Externalities, Environmental Policy, and Public Goods – Microeconomics Study Notes

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Chapter 5: Externalities, Environmental Policy, and Public Goods

5.1 Externalities and Economic Efficiency

Externalities occur when the actions of individuals or firms have effects on third parties that are not reflected in market prices. These can be either positive or negative and lead to market outcomes that are not economically efficient.

Externality: A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.
Negative externality: Imposes costs on others (e.g., pollution).
Positive externality: Confers benefits on others (e.g., education).
Private cost: Cost borne by the producer.
Social cost: Total cost to society, including private and external costs.
Private benefit: Benefit received by the consumer.
Social benefit: Total benefit to society, including private and external benefits.

Example: Pollution from electricity production is a negative externality because it imposes costs on others not involved in the transaction.

Graph showing marginal private cost and marginal social cost with efficient equilibrium

When negative externalities exist, the market equilibrium quantity is higher and the price is lower than the socially optimal level, resulting in deadweight loss.

Graph showing deadweight loss from negative externality

Positive externalities, such as those from education, result in underproduction relative to the efficient level.

Graph showing positive externality and deadweight loss

Market failure occurs when externalities cause the market to produce a quantity that is not efficient, leading to deadweight loss.

5.2 Private Solutions to Externalities: The Coase Theorem

The Coase Theorem states that if property rights are well-defined and transaction costs are low, private bargaining will result in an efficient allocation of resources, regardless of who holds the rights.

Property rights: Legal rights to use and transfer resources.
Transaction costs: Costs of negotiating and enforcing agreements.

Example: If a farmer and a paper mill share a stream, assigning property rights allows them to negotiate an efficient outcome.

Optimal pollution is not necessarily zero; it is where the marginal benefit of pollution reduction equals the marginal cost.

Equation:

Graph showing marginal benefit and marginal cost of pollution reduction Graph showing total benefits and costs of pollution reduction

The assignment of property rights does not affect the efficient outcome, but it does affect the distribution of income.

Example: Negotiating seat reclining on an airplane can be analyzed using the Coase theorem if transaction costs are low.

Passengers negotiating seat reclining on an airplane

5.3 Government Policies to Deal With Externalities

When private solutions are not feasible, government intervention can help achieve economic efficiency. The main tools are taxes, subsidies, and regulation.

Pigovian tax: A tax imposed to correct a negative externality, equal to the external cost.
Pigovian subsidy: A subsidy to encourage activities with positive externalities, equal to the external benefit.

Equation:

Taxes shift the supply curve up (for negative externalities), reducing quantity to the efficient level.

Tax shifting supply curve for negative externality Tax shifting supply curve and price effects

Subsidies shift the demand curve up (for positive externalities), increasing quantity to the efficient level.

Subsidy shifting demand curve for positive externality

Other policies include command-and-control (regulations) and tradable emissions allowances (cap-and-trade), which use market mechanisms to achieve efficient pollution reduction.

5.4 Four Categories of Goods

Goods can be categorized based on rivalry and excludability, which affects how efficiently markets provide them.

Rival good: One person's consumption reduces availability for others.
Excludable good: People can be prevented from using it if they do not pay.

Type of Good	Rival?	Excludable?
Private goods	Yes	Yes
Public goods	No	No
Common resources	Yes	No
Quasi-public goods	No	Yes

Markets efficiently provide private goods but tend to underprovide public goods (due to free-riding) and overuse common resources (tragedy of the commons).

Efficient provision: For private goods, add quantities demanded at each price (horizontal summation). For public goods, add willingness to pay at each quantity (vertical summation).

Common resources are overused because individuals ignore the external cost imposed on others, leading to deadweight loss.

Solution: Assign property rights, use taxes, quotas, or community norms to restrict access and prevent overuse.

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