Chapter 9 PDF

Copyright © 2018, 2015, 2013 Pearson Education, Inc.
All Rights Reserved

How can we limit climate change?
Copyright © 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved
Externalities: Pollution,
Education, and Heathcare
9
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain why negative externalities lead to inefficient

overproduction and how property rights, pollution charges,
and taxes can achieve a more efficient outcome.
2 Explain why positive externalities lead to inefficient

underproduction and how public provision, subsidies, and
vouchers can achieve a more efficient outcome.
EXTERNALITIES IN OUR DAILY LIVES
An externality is a cost or a benefit that arises from:

• Production that falls on someone other than the
producer
• Consumption that falls on someone other than the
consumer
Negative externality
A production or consumption activity that creates an
external cost.
Positive externality
A production or consumption activity that creates an
external benefit.
Four types of externalities:

• Negative production externalities
• Positive production externalities
• Negative consumption externalities
• Positive consumption externalities
Negative Production Externalities

Pollution is the major example of this type of externality.
Others are noise and congestion.
Positive Production Externalities
Example: Orchards provide positive production
externalities to honey producers, who in turn provide
positive production externalities to orchards.
Negative Consumption Externalities

Smoking tobacco in a confined space
Noisy parties
Positive Consumption Externalities
Education is a major example of this type of externality.
Others are a flu vaccination and restoration of an
historic building
9.1 NEGATIVE EXTERNALITIES: POLLUTION
Private Costs and Social Costs

Marginal private cost is the cost of producing an
additional unit of a good or service that is borne by the
producer of that good or service.
Marginal external cost is the cost of producing an
additional unit of a good or service that falls on people
other than the producer.
Marginal social cost is the marginal cost incurred by

the entire society—by the producer and by everyone
else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal
private cost (MC) and marginal external cost.
MSC = MC + Marginal external cost
Figure 9.1 shows the

relationship between cost
and output.
When output is 4 million

gallons of paint a month:
1. Marginal private
cost is $1.00 a gallon.
2. Marginal external
cost is $1.25 a gallon.
3. Marginal social cost is
$2.25 a gallon.
Production and Pollution: How Much?

When an industry is unregulated, the amount of
pollution it creates depends on the market equilibrium
price and the quantity of the good produced.
If the industry creates an external cost, the market
equilibrium is inefficient. Too much of the good is
produced.
Figure 9.2 shows
inefficiency with an
external cost.
1. The equilibrium price
of $1.00 a gallon and
4 million gallons of
paint a month is
inefficient.
2. Marginal social cost
exceeds ...
3. Marginal benefit.
4. The efficient quantity is

2 million gallons of
paint, where marginal
social cost equals
marginal benefit.
5. The gray triangle

shows the deadweight
loss created by the
pollution externality.
Fixing the Inefficient Overproduction

Three ways of dealing with externalities that avoid the
overproduction they bring are to
• Establish property rights.
• Mandate clean technology.
• Tax or price pollution.
Establish Property Rights

Externalities arise when property rights are missing.
Property rights are legally established titles to the
ownership, use, and disposal of factors of production
and goods and services that are enforceable in the
courts.
Establishing property rights is one way of dealing with
externalities
To see how property rights can work, suppose the paint

producers own the homes and the river.
The rental income they can earn on the homes depends
on the amount of pollution they create.
The effect of pollution on rental income gives the paint
producers an incentive to limit pollution.
They might limit pollution by:
• Using an abatement technology
• Decreasing production
Firms will chose the least-cost alternative method.
The Coase Theorem

Coase theorem is the proposition that if property
rights exist, only a small number of parties are involved,
and transactions costs are low, then private
transactions are efficient and the outcome is not
affected by who is assigned the property right.
Transactions costs are the opportunity costs of
conducting a transaction.
Application of the Coase Theorem

• If polluting paint factories own homes and river, the rent
people willingly pay decreases as the amount of
pollution increases.
• If homeowners own the river, the factories must pay
homeowners for any pollution, and the more the
factories pollute, the more they pay.
• Regardless of who owns the river, so long as someone
owns it, the factories bear the cost of pollution, and the
quantity of production and pollution are efficient.
Efficient Market
Equilibrium With
Property Rights
Figure 9.3 illustrates.
1. With property
rights, the MC
curve that excludes
the cost of pollution
shows only part of
the producers’
marginal cost.
2. The marginal
private cost curve
includes the cost
of pollution, and
the supply curve
is S = MC.
3. Market equilibrium
is at a price of
$1.50 a gallon and
a quantity of 2
million gallons of
paint a month and
is efficient
because…
4. Marginal social
cost equals
marginal benefit.
Mandate Clean Technology

Governments regulate what may be dumped in rivers
and lakes and emitted into the atmosphere.
The Clean Air Act of 1970 gives the Environmental
Protection Agency the authority to issue regulations that
require utilities, chemical plants, and steel mills to limit
pollution.
Mandated limits are not likely to be the most efficient
limits.
Tax or Cap and Price Pollution

Governments use two methods to confront polluters with
the costs of their decisions:
• Taxes
• Cap-and-trade
To work out the pollution charge or pollution tax that
achieves efficiency, the regulator needs a lot of
information about the industry, which is generally not
available.
Taxes
By setting the tax equal to the marginal external cost (or
marginal abatement cost if it is lower), firms can be
made to behave in the same way as they would if they
bore the cost of the externality directly.
To see how a tax works, assume that the government
has assessed the marginal external cost of pollution
accurately and imposes a tax on the factories that
exactly equals this cost.
Figure 9.4 shows

the effects of a
pollution tax.
1. The pollution
tax is imposed
that is equal to
the marginal
external cost of
pollution.
The supply curve

becomes the marginal
private cost curve,
MC, plus the tax—
the curve labeled
S = MC + tax.
Because the charge
or tax equals the
marginal external cost
the supply curve
becomes the MSC
curve. Copyright © 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved
2. Market
equilibrium at a
price of $1.50 a
gallon and 2
million gallons of
paint a month is
efficient
because…
3. Marginal social
cost equals
marginal benefit.
4. The
government
collects
revenue equal
to the area of
the purple
rectangle.
Cap-and-Trade
Cap-and-trade places a cap or ceiling on emissions and
assigns or sells emission rights to individual producers
who are then free to trade permits.
It is a tool that seeks to combine the power of
government to limit total emissions with the power of the
market to minimize cost and maximize benefit.
To use this method, the government must first estimate
the efficient quantity of pollution, set the overall
emissions cap to achieve the efficient outcome, and
allocate the cap to producers.
The market in permits determines the equilibrium price

of emissions.
Each firm, confronted with that price, maximizes profit
by setting its marginal pollution cost or marginal
abatement cost, whichever is lower, equal to the market
price of a permit.
By confronting polluters with a price of pollution, trade in
pollution permits can achieve the same efficient
outcome as a tax.
9.2 POSITIVE EXTERNALITIES: EDUCATION
AND HEALTHCARE
Private Benefits and Social Benefits

Marginal private benefit is the benefit of an
additional unit of a good or service that the consumer of
that good or service receives.
Marginal external benefit is the benefit of an
additional unit of a good or service that people other
than the consumer of the good or service enjoy.
AND HEALTHCARE
Marginal social benefit is the marginal benefit

enjoyed by society—by the consumer of a good or
service and by everyone else who benefits from it.
Marginal social benefit (MSB) is the sum of marginal
private benefit (MB) and marginal external benefit.
MSB = MB + Marginal external benefit
AND HEALTHCARE
Figure 9.5 shows an
external benefit.
When 15 million students
attend college:
1. Marginal private benefit
is $10,000 per student.
2. Marginal external benefit

is $15,000 per student.
3. Marginal social benefit is

$25,000 per student.
AND HEALTHCARE
Figure 9.6 shows
inefficiency with an
external benefit.
1. Market equilibrium
is at a tuition of
$15,000 a year and
7.5 million students
and is inefficient
because …
2. Marginal social
benefit exceeds …
3. Marginal cost.
AND HEALTHCARE
4. The efficient
number of students
is 15 million.
5. The gray triangle

shows the
deadweight loss
created because
too few students
enroll in college.
AND HEALTHCARE
Government Actions In the Face of External

Benefits
Three devices that governments can use to achieve a
more efficient allocation of resources in the presence of
external benefits:
• Public provision
• Private subsidies
• Vouchers
AND HEALTHCARE
Public provision is the production of a good or

service by a public authority that receives the bulk of its
revenue from the government.
A subsidy is a payment that the government makes to
private producers to cover part of the costs of
production.
A voucher is a token that the government provides to
households that can be used to buy specified goods or
services.
AND HEALTHCARE
Public Provision
Figure 9.7 shows how public
provision can achieve an
efficient outcome.
1. Marginal social benefit equals
marginal cost with 15 million
students enrolled in college.
2. The efficient quantity.
3. Tuition is $10,000 per year.
4. Taxpayers cover the
remaining $15,000 of
marginal cost per student.
AND HEALTHCARE
Subsidies
Figure 9.8 shows how a
subsidy achieves an
efficient outcome of
15 million students.
1. A $15,000 subsidy
per student shifts
the supply curve to
S = MC – subsidy.
2. The dollar price is
$10,000 a student.
AND HEALTHCARE
3. The market equilibrium

is efficient with 15 million
students enrolled in
college.
4. Marginal social
benefit equals
marginal cost.
AND HEALTHCARE
Vouchers
Figure 9.9 shows how
vouchers can achieve an
efficient outcome.
The MSB curve becomes
the demand curve
because…
1. With vouchers, buyers
are willing to pay MB
plus the value of the
voucher.
AND HEALTHCARE
2. Market equilibrium is
efficient with 15 million
students enrolled.
3. Price, marginal
social benefit, and
marginal cost are
equal.
4. Tuition equals the dollar
price of $10,000 plus the
value of the voucher.
AND HEALTHCARE
Economic Problems in Healthcare Markets

Healthcare is two distinct products:
1. Health insurance—insurance that pays healthcare
bills
2. Health-care services—the services of healthcare
professionals and hospitals.
With no government intervention, both health insurance
and healthcare services would be underprovided.
AND HEALTHCARE
Reasons for Underprovision in Healthcare Markets
Positive consumption externalities arise from the
provision of public sanitation systems and vaccination
programs.
People who get a flu shot protect not only themselves
but everyone with whom they come into contact.
The marginal social benefit of flu shots exceeds the
marginal private benefit.
The efficient quantity of flu shots exceeds the quantity
that an unregulated market would provide.
AND HEALTHCARE
Public health consumption externalities are not the main
reason why healthcare markets underprovide.
The main reason is that health insurance markets suffer
from an asymmetric information problem.
People know more about the risk they impose to an
insurance company than the insurer knows, and …
doctors know more about the treatment that should be
prescribed and its cost than the insurance company
knows.
The result is an underprovision of health insurance.
AND HEALTHCARE
The young and healthy don’t insure.
Those who have the highest chance of making claims
buy insurance, so insurance premiums are high and the
aged and the poor get priced out of the market.
Also, people with pre-existing health issues find it
difficult or impossible to get insurance.
Also those who do get care get very good and
extremely costly care.
The costs keep rising as the population ages and
healthcare technology advances.
AND HEALTHCARE
A Reform Idea
Healthcare in the United States faces two problems:
Too many people are uninsured and healthcare costs
too much.
Obama Affordable Care Act addresses the first of these
problems but does little to address the overexpenditure.
A solution to both the problems is to use healthcare
vouchers to ensure universal coverage and put a cap
on total expenditure.
The Problem
Earth’s average
temperature is
rising and so is…
the amount of
carbon dioxide,
CO2, in the
atmosphere.
The figure shows
these upward
trends.
China, the United
States, and Europe
create 54 percent of
carbon emissions and
another eight large
emitters create a further
25 percent.
On current trends, by
2050, three quarters of
carbon emissions will
come from developing
economies.
On current trends, by
2100, the temperature
will have increased by
3°C to a level that
brings extreme weather
and widespread coastal
flooding.
Economist Nicholas Stern, principal
author of The Stern Review on the
Economics of Climate Change, says
that carbon emission is “the greatest
market failure the world has ever
seen.”
And to avoid the risk of catastrophic
climate change, the upward CO2 trend
must be stopped.
Most economists agree with Stern and
favor action.
Coping with the Problem
At the 2015 UN climate change conference,
197 countries agreed to:
1. Limit greenhouse gases emitted by human activity.
2. Keep global temperatures “well below” 2°C above
pre-industrial levels.
3. Rich countries to pay $100 billion a year to help
poorer countries move straight to renewables.
4. Review each country’s voluntary contribution to
cutting emissions every five years.
If carbon emissions are to be cut, incentives must
change.
The cost of carbon-emitting activities must rise and the
cost of alternative clean-energy technologies must fall.
Disagreement centers on how to change incentives.
Should countries use carbon taxes or cap emissions and
introduce carbon trading?
Should clean energy and the research to develop new
green technologies be subsidized?
For example, Americans pay a much lower gas tax than
Europeans pay.
The figure shows the stark difference between the United
States and the United Kingdom.
Why is Not More Being Done?
Four reasons are:
1. Developing economies want low-cost energy and
coal is an attractive choice for them.
2. Getting global agreement is hard.
3. The costs are certain and are borne now while
most of the benefits come in the future.
4. Technology is advancing and the cost of cleaner
energy is falling, so a temptation is to rely on this
trend continuing.
Considering costs and benefits,
Bjørn Lomborg, author of The
Skeptical Environmentalist,
says that
“For little environmental
benefit, we could end up
sacrificing growth, jobs, and
opportunities for the big
majority, especially in the
developing world.”

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Copyright © 2018, 2015, 2013 Pearson Education, Inc.

All Rights Reserved

1 Explain why negative externalities lead to inefficient

2 Explain why positive externalities lead to inefficient

An externality is a cost or a benefit that arises from:

Four types of externalities:

Negative Production Externalities

Negative Consumption Externalities

Private Costs and Social Costs

Marginal social cost is the marginal cost incurred by

Figure 9.1 shows the

When output is 4 million

Production and Pollution: How Much?

4. The efficient quantity is

5. The gray triangle

Fixing the Inefficient Overproduction

Establish Property Rights

To see how property rights can work, suppose the paint

The Coase Theorem

Application of the Coase Theorem

Mandate Clean Technology

Tax or Cap and Price Pollution

Figure 9.4 shows

The supply curve

The market in permits determines the equilibrium price

Private Benefits and Social Benefits

Marginal social benefit is the marginal benefit

2. Marginal external benefit

3. Marginal social benefit is

5. The gray triangle

Government Actions In the Face of External

Public provision is the production of a good or

3. The market equilibrium

Economic Problems in Healthcare Markets

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