• The effect of a market action on someone
outside of the market
• A transaction spillover
• A cost or benefit not transmitted through
prices affecting someone who did not agree to
the action that caused the effect
• It is a market failure
– Negative Externality
• Hurts someone outside of the market
– Positive Externality
• Helps someone outside of the market
• Example of negative externalities
– Exhaust from cars
– A loud barking dog
– An unmowed yard
• Examples of positive externalities
– Vaccinations
– Education
– Research in to new technologies
• Producers/consumers do not take into
account their externalities (ie external)
– So government should correct the market failure
• Externalities cause inefficient allocation of
• Remember at efficient point cost = benefit
• In other words value to consumers = cost to
producers if no externality
– That is where supply cross demand
• If an externality exists than true benefit
(value) or cost is not reflected in the
demand/supply curves
• Remember
– View Supply Curve now as cost curve to society (if
no externality)
– View Demand Curve as benefit to society (if no
– We care about society wide gains (benefits/cost)
• Differentiate fairness from efficiency
– Doesn’t matter who pays the cost, it is a cost that
should matter when finding efficient point
– Doesn’t matter who gains, it is a benefit that
should be included when finding efficient point
Market for Coal
Supply (private cost)
Market Equilibrium
Demand (private value)
• But there exists an externality
• Production of coal pollutes local watersheds
• So actual Social Cost is greater than cost of
– Remember welfare is about economy wide effects,
the total to all, not how its split up
• Social Cost
– Cost of production plus
– Cost to clean water ways
• Social cost above the supply curve
Market With Negative Externality
Social cost (private cost
plus external cost)
Supply (private cost)
External Cost
Original Market Equilibrium
Demand (private value)
• In the presence of a negative externality the
optimum point is a quantity lower than the
market produces on its own
• Governments role is to step in and correct the
market failure to maximize welfare
• How
– Tax producers equivalent to the cost of the
– This raises the supply curve to the level of private
cost plus external cost
Tax as Fix To Externality
Social cost (private cost
plus external cost)
Efficient Point =
New Eq. With Tax
Supply (private cost)
Tax = External Cost
This is NOT a DWL. The Tax does not make the market
Inefficient, it fixes an inefficiency.
Demand (private value)
Positive Externality
• When there is a positive externality it means
the market is not making enough of the good.
• The market is inefficient
• There is a benefit which is not incorporated in
the demand curve
• Actual benefit curve to society is above the
demand curve
• To correct the market failure the government
should subsidize the market
Market with Positive Externality
Original Market
Private cost =
social cost
(no negative
External Benefit
Social Benefit =
Private Benefit +
external benefit
Private Benefit
• Government should place a subsidy on the
good equal to the external benefit
• This will increase the market to the efficient
• This does not lead to inefficiency like a subsidy
on a “good” market does
• It fixes an inefficiency due to the market
failure that is the externality
Market Correction Thru Subsidy
Private cost =
social cost
(no negative
These units produce are
NOT inefficient
Original Market
Subsidy =
External Benefit
Social Benefit =
Private Benefit +
external benefit
Private Benefit
• Externalities are Market Failures
– Markets with negative externalities produce more
than the efficient amount
– Markets with positive externalities produce less
than the efficient amount
– Why? Because the market (supply/demand
curves) don’t internalize the external cost/benefit
• Taxes/Subsidies correct the failure, they bring
us to the efficient point
– Taxes shrink the market
– Subsidies expand the market
Focus on Pollution
• How to deal with pollution?
• Maybe “command and control”
– Government tells companies exactly what to do to
limit pollution (like what type of inputs to use, or
what type of process)
– Not efficient
• Maybe use a market based approach (that is
provide an incentive)
– Taxes
– Cap and Trade
Pollution Market
• Pollution is a byproduct of almost every type
of market action
• Without it there could be no production of the
stuff we like to consume
• So we want to think of there being a market
for pollution
• We want to think of the demand/supply curve
in terms of benefits/cost
• Again still looking for efficient point
Market For Pollution Emissions
Cost Curve: The cost
of the pollution. We
have to live with bad
side effects.
Value of
Efficient Point (costs
= benefits)
Benefit Curve: The value of
Polluting. Allows us to
produce things
Efficient Emission Level
• There is no natural market for pollution
• Given no natural market then the price of
pollution is zero
• Producers will emit pollution till the benefit
curve hits the horizontal axis
• This is more emissions than is efficient
(negative externality so more in market than
should be)
• Government has to create the market, or
create the price to reach efficient level
– Problem of having the information to know what
the benefit/cost curves look like, because need
these to find efficient price or efficient quantity
• Can do this two ways
• Price the pollution
– That is tax pollution at the level of the EQ point
• Limit the pollution level
– That is Cap the emissions at the level of the EQ pt
• Tax or Cap should be set at efficient level
– How to find these? Ask and economist.
• Either way leads to same outcome
• Tax
– Government prices pollution and market finds level of
• Cap and Trade
– Government sets pollution level and market finds
price of polluting (Like a market with perfectly
inelastic Supply Curve)
Resulting Price/Quantity the same under both
Cap and Trade
price of
Market decide Quantity
• Notice the efficient level of pollution is not
• We do “want” some pollution – it allows us to
make the things we want
• But we want an efficient level of pollution
– Costs = Benefits
• Government must create market because it
does not naturally exist
• The Tax or Cap-and-Trade does not distort the
market, it fixes the market failure

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