Lecture 31: Externalities and Market Failure

economic efficiency
policies for externalities

Economic Efficiency

Economists make a distinction between private costs and external costs. Private costs are those costs paid by the firm producing the good. External costs are borne by someone not involved in the transaction. The same distinction is made between private and external benefits. Private benefits are the benefits to people who buy and consume a good. External benefits are the benefits to a third party, someone who is not the buyer or the seller.

Social costs = private costs + external costs

Social benefits = private benefits + external benefits

MSC=MSBEconomic efficiency occurs at the level of output at which the marginal social benefits (MSB) equal the marginal social costs (MSC). Demand and supply determine equilibrium prices and quantities in a free market. A free market will result in efficiency when (1) the demand curve is the same as the MSB curve and (2) the supply curve is the same as the MSC curve, that is, when there are no external costs or external benefits.


Externalities are side effects of production or consumption.


When there are external costs or benefits, a free market produces too much or too little of the good.

external costs

When there is a harmful production externality, the production of a good imposes external costs. The marginal social costs exceed marginal private costs by the amount of the external costs. When choosing how much to produce, firms are only concerned with their own costs, the marginal private costs (MPC). The market supply curve is the MPC curve. Although the firm is unconcerned with the external costs, society counts these costs as part of the cost of producing the good. So the free market results in too much of the good being produced.

Policies for Externalities

1. regulation

Regulation is a mandated level of performance that is enforced in law. Regulations can specify either (1) the maximum rate of emissions that is legally allowed or (2) the technologies or practices potential polluters must adopt (for example, chemical truck drivers must obtain a commercial drivers' license and be drug tested). Regualtions are typically applied uniformly to all situations but this cannot be efficient or cost effective

2. taxes/subsidies

An emission tax is a per unit tax on emissions of some pollutant. For example, in 1970, President Nixon proposed a 15 cents per pound tax on sulfur emissions from large power plants. With an emission tax, firms responsible for emissions must pay for the services of the environment just like any other input. So, they have an incentive to conserve on their use of environmental services. How do they do this? Polluters are free to determine how best to reduce emissions. Therefore, they will find the least cost way. A subsidy for reducing pollution works, in principle, the same way as a tax on polluting activities. Emissions taxes are utilized more in Europe (as a source of revenue for environmental cleanup) than in the U.S.

3. pollution permits

Each permit entitles the holder to emit one unit of the pollutant specified during some specified period of time. Permits can be bought and sold at whatever price the participants agree on.

Suppose we own a power plant emitting 8000 tons of sulfur per year and the government wants an overall reduction of 25% in SO2 emissions. We will initially be given 6000 discharge permits.


Our choice depends on our costs of reducing emissions and the price of a permit. We will do whatever is the most profitable.

The advantage of pollution permits over simple regulation is that we get the same overall level of environmental quality at a lower cost since those power plants that find it inexpensive to reduce emissions will do so and sell permits to power plants that have high abatement costs.

4. assign property rights

Giving someone ownership of a resource gives them an incentive to mange it in a way that maximizes its value.

For example, suppose a group of college students is having a noisy party that keeps up the old lady across the street. Can solve the problem by giving someone ownership of the right to make noise.

Suppose the students own the right to make noise. The old lady can pay them to reduce the noise. Suppose the old lady owns the right to make noise. The amount of noise would be zero. The students can pay the old lady to allow them to make some noise. In principle we get the same level of noise no matter who was initially given the property right.