Lecture 4

Externalities

Byeong-Hak Choe
bchoe@geneseo.edu

SUNY Geneseo

September 5, 2025

Externalities

What is an Externality?

  • An externality is a side effect of a market transaction—positive or negative—that affects the well-being of people who are not directly involved as buyers or sellers.
    • Negative externality: imposes costs on others (e.g., air pollution from autos).
    • Positive externality: confers benefits on others (e.g., tree planting—amenity value, carbon uptake, habitat).
  • Comprehensive analysis must account for all members of society (and possibly ecosystems), not only buyers and sellers.

Tip

Key idea: Markets maximize total surplus only when all marginal costs and benefits are internal to decision‑makers.

The Market for Automobiles

  • Supply curve ≈ PMC: private marginal cost of producing one more unit (labor, materials, energy, etc.).
  • Demand curve ≈ PMB: private marginal benefit (consumers’ willingness‑to‑pay for one more unit).
  • Market equilibrium \((P_{M}, Q_{M})\) is efficient only if PMC = SMC and PMB = SMB (i.e., no externalities).

Accounting for Environmental Costs

  • Auto production & use create multiple negative externalities: local/regional air pollution, CO₂, water contamination, toxic wastes, habitat loss, road salt runoff, congestion.
  • These costs do not appear in the private supply curve; hence market overstates net social benefits at \((P_{M}, Q_{M})\).
  • We must internalize external costs to evaluate the market’s true impact.

EPA Endangerment Finding on GHG Emissions

  • Proposal Date: July 29, 2025 — EPA formally proposed rescinding the 2009 Greenhouse Gas (GHG) Endangerment Finding (US EPA).
  • Statutory Impact: Without the Endangerment Finding, EPA would lose authority under CAA §202(a) to regulate GHG emissions from motor vehicles (US EPA; Wikipedia).
    • CAA §202(a) is the EPA’s authority to regulate tailpipe pollution from new vehicles when it threatens public health or welfare.
  • Regulatory Effect: Proposal includes removal of GHG standards for light-, medium-, and heavy-duty vehicles and engines (US EPA).
  • What Remains: Standards for criteria pollutants, toxic emissions, corporate average fuel economy (CAFE), and labeling will not be changed(US EPA).

EPA Endangerment Finding: Process & Reactions

  • Public Hearing & Comment Period:
  • Deregulatory Framing:
    • The proposal is presented as part of a broader deregulatory agenda, hailed as one of the largest in U.S. history (US EPA).
    • EPA claims the repeal could save Americans $54 billion annually and $170 billion for small businesses (US EPA).
  • Criticisms:
    • Critics argue the rule ignores scientific consensus and is legally weak, potentially dismantling key rules and safeguards designed to protect against climate change (The Washington Post).

Valuing Damages

  • Assign monetary values to external harms to build SMC:
    • Direct costs (e.g., water treatment for contaminated sources).
    • Health damages (medical expenses, morbidity, mortality risk).
    • Aesthetic/amenity losses (visibility, recreation quality).
    • Ecosystem impacts (biodiversity, habitat quality).
  • If we assign no value, the market implicitly assigns zero—biasing decisions.

Warning

Valuation aggregates tangible and intangible impacts; precision is hard, but order‑of‑magnitude estimates guide better policy than zeros.

The Market for Automobiles with Negative Externalities

  • SMC = PMC + EMC, where EMC is the external marginal cost.
  • Typically, EMC rises with output when pollution/congestion intensify.
  • SMC lies above PMC by the vertical distance equal to EMC.

Internalizing Environmental Costs

Automobile Market with Pigovian Tax

  • Impose a per‑unit tax \(t\) equal to EMC at \(Q^{*}\).
  • Effect: raises firms’ marginal private cost so the effective supply coincides with SMC.
  • New equilibrium: \((P^{*}, Q^{*})\)—the socially efficient outcome.

Practical Design Choices

  • Set the right tax: Requires damage estimation (economics + science).
  • Administrative cost vs benefit: Not every small externality warrants a bespoke tax.
  • Upstream taxes: Levy at raw inputs (fossil fuels, toxic chemicals, ores) to simplify coverage; costs ripple downstream to products according to input intensity.
  • Revenue recycling: Use proceeds for rebates, tax credits, rate relief, or public goods to address equity/political feasibility.

Incidence & Elasticities

  • Tax burden split depends on price elasticities of supply and demand.
  • Steeper (less elastic) side bears more burden.
  • Common claim “firms pass it all on” is generally false; division is empirical.

Distributional Concerns

  • Many environmental taxes (e.g., on fuels) can be regressive.
  • Policy package can include lump‑sum rebates, earned income credits, or targeted transfers to protect low‑income households.

Tip

A 2013 estimate put global primary‑industry externalities near $7.3T (~13% of world output); in magnitude, comprehensive Pigovian systems could rival global tax revenues—raising ideas of tax swaps. (Use with caution; orders of magnitude, not precise policy blueprints.)

Positive Externalities

The Market for Solar Energy with Positive Externalities

  • SMB = PMB + EMB, where EMB is external marginal benefit.
  • Examples: solar panels (emissions reductions), vaccinations, R&D spillovers, urban trees.

The Market for Solar Energy with a Subsidy

  • A producer subsidy of \(s\) per unit lowers effective marginal cost (downward supply shift).
  • A consumer subsidy / tax credit raises effective willingness‑to‑pay (upward demand shift).
  • Correct subsidy aligns the market with \(Q^{*}\) where SMC = SMB.

Welfare Analysis of Externalities

Welfare Analysis of the Automobile Market

  • Consumer Surplus (CS): Area under demand and above price.
  • Producer Surplus (PS): Area above supply (PMC) and below price.
  • Without externalities, equilibrium maximizes CS + PS.

Welfare Analysis of the Automobile Market with Externalities

  • With a negative externality, true net social welfare is: \[ \begin{align} &\quad\;\; \text{NSW}\\ \,&=\, (\text{CS} + \text{PS}) \\ &\;\,- \text{External Damages}. \end{align} \]
  • External damages are the area between PMC and SMC up to the chosen quantity.

Pigovian Tax Improves Welfare

  • Set tax so that the equilibrium moves to \(Q^{*}\).
  • Tax revenue equals the external damages at \(Q^{*}\) (rectangle D): revenue can compensate for damages.
  • Net social welfare becomes A’’ + B’‘, which equals A’ + B’; hence welfare rises by C relative to the unregulated outcome.

Optimal Pollution

  • Zero pollution generally implies zero production; instead, economists seek the efficient (not necessarily zero) level of pollution given current technology and preferences.
  • The Pigovian tax yields optimal (residual) pollution—the remaining damages at \(Q^{*}\).
  • Caveat: If demand shifts right (e.g., autos more valued), the efficient pollution level can rise—raising questions about science‑based caps vs pure efficiency.

Warning

Policy practice often sets health‑based standards (e.g., the Clean Air Act) and then uses market instruments to achieve those standards cost‑effectively.