This document provides an overview of externalities and government policies to address them. It defines externalities as costs or benefits of an action that impact others, leading to under- or over-production. For negative externalities like pollution, unregulated markets produce too much because producers ignore social costs; for positive externalities like flu vaccines, markets provide too little because consumers ignore social benefits. The Coase Theorem holds that if property rights are assigned and bargaining is costless, markets can efficiently address externalities through negotiation. However, in reality transactions costs exist. Therefore, governments implement policies like taxes, permits, and subsidies to force agents to internalize externalities and achieve efficient outcomes.

1. Microeconomics
Third Edition
Chapter 16
Externalities
Copyright © 2013 by Worth Publishers
Paul Krugman and Robin Wells

2. 1.
A.
B.
C.
*
*
What’s an externality? Costs or benefits of an action that are
external to the decision-maker, are paid/enjoyed by others
positive (beneficial) externalities: flu vaccine
negative (harmful) externalities: pollution, barking dogs
key distinctions:
social cost = private cost + negative externality social benefit =
private benefit + positive externality
externalities…
cause a divergence between private and social costs and/or
benefits of an action
lead to under- or over-production (relative to the efficient, or
surplus-maximizing, level of output)

3. D. Example: polluting producer ignores extra social cost,
produces too much

4. E. Example: consumers ignore added social benefit of flu vaccines,
consume too little

5. F. Thus, there is an “optimal” amount of pollution
(along with the pollution, we get output which we value) –
BUT, an unregulated
market generates “too
much” pollution
(see next slide!)

6. Figure 16.2 Why a Market Economy Produces Too Much Pollution
Krugman and Wells: Microeconomics, Third Edition
Copyright © 2013 by Worth Publishers

7. Unnumbered Figure 16.1 Economic Growth And Greenhouse Gases In Six Countries
Krugman and Wells: Microeconomics, Third Edition
Copyright © 2013 by Worth Publishers
Panel (a): In absolute terms, the US is one of the biggest polluters.
Panel (b): But relative to GDP, we are one of the smallest polluters!

8. 2.
A.
B.
C.
Can the private sector “free market” economy solve externalities?
Rely on moral codes? (the Golden Rule, charity, etc.)
Internalize the externalities? e.g., mergers of…
bee-keeper (needs apple blossoms) and apple-grower (needs bees)
beer company (uses water) and chemical company (pollutes water)
Coase Theorem:
If government assigns property rights, and
if private parties can bargain costlessly over resource allocation,
then the private market will always solve externalities problems
and will allocate resources efficiently, no
matter how property rights were assigned (!),
without any need for further government intervention.

9. 3.
4.
A.
B.
The Coase Theorem: An example
A’s roaming cattle cause $1000 damage to B’s land. Building a fence to
stop this would cost $X.
If A has the right to let cattle roam: If X < $1000, B will build a fence.
If X > $1000, the cattle will roam (and B sustains the damage) –
socially efficient (though maybe not great for B!)
If B has property rights:
If X < $1000, A will build a fence.
If X > $1000, A will pay B for the damage – again, socially efficient!
Caveats on Coase
The distribution of rights determines distribution of well-being.
Transactions costs matter:if bargaining/legal system isn’t
costless, then the Coase theorem breaks down.
(this limitation can be especially important if many people/entities
are involved)

10. 4.
A.
•
•
•
B.
Government and externalities
Regulation: set quantities: e.g.,
maximum level of pollution,
minimum fuel economy requirement,
minimum abatement technology, etc.
Regulation: set prices (force agents to “internalize the externality”) e.g.
, tax raises cost of an activity with negative externality,
forces people to recognize the added (social) cost,
encourages people to consume less
auction permits for the “right to pollute” (similar to a tax) subsidy
reduces cost of an activity with positive externality,
encourages people to consume more

11. Figure 16.3 Environmental Standards versus Emissions Taxes
Krugman and Wells: Microeconomics, Third Edition
Copyright © 2013 by Worth Publishers
(a)
(b)
Regulate quantities:set maximum emissions levels set level at
300:combined emissions fall by 600
Regulate prices: impose a tax on emissions
e.g., set tax (= marginal cost of emissions) at 200: emissions for
firm with smaller marginal benefit fall by more

12. 5. Example: Taxing a negative externality
pre-tax equilibrium
post-tax equilibrium
surplus consumer pre-tax equilibrium
A+B+G+K
post-tax equilibrium A change
-(B-G-K)
producer E+F+R+H+N B+E+F+R+H+G B+G-N
cost of externality R+H+N+G+K+M R+H+G -(M+N+K)
(= cost savings)
net social surplus A+B+E+F-M A+B+E+F M
deadweight loss M (zero) -M

13. Why is gasoline taxed so heavily? (Why not tax it even more?)
Demand is inelastic, thus low deadweight loss Gasoline
generates huge negative externalities:
congestion accidents pollution
Yet gasoline is taxed much less in the US than in Europe! price
per gallon (source: Bloomberg, August 2012)
Norway: $10.12
Netherlands: $8.26
Italy: $8.15
UK: $7.87
USA: $3.75
Saudi Arabia: $0.61
Venezuela: $0.09

14. 6. Example: subsidies to deal with a positive externality