Public Economics
05 Externalities
Dr. Jonathan St¨abler
Masaryk University
Faculty of Economics and Administration
Fall 2024
Public Economics 5 Externalities Fall 2024 1 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 1 / 30
Introduction
Definition externality: An action by a firm or consumer that affects other firms or
consumers but is not accounted for in the price mechanism.
▶ Negative externality: A cost is imposed on a third party without compensating
them.
→ Oversupply of such goods.
Examples: air, water, or soil pollution; noise; smoking; road usage: traffic
congestion
▶ Positive externality: A benefit is received by a third party without receiving a
financial reward.
→ Undersupply of such goods.
Examples: beautification of building facades; oil exploration on public land;
spendings on research and development
Public Economics 5 Externalities Fall 2024 2 / 30
Negative Externalities: Example SUV
The consumption of large cars such as SUVs produces three types of negative
externalities:
▶ Environmental externalities: SUVs need more gas than compact cars (or public
transports).
▶ Wear and tear on roads: Larger cars wear down the roads more.
▶ Safety externalities: The odds of having a fatal accident quadruple if the accident is
with a typical SUV and not with a car of the same size.
Public Economics 5 Externalities Fall 2024 3 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 3 / 30
Market Failure due to Externalities
Example:
▶ Steel mill discharges wastewater into a river, while downstream, fisherman are
catching fish.
▶ Wastewater is a byproduct of steel production.
▶ Wastewater reduces the fish population.
▶ Now, fishermen must fish longer to catch the same amount of fish.
Public Economics 5 Externalities Fall 2024 4 / 30
Marginal Costs and External Costs
▶ Private Marginal Costs (PMC)
= The additional cost incurred to produce one more unit of a good or service.
▶ External Marginal Costs (Marginal Damage MD)
= The additional costs incurred by the fishermen when the steel mill produces one
additional unit.
▶ Marginal Social Costs
= Marginal Costs (MC) + Marginal Damage (DM)
Public Economics 5 Externalities Fall 2024 5 / 30
Market Failure due to Negative Externalities
Source: Gruber (2005)
Result: The private market equilibrium (point A, Q1) leads to overproduction compared to the
socially optimal level (point C, Q2).
Public Economics 5 Externalities Fall 2024 6 / 30
Market Failure due to Positive Externalities
▶ Not all externalities are negative. There are positive externalities, where
production benefits others without compensation to the producer.
▶ Example: Oil exploration on public land.
−→ The first company to explore increases the chances of finding oil for other companies,
creating a positive externality.
▶ Positive production externality: The social marginal cost (SMC) of exploration is
lower than the private marginal cost (PMC), as exploration benefits other firms.
Public Economics 5 Externalities Fall 2024 7 / 30
Market Failure due to Positive Externalities
Source: Gruber (2005)
Result: The private market equilibrium (point A, Q1) leads to underproduction compared to the
socially optimal level (point B, Q2) since the first explorer is not compensated for the benefits it
generates.
Public Economics 5 Externalities Fall 2024 8 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 8 / 30
Remedies for the Problem of Externalities
Internalizing an externality means incorporating external costs or benefits into the
decision-making of those responsible.
Possibilities:
▶ Taxes or fines
▶ Subsidies
▶ Regulations
▶ Tradable Permits
Goal: Align private actions with public welfare by making parties accountable for social
costs or benefits.
Public Economics 5 Externalities Fall 2024 9 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 9 / 30
Corrective (Pigouvian) Taxation
▶ Corrective taxation can internalize externalities when private markets fail to do so.
▶ Example: Steel production.
▶ The government levies a tax equal to the marginal damage (MD) per unit of steel
produced.
▶ Effect of the tax:
▶ Shifts the private marginal cost (PMC) upward to align with the social marginal cost
(SMC).
▶ Leads to the socially optimal outcome (quantity Q2, point B) by reducing production
to the efficient level.
▶ Pigouvian taxation: Named after A.C. Pigou, this approach addresses externalities
by making producers account for the social costs of their actions.
Public Economics 5 Externalities Fall 2024 10 / 30
Corrective (Pigouvian) Taxation
Source: Gruber (2005)
Public Economics 5 Externalities Fall 2024 11 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 11 / 30
Subsidies for Positive Externalities
Source: Stiglitz and Rosengard (2015)
Public Economics 5 Externalities Fall 2024 12 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 12 / 30
Pollution Abatement
Pollution Abatement: Reduction or elimination of pollutants released into the
environment.
Example: Technological innovations, which lead to cleaner production processes and
pollution control technologies.
▶ Reducing pollution is costly (marginal costs of pollution abatement).
▶ Reducing pollution creates a social benefit as it decreases the externality (marginal
benefit of pollution abatement).
▶ Giving a fine for every quantity of pollution introduces an incentive to reduce
pollution.
▶ Subsidizing pollution abatement introduces a private benefit of pollution abatement.
Public Economics 5 Externalities Fall 2024 13 / 30
Fines and Pollution Abatement
Source: Stiglitz and Rosengard (2015)
▶ Set a fine f ∗ equal to the marginal social cost of pollution (marginal benefits of
pollution abatement) to achieve a pollution abatement level of P∗.
▶ Efficient level can be achieved (similar to Pigouvian taxation).
Public Economics 5 Externalities Fall 2024 14 / 30
Pollution Abatement Subsidies
Source: Stiglitz and Rosengard (2015)
Alternatively, subsidize pollution abatement such that the marginal private benefit of
pollution abatement equals the the marginal social benefit of pollution abatement to
achieve Qe.
Public Economics 5 Externalities Fall 2024 15 / 30
Subsidizing Pollution Abatement
Source: Stiglitz and Rosengard (2015)
▶ Subsidy decreases social costs, as Qm − Qe > QS − Q0.
▶ Subsidies reduce pollution but still lead to overproduction (QS − Q0), as firms don’t
account for full social costs (which include the subsidy itself).
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Pollution Abatement Conclusion
▶ Firms have little incentive to reduce pollution without penalties or subsidies, leading
to underinvestment in pollution abatement.
▶ Fines and subsidies for pollution abatement can reduce pollution by lowering the
total marginal social cost of production.
▶ However, subsidies do not address the full social cost of production, leading to
overproduction (Qs > Q0).
▶ Firms prefer subsidies over fines as they increase profits, but fines are more efficient,
as they force firms to internalize the true social costs of their actions.
▶ A well-designed subsidy scheme may reduce distortions but remains less efficient
than fines.
Public Economics 5 Externalities Fall 2024 17 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 17 / 30
Regulations
Traditional Regulation: Governments have relied on direct regulation to reduce
externalities.
Examples:
▶ Emission standards/ caps for automobiles (and other products).
▶ Regulations on toxic chemical disposal.
▶ Smoking bans on flights.
▶ Restrictions on fishing and hunting to manage common resources.
+ Advocates argue regulations provide certainty in pollution limits.
− Critics highlight inefficiencies:
▶ Regulations may not account for varying marginal costs of abatement.
▶ No incentive to reduce pollution below set standards.
Public Economics 5 Externalities Fall 2024 18 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 18 / 30
Coase Theorem
Coase Theorem (Part I): When there are well-defined property rights and costless
bargaining, then voluntary negotiations between the party creating the externality and
the party affected by the externality will lead to efficiency.
Coase Theorem (Part II): The efficient quantity for a good producing an externality
does not depend on which party is assigned the property rights, as long as someone is
assigned those rights.
[[Watch Video]]
Public Economics 5 Externalities Fall 2024 19 / 30
Example Coase Theorem
Example: Individual X has a car worth $3000 to her, individual Y values the car with
$4000.
▶ Socially efficient if individual Y owns the car.
▶ We don‘t need the law to allocate the car to Y.
Case 1: Y owns the car.
▶ No reason for X to buy the car. −→ Efficient allocation.
Case 2: Y owns the car.
▶ Clear incentive for Y to buy it, Y ends up with the car. −→ Efficient allocation.
Regardless of who owns the car first (who gets allocated the property rights), we
get to the efficient outcome due to voluntary negotiations.
−→ The key: lack of transaction costs.
Public Economics 5 Externalities Fall 2024 20 / 30
Example Coase Theorem
Example: Individual X has a car worth $3000 to her, individual Y values the car with
$4000.
Coase theorem is about efficiency, not distributional justice (inequality):
▶ If Y starts with the car, she doesn‘t have to pay for it.
▶ If X starts with the car, Y has to pay $3000 to X to buy the car
▶ It matters for individual payoffs, who starts with the car.
▶ It does not matter for efficiency (sum of individual payoffs), as Y will always end up
with the car.
Public Economics 5 Externalities Fall 2024 21 / 30
Example Coase Theorem
Example: You want to have a party in the house next door to mine.
▶ If it‘s efficient for you to have the party...
▶ Your benefit from having the party is higher than my benefit from a good night‘s sleep.
▶ If you start out with the right to have the party, no problem.
▶ If I start out with the right to quiet, you can pay me for the right to have the party.
▶ If it‘s efficient for you not to have the party...
▶ Good night sleep is worth more to me than for you to have the party.
▶ If I start with the right to silence, no problem.
▶ If you start with the right to party, I can pay you to not have it.
−→ Independent of what is efficient, we achieve efficiency through voluntary
negotiations.
−→ Regardless of who started with the right.
Public Economics 5 Externalities Fall 2024 22 / 30
Conditions for the Coase Theorem
▶ Property rights have to be well-defined.
−→ We need to be clear on who has what rights, so we know the starting point for
negotiations.
▶ Property rights need to be tradable.
−→ We need to be allowed to sell/transfer/reallocate rights if we want to.
▶ No transaction costs.
−→ It can‘t be difficult or costly for us to buy/sell the right.
Public Economics 5 Externalities Fall 2024 23 / 30
The Coase Theorem
Coase Theorem (Part I): When there are well-defined property rights and costless
bargaining, then voluntary negotiations between the party creating the externality and
the party affected by the externality will lead to efficiency.
Coase Theorem (Part II): The efficient quantity for a good producing an externality
does not depend on which party is assigned the property rights, as long as someone is
assigned those rights.
−→ Initial allocation of rights does not matter to reach efficiency.
−→ Initial allocation of rights matters for distribution (inequality).
Public Economics 5 Externalities Fall 2024 24 / 30
Coasian Payments
Coasian payments equal the damage of each produced quantity of the externality.
▶ If price is above MD, individuals would want to sell an extra unit of the externality,
so price must fall.
▶ MD is the equilibrium efficient price in the newly created externality market.
Public Economics 5 Externalities Fall 2024 25 / 30
Problems with Coasian Solution
In practice, the Coase theorem is unlikely to solve many of the types of externalities that
cause market failures:
1. The assignment problem: In cases where externalities affect many agents (e.g.,
global warming), assigning property rights is difficult.
2. The holdout problem: Shared ownership of property rights gives each owner power
over all the others (because joint owners have to all agree to the Coasian solution).
3. Transaction Costs and Negotiating Problems: it is hard to negotiate when
there are large numbers of individuals on one or both sides of the negotiation.
Public Economics 5 Externalities Fall 2024 26 / 30
Outline of Lecture
1. Definition Externality
2. Market Failure due to Externalities
3. Public Sector Remedies
3.1 Taxes
3.2 Subsidies
3.3 Fines and Subsidies for Pollution Abatement
3.4 Regulations
4. Tradable Permits as a Remedy
4.1 Coase Theorem
4.2 Tradable Permits
Public Economics 5 Externalities Fall 2024 26 / 30
Application of Coase Theorem: Tradable Permits to Reduce
Externalities
Examples: EU Emissions Trading System, water pollution trading programs in the US,
etc. [[Watch video]]
▶ Tradable permits operate under a cap-and-trade system.
▶ A cap limits total emissions; permits are allocated or sold to firms.
▶ Firms can trade permits, allowing flexibility in emissions reductions.
▶ Firms who can reduce pollution most efficiently, reduce their emissions and sell
permits
▶ Firms, for which it is expensive to reduce pollution buy permits.
▶ In equilibrium, firms reduce pollution where marginal cost equals permit price.
Public Economics 5 Externalities Fall 2024 27 / 30
Challenges of Tradable Permits
▶ Initial Assignment Issues:
▶ Assigning permits based on past pollution raises equity concerns.
▶ Alternatives: base on production levels or auction permits.
▶ Governments may issue too many permits, reducing pollution effectiveness.
▶ Geographical Considerations:
▶ Pollution location matters; effects vary by area.
▶ Tradable permits may not address regional pollution disparities effectively.
Public Economics 5 Externalities Fall 2024 28 / 30
Conclusion
When externalities exist, market outcomes are often not efficient.
▶ Coase theorem: Private bargaining can solve externalities, but when many parties
are involved and there are transactions costs, negotiations may fail.
▶ The role of government: When private solutions fail, the public sector can
intervene through:
− Pigouvian taxes: Imposing taxes that align private costs with social costs.
− Subsidies and fines for pollution abatement.
− Regulation: Setting rules to limit harmful externalities.
− Pollution permits: Creating a market for externality rights.
Conclusion: Market forces, when properly redirected, remain powerful tools to address
market failures. Government intervention should complement, not replace, the market.
Public Economics 5 Externalities Fall 2024 29 / 30
Readings for Next Week
6 Public Expenditures
Main Reading: Stiglitz and Rosengard (2015)
▶ Chapter 8: Public Production of Goods and Services (p.199-213)
▶ Chapter 12: Research and Technology (p.345 - 354)
▶ Chapter 13: Health Care (p. 357-371 )
▶ Chapter 14: Education (p.394-407)
Public Economics 5 Externalities Fall 2024 30 / 30
Thank you and see you next week!
Jonathan.Stabler@econ.muni.cz
Public Economics 5 Externalities Fall 2024 30 / 30
References I
Gruber, J. (2005). Public Finance and Public Policy, Worth Publishers.
Stiglitz, J. E. and Rosengard, J. K. (2015). Economics of the public sector (4th edition).
Public Economics 5 Externalities Fall 2024 30 / 30