The document discusses externalities and the role of government in addressing market failures caused by externalities. It defines externalities as costs or benefits imposed on third parties by production or consumption activities. When externalities are present, markets allocate resources inefficiently. The government can intervene to correct market failures through Pigouvian taxes to internalize negative externalities or subsidies to encourage positive externalities. By internalizing external costs and benefits, the government can make prices reflect true social costs and benefits, leading to more economically efficient outcomes.

1. ECONOMICS
What Does It Mean To Me?
Part VI:Part VI:
The Role ofThe Role of
Government inGovernment in
Microeconomics/Microeconomics/
ExternalitiesExternalities

2. Economic functions of Government:Economic functions of Government:
1) Enforce laws and contracts.1) Enforce laws and contracts.
2) Maintain competition.2) Maintain competition.
3) Redistribute income--providing an3) Redistribute income--providing an
economic safety net.economic safety net.
4) Provide public goods4) Provide public goods
-nonexclusion-nonexclusion
-shared consumption-shared consumption

3. 5) Correct Market Failures5) Correct Market Failures
-provide market information-provide market information
-correct negative externalities-correct negative externalities
-subsidize goods with positive-subsidize goods with positive
externalitiesexternalities
6) Stabilize the economy6) Stabilize the economy
- fight unemployment- fight unemployment
- encourage price stability- encourage price stability
- promote economic growth- promote economic growth

4. EXTERNALITI
ES

5. Externality
When one person’s
actions imposes a
cost or benefit on the
well-being of a
bystander.
Externalities usually
result in market
failure.

6. Externalities can be:
1) Positive:Positive: an external
benefit is imposed on
someone. (examples: gardens,
restored historic buildings,
research)
2) Negative:Negative: an external
cost is imposed on
someone. (examples: exhaust
from autos, barking dogs, noise
from airplanes)

7. Externalities cause marketsExternalities cause markets
to allocate resourcesto allocate resources
inefficiently.inefficiently.

8. This happens through:
1) CONSUMPTION: consuming a good
results in externality.
2) PRODUCTION: producing a good results
in externality.
In general, an external cost means the
market overproduces the good (ie, paint).
An external benefit means the market
underproduces the good (ie, gardens)

9. Your neighbor puts in aYour neighbor puts in a
nice garden. Are younice garden. Are you
receiving a benefit?receiving a benefit?

10. When you admit you are receiving aWhen you admit you are receiving a
positive benefit, your neighbor askspositive benefit, your neighbor asks
you to pay him $100 a month for theyou to pay him $100 a month for the
benefit.benefit.
When you say no,When you say no,
he puts up a fence.he puts up a fence.

11. What if you livedWhat if you lived
next door to this?next door to this?
Do you receive aDo you receive a
benefit?benefit?

12. PROPERTY RIGHTS is the issue?PROPERTY RIGHTS is the issue?
Who owns the air? The rivers? TheWho owns the air? The rivers? The
parks?parks?

13. If we can figure out who pollutes theIf we can figure out who pollutes the
stream, we punish the offenderstream, we punish the offender
because we are not sure who owns thebecause we are not sure who owns the
stream, but we DO know who pollutesstream, but we DO know who pollutes
it.it.
We get into trouble when we use thisWe get into trouble when we use this
criteria regarding the air.criteria regarding the air.

14. The tendency for a society to overuse and
therefore abuse common resources is called:
TRAGEDY OF THE COMMONSTRAGEDY OF THE COMMONS
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.

15. What is the difference between a publicWhat is the difference between a public
good and a private good?good and a private good?
Exclusion vs. non-exclusionExclusion vs. non-exclusion
andand
Shared consumption (rival good)Shared consumption (rival good)
vs.vs.
non-shared consumption (non-rivalnon-shared consumption (non-rival
good)good)

16. What definesWhat defines property rightsproperty rights??
Property rights are established byProperty rights are established by formalformal
and informal rulesand informal rules about the privilegesabout the privileges
and limitations on theand limitations on the ownershipownership, use,, use,
andand transfertransfer of goods and resources.of goods and resources.
These rights are specified in variousThese rights are specified in various
municipal ordinances, other legislation,municipal ordinances, other legislation,
court decisions (common law), traditioncourt decisions (common law), tradition
and custom.and custom.

17. Property rights need to be:Property rights need to be:
1) clearly defined1) clearly defined
2) exclusive2) exclusive
3) enforceable3) enforceable
4) transferable4) transferable

18. What is a free-rider?What is a free-rider?
Someone who uses the good but doesn’tSomeone who uses the good but doesn’t
pay for it.pay for it.
Free riders occur when there areFree riders occur when there are
nonexclusion and shared consumption.nonexclusion and shared consumption.
Spraying for mosquitoesSpraying for mosquitoes
Police & fire protectionPolice & fire protection
National defenseNational defense
Street lightsStreet lights

19. Coase TheoremCoase Theorem
The proposition that if private parties canThe proposition that if private parties can
bargain without cost over the allocation ofbargain without cost over the allocation of
resources, they can solve the problem ofresources, they can solve the problem of
externalities on their own.externalities on their own.

20. ExternalitiesExternalities
PositivePositive
(+benefit)(+benefit)
NegativeNegative
(+cost)(+cost)
ProductionProduction
(honey)(honey)
ConsumptionConsumption
(education)(education)
ConsumptionConsumption
(cigarettes)(cigarettes)
ProductionProduction
(pollution)(pollution)
In review:In review:

21. What is efficient?
S = MC to
Society
D = MB to Society
Efficiency occurs
when MC = MB for
society.
For a perfectly
competitive market
with no externalities
and for a good that is
not a public good, the
market is efficient.
P
R
I
C
E
QUANTITY

22. What is efficient?
MC
Market Price
Another way to
measure efficiency
would be where
Profit Maximizing
Output is found
where P = MC
P
R
I
C
E
QUANTITY

23. What happens when the firms’
marginal cost of production is not
equal to the marginal cost to
society?
Or if the marginal benefit to
consumers is not equal to the
marginal benefit to society?

24. NEGATIVE EXTERNALITY INNEGATIVE EXTERNALITY IN
PRODUCTION:PRODUCTION:
Example: Pollution
S = MPC to
Firm
D = MB to Society
P
R
I
C
E
QUANTIT
Y
MSC
MC is the private cost to the
firm.
Marginal social cost (MSC) is
cost to society = MC +
externality.
The market overproduces and charges a priceThe market overproduces and charges a price
that is too low.that is too low.
Because of the externality,Because of the externality,
the cost to society is largerthe cost to society is larger
than the cost to producers.than the cost to producers.
QQ
optim
um
optim
um
Q
m
arket
Q
m
arket

25. POSITIVE EXTERNALITY INPOSITIVE EXTERNALITY IN
PRODUCTION:PRODUCTION:
Example: Honey
S = MSC
D = MB to Society
P
R
I
C
E
QUANTIT
Y
MPC to
firm
MC is the private cost to the
firm.
Marginal social cost (MSC) is
cost to society = MC +
externality.
The market underproduces and charges aThe market underproduces and charges a
price that is too high.price that is too high.
QQ
optim
um
optim
um
Q
m
arket
Q
m
arket

26. NEGATIVE EXTERNALITY INNEGATIVE EXTERNALITY IN
CONSUMPTION:CONSUMPTION:
Example: Cigarettes
MC
D = MB to
Buyer
P
R
I
C
E
QUANTITY
D gives the private
benefit in
consumption.
Marginal social benefit
(MSB) = D + externality.
The market overproduces and charges a price
that is too high.
MS
B
Overproduction in thisOverproduction in this
case raises MC.case raises MC.
Q
m
arket
Q
m
arket

27. POSITIVE EXTERNALITY INPOSITIVE EXTERNALITY IN
CONSUMPTION:CONSUMPTION:
Examples: Education, Charities
MC
D = MB to
Buyer
P
R
I
C
E
QUANTIT
Y
D gives the private benefit in
consumption.
Marginal social benefit
(MSB) = D + externality.
The market underproduces and charges aThe market underproduces and charges a
price that is too low.price that is too low.
MS
B
Underproduction in thisUnderproduction in this
case lowers MC.case lowers MC.
The social value ofThe social value of
education is greater thaneducation is greater than
the private value.the private value.
QQ
optim
um
optim
um
Q
m
arket
Q
m
arket

28. SOLUTIONS:
1) Assign property rights => internalize
externality
(Negotiate if mutually beneficial)
2) Government involvement
Tax on negative externality
(Pigovian tax)
Subsidy for positive externality
Permits

29. Pigovian TaxPigovian Tax
Named after economist, Arthur Pigou
•A tax on firms based on the external costs
they generate.
•Internalizes the externality and reimburses
society for the external costs.
•The term “pollution tax” is used when the tax
may not be equal to marginal external cost.

30. PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
A Pigovian tax sets theA Pigovian tax sets the
priceprice of pollution…….of pollution…….
Pigovian Tax
Q
P
…………which, together withwhich, together with
the demand curvethe demand curve
determines thedetermines the quantityquantity
of pollution.of pollution.
PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Pollution permits sets thePollution permits sets the
quantityquantity of pollution…..of pollution…..
Supply of
pollution
permits
Q
P
…………which, togetherwhich, together
with the demand curvewith the demand curve
determines thedetermines the priceprice ofof
pollution.pollution.

31. PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Pigovian Tax
Q
P
PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Supply of
pollution
permits
Q
P
Notice that in both cases, price andNotice that in both cases, price and
quantity are the same. . . .quantity are the same. . . .

32. PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Pigovian Tax
Q
P
PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Supply of
pollution
permits
Q
P
Notice also that the pigovian tax line isNotice also that the pigovian tax line is
perfectly elastic--firms can pollute as muchperfectly elastic--firms can pollute as much
as they want as long as they pay a tax. . .as they want as long as they pay a tax. . .

33. PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Pigovian Tax
Q
P
PriceofPollution
Quantity of Pollution
Demand for
Pollution Rights
Supply of
pollution
permits
Q
P
. . .while in the second panel, the EPA sets. . .while in the second panel, the EPA sets
the quantity of pollution, and the supply ofthe quantity of pollution, and the supply of
pollution is completely inelastic.pollution is completely inelastic.

34. Economists usually prefer pigovian taxes to
regulation as a way to deal with pollution
because they reduce pollution at a lower
cost to society.
Using pigovian taxes to internalize
externalities will cause market price to
reflect the true social costs of production
and force firms to bear the full social cost
of their production activities.

35. Now, suppose that two firms are awardedNow, suppose that two firms are awarded
permits and have met the governmentpermits and have met the government
standard.standard.
Firm 1 then decides it wants to increaseFirm 1 then decides it wants to increase
its emissions by 100 tons and firm 2its emissions by 100 tons and firm 2
agrees to reduce its emissions by 100 tonsagrees to reduce its emissions by 100 tons
if firm 1 pays it $5 million.if firm 1 pays it $5 million.
Should the government allow twoShould the government allow two
factories to make this deal?factories to make this deal?

36. If the EPA allows the firms to makeIf the EPA allows the firms to make
this deal, it will have created a newthis deal, it will have created a new
scarce resource:scarce resource: pollution permitspollution permits..
A market to trade these permits willA market to trade these permits will
develop and that market will bedevelop and that market will be
governed by the forces of supply andgoverned by the forces of supply and
demand.demand.

37. The EndThe End
Created by:Created by:
Virginia Meachum, Economics Teacher, Coral SpringsVirginia Meachum, Economics Teacher, Coral Springs
High SchoolHigh School
Sources:Sources:
FTE Economics of Water and the EnvironmentFTE Economics of Water and the Environment
AP MicroEconomics Test Question (2005)AP MicroEconomics Test Question (2005)