Production Externalities

Costs ** of production

borne by someone other than the producer

That creates a difference between the cost to the producer and the real cost (to society)

** can be positive or negative

A logging company only has to pay for the the lost value of the trees to the owner.

But the lost value of a forest is much greater than that.

A logging company only has to pay for the the lost value of the trees to the owner.

But other costs, such as erosion, loss of animal habitats and beauty are not charged.

Consumption Externalities

Costs or Benefits of consumption

Obtained by someone other than the consumer.

That creates a difference between the benefit to the consumer and the real benefit (to society)

When you pay for the vehicle Ö

You donít pay for the pollution you create

Which is a real economic cost.

Loss of peopleís health and well being.

Externalities in Consumption

A consumer, like a producer, tends to maximize personal utility or welfare.

Without correction, people will:

Overuse disposable items

Dump toxic materials in their drains or in the air

Overuse personal vehicles, especially high polluting SUVís and trucks

External Benefits

Externalities can also be beneficial.

Example: education, vaccines

In this case, real demand of society is greater than the market demand.

It is as if there is a small component of "collective good" and thus a free rider problem

Production Externalities

Negative: Costs that the producer or consumer does not have to pay for.


Pollution: coal, SUVís

Congestion on the freeway.

Second hand smoke.

Production Externalities

Positive: Benefits that the producer or consumer cannot charge for.


Creating a beautiful yard

Research, information,

Worker training

Effect of increased education on democratic processes


Producers and consumers do not face the right incentives.

The true cost or benefits of a good is not the cost or benefit of the person making the decision.

SO: Market prices do not reflect the true costs and benefits

The market is not efficient.


To have Allocative Efficiency

producers must produce the quantity at which the total or social MC = Price

If there are no externalities:

Private MC = Social MC and competitive producers make the efficient decision

If there are externalities:

Private MC < Social MC

Producers will underestimate costs and produce too much.

W/ externality, efficient output is Qs, but firms will produce Qp

Negative Production externality

Social (Average and Marginal) Costs will be greater than private costs

The market will under-produce goods that yield external benefits

and overproduce those that generate external costs.

Choose inefficient technology

If certain costs are external

Producers will not choose the right production options

In long run, will choose the inefficient technology

Correcting Misallocation

Internalize the externality

Make sure the person making the decision must weigh all of the costs and benefits

Give the "external" person a property right.

Directly regulate the activity

Correcting for Negative Externalities

Internalize: Charge the cost

Gasoline tax reflecting costs

Regulate activity

set limits on pollution emission

control freeway entrances

Regulate products

Require smaller/cleaner/ more efficient vehicles

Give the "external" person a property right.

Copyrights, patent

Allows trades, agreements, right to sue

Correcting for Positive externalities

Provide more of the goods collectively (govt, churches)

Schools, libraries,

Subsidy to producer

tax credit for wind farms; grants from non-profitsÖ

Subsidy to consumer

tax credits for education, efficient refrigerators

What is the Threat of Pollution?

Destroys the balance in the environment

Loss of productive natural resources, including the beauty of nature

Impairs health, including mental health

Reduces life expectancy

Causes climate change

Acid Rain: Soxes and noxes

Destroys forests and gardens, even buildings. Caused by:

Sulfur dioxide (SO2) is an acrid, corrosive, and poisonous gas created when high-sulfur fuels (oil, coal) are burned.

Nitrogen oxides (NOX) Automobile emissions account for 40 percent of urban smog.

The Greenhouse Effect

Excess buildup of carbon dioxide is creating a gaseous blanket around the earth.

Everyone agrees that the burning of fossil fuels (manufactring, autos) is a significant source of CO2.

The destruction of rain forests, which absorb CO2, also contributes to the greenhouse effect.


Solid-Waste and organic Pollution

People in U.S. generate over 5 billion tons of solid waste each year, mostly from agriculture and mining.

Most of this waste is simply building up in dumps and ponds

1.4 billion tons of manure from production of beef and pork

Over 5 tons per person!!!

Assigning Cost/Value

Scientists can measure increases in cancer, heart attacks, and other disorders.

Economists can estimate the dollar value of damage by assessing the economic value of lives, forests, lakes, and other resources.

Difficult to measure the value of lost views of sunsets, wildlife, and recreation opportunities.

Damage Avoidable

Most environmental damage could be avoided.

The EPA estimates that 95 percent of current air and water pollution could be eliminated by known and available technology.

Cleanup Possibilities

Pollution control measures include: auto-emission controls, smokestack cleaners, improved sewage and waste-treatment facilities and cooling towers for electric power plants.

Cleanup Possibilities

Solid waste can be reduced by less packaging, recycling more materials or transforming garbage into a useful energy source.

Market incentives play a major role in pollution behavior.

Regulatory Options

There are two general strategies for environmental protection.

Alter market incentives in such a way that they discourage pollution.

Bypass market incentives with some form of regulatory intervention.

Market-Based Options

Market incentives can be used to reduce or eliminate the divergence between private and social costs.

Emission charges

Recycling payments

Cleanup requirements

Emission Charges

A fee imposed on polluters, based on the quantity of pollution.

increases private marginal cost using polluting technology

lower output in short run

Investment decision: cleaner technology.

Emission Charges

Actual response depends on the relative costs and benefits of possible technologies.

If charges are too high, firms may not bear the cost

If phased in or begin in 1-2 years, firms have incentive and more ability to install new technology to avoid the charges.

Important for firm to have long run perspective

Lending markets critical.

Emission Charges

Some communities have begun to charge a fee for each container of garbage collected.

This has reduced the volume of garbage households leave out for collection.

Recycling Materials

A bonus that emission charges offer is an increased incentive for the recycling of materials.

A producer has no incentive to use recycled materials unless they offer superior cost efficiency and thus greater profits.

Raising the price consumers pay for scare resources encourages them to use less.

Pollution Fines

Imposing fines or liability for cleanup costs changes the incentive structure for firms.

Ex. Royal Caribbean Cruises


Problems: not enough government muscle to oversee

Relies on private litigation: expensive lawsuits


The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 gave the EPA the authority to create a tax on crude oil and assorted chemical products.

The resulting "superfund" is used to clean up hazardous oil and chemical spills.

Tradable Pollution Permits

Government sets standard for pollution reduction.

Firms that reduce pollution by more than the standard earn pollution credits

These credits can be sold to other firms.

Tradable Pollution Permits

incentive to minimize the cost of pollution control.

AND discover cheaper methods for pollution abatement.

Pricing Pollution Permits

Command-and-Control Options


commands firms to reduce pollution

controls the process for doing so.

Example: Clean Air Acts mandating not only fewer auto emissions but also specific process for attaining them.

Command-and-Control: Problems

Excessive process regulation may raise the costs of environmental protection and discourage cost-saving innovation.

Theses policies regulate only 1-3 percent of total output.

The Optimal Rate of Pollution

The optimal rate of pollution exists when the marginal benefit of pollution abatement equals the marginal cost of pollution abatement.