NPTEL-Economics-Public Economics

Module 3
EXTERNALITIES
Lecture (8 -14)
Topics
3.1 Externalities
3.2 Definition
3.3 Policy Questions
3.4 Revealed Preference Approach to Measuring the Size of
Externalities
3.5 Economics of Negative Production Externalities
3.6 Production Externality
3.7 Negative Production Externalities
3.8 Positive Externalities
3.9 Externalities and DWL
3.10 Private Solution (Coase Theorem)
3.11 Coarse Theorem Symmetric Solution
3.12 Problems with Coasian Solutions
3.13 Public-Sector Remedies for Externalities
3.14 Corrective Taxation
3.15 Subsidies
3.16 Pigouvian Tax/Subsidy
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3.17 Regulation
3.18 Price vs. Quantity Approach
3.19 Model of Pollution Reduction
3.20 Two Firms Emit Pollution
3.21 Price vs. Quantity Approach
3.22 Assigning Permits
3.23 Policy Without Uncertainly
3.24 Optimal Policy With Uncertainly
3.25 Price vs. Quantity Approach
3.25.1 Optimal Policy with Uncertainty

3.26 Weitzman:Uncertainty About Benefits

3.27 Recap of Externalities: Problems and Solutions
3.28 Number of Cigarettes Smoked in the US
3.29 An Application: Economics of Smoking
3.30 The Economics of Smoking
3.31 The Externalities of Smoking
3.32 External Costs
3.32.1

Tax to Offset External Costs

3.33 Should we Care Only About Externalities, or do

Internalities also Matter?
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3.34 Nudge? Implications for Government Policy

3.35 Implications for Government Policy

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Module 3
Lecture 8
Topics
3.1 EXTERNALITIES
Externalities arise whenever the actions of one party make another party worse or
better off, yet the first party neither bears the costs nor receives the benefits of
doing so.
A classic example of market failure
Externalities can be negative or positive
Is government intervention necessary to combat externalities
Under what conditions can private markets solve the problem

AN EXAMPLE
Externality in the case of primary education: should the government intervene?
Why or why not?
Equity grounds
Moral grounds
Efficiency?

Separate from the question of how should

the government intervene public-privatepartnership or voucher or public provision.

Education is classic case of positive externality. Reduces crime, complementarily in

application of knowledge peer effect, health behavior improves etc. That is why we are
not only interested in education of kids from poor families who are interested in
educating their children but also on education of kids from parents who are not interested.
Classic justification for government intervention
Intervention of helping the poor not just from equity/moral point of view but also
possibly from efficiency point of view in the longer run. It increases overall productivity
Hardin's Commons Theory is frequently cited to support the notion of sustainable
development, meshing economic growth and environmental protection, and has had an
effect on numerous current issues, including the debate over global warming. An asserted
impending "tragedy of the commons" is frequently warned of as a consequence for
adopting policies which restrict private property.

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Figure 8.1
Figure 8.1 shows the trend in global warming over the last century.
Although this warming trend has negative effects overall on society, the distributional
consequences vary.
In much of the United States, warmer temperatures will improve agricultural output and
quality of life.
In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea
levels.

3.2 DEFINITION
An externality arises whenever the utility or welfare or production possibility of an
agent depends directly on the actions of another agent.
A negative production externality is when a firms production reduces the wellbeing of others who are not compensated by the firm.
A negative consumption externality is when an individuals consumption reduces
the well-being of others who are not compensated by the individual.
Important distinction between pecuniary vs. non-pecuniary externalities
Pecuniary externalities create third-party effects through
changes in relative prices or asset prices
No direct resource effect like non-pecuniary externalities

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Conventional cost-benefit analysis only for non-pecuniary externalities

3.3 POLICY QUESTIONS

Theoretical: what is the best way to correct externalities and move closer to the
social optimum?
Empirical: how to measure the size of externalities?

3.4 REVEALED PREFERENCE APPROACH TO

MEASURING THE SIZE OF EXTERNALITIES
The revealed preference approach attempts to determine the cost of an externality by
determining how much damage reduces the price of a good.
Revealed preference can also be used to estimate the price people pay for various
protection (defense/ abatement) measures and the effectiveness of those measures. For
instance, insulation costs a certain amount of money and provides a certain amount of
effectiveness in reducing noise. The extent to which individuals then purchase insulation
or double-glazed windows may suggest how much they value quiet. However
individuals may be willing to spend some money (but less than the cost of insulation) if
they could ensure quiet by some other means which they do not control - but which may
be technically feasible.
According to some economists, the valuation of benefits and costs used in Cost benefit
analysis should reflect the preferences revealed by choices which have actually been
made by individuals and businesses in different markets.
Example:
20 employees are given the chance of using a new car park close to work for Rs 5 per
day or parking further away from work for free but involving an extra 10 minutes
walk. Their decisions reveal how much they value time. If they all choose to spend the
Rs 5 per day on car parking, this reveals that time is more important to them than 50p
per minute. If only half take up the car parking option, this reveals that average value of
time to them was 50p per minute. Hard choices made in markets are the best guide to
private benefit.
Information contained in the demand curve tells us much about how much people are
willing and able to pay for something. This is important in revealed preference theory.
When consumers make purchases at market prices they reveal that the things they buy
are at least as beneficial to them as the money they relinquish. However, consider that

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there was another option of taking a bus from the parking that costs less. We would not
know whether people would prefer that to walking.
To recap, cost benefit analysis is basically an appraisal technique that tries to place
monetary values on all benefits arising from a project and then compares the total value
with the project's total cost. It has numerous potential applications although there are
inherent difficulties with the issue of valuation.

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