ARE WE STILL FRIENDS? A TALE OF FACEBOOK,
MYSPACE, AND FRIENDSTER
“When do you focus on growth, and when do you focus on
money? We focused on money and Facebook focused on
growing the user base and user experience.” Chris Wolfe,
MySpace
Technical issues and clunky ads pushed users to Facebook…
now some are moving to Snapchat, Instagram, Tumblr, Reddit
and Twitter.
What’s your prediction?
Back to Table of contents
LEARN BY DOING: BUSINESS CASE
Image ©pumkinpie/Alamy
38