1. Externalities
April 22, 2013

2. Announcements
• Homework 3 is due; pass to aisle!
• I have old problem sets in my office if you
didn’t pick them up last week.
– Friday 12:30-2:30 SEQ 236

3. Last Time
• Finished discussion of game theory with
refinements.
• If you were not in class on Friday, please
please talk to somebody who was.

4. Externalities
• External benefit: a benefit of an activity received by people
other than those who pursue the activity.
– Also know as: positive externality
– Example: bee farm next to apple orchard, antibiotic use
• External cost: a cost of an activity that falls upon people other
than those who pursue the activity.
– Also known as: negative externality
– Example: polluting factory, antibiotic use

5. Positive Externality
Antibiotic Use
P
Q
S
D
D+XB

6. Negative Externality
Antibiotic Use
P
Q
S
DD-XB

7. Consumption and Production
Externalities
• The last two slides showed consumption externalities—
external costs or benefits that arose from the consumption of
a good or service.
– Typically modeled as a shift in the demand curve.
• There are also production externalities—external costs or
benefits that arise because of the production of a good or
service.
– Typically modeled as a shift in the supply curve.

8. Examples of Production Externalities
• Bee keepers who
produce honey also
benefit the owners of
fruit orchards.
• Production processes
that pollute the
environment, impose a
cost upon everyone else.
P
Q
S
D
P
Q
S
D

9. Does it Matter?
• A good with positive externalities (consumption or
production) will be underproduced.
• A good with negative externalities (consumption or
production) will be overproduced.
• All externalities distort the allocation of resources in
otherwise efficient markets—and the individual pursuit of self
interest will not result in the largest possible economic
surplus.

10. The Coase Theorem
• If an outcome is not socially optimal, that means that at least
some people can be made better off without harming
anyone—there’s “cash on the table”.
• This creates an incentive for individuals to take steps to
improve the situation.
• The Coase Theorem: If at no cost people can negotiate the
purchase and sale of the right to perform activities that cause
externalities, then can always arrive at efficient solutions to
the problems caused by externalities.

11. Example
• Suppose Barack likes to play loud music late at night, but it
disturbs his neighbor Mitt. Barack could stop playing music
late at night, but he enjoys doing this. The table below shows
their monthly enjoyment from being at home under different
scenarios.
• Suppose Barack and Mitt can’t negotiate with each other,
what will the outcome be?
Don’t Play Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $10/month

12. Example 1
• Now suppose they can easily negotiate with each other, what
will the outcome be?
• One possibility: Mitt could offer Barack $30 per month to stop
playing music.
Don’t Play Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $10/month

13. Example 2
• Now suppose they can still easily negotiate with each other,
but the law gives Mitt the right to make Barack stop playing
music. What will the outcome be?
• Barack won’t play music.
Don’t Play Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $10/month

14. Example3
• Now it’s socially optimal to NOT play music after 10pm, but
suppose the law still gives Mitt the right to make Barack stop
playing music.
• Will Mitt make Barack stop playing music?
• If the two parties can negotiate, a more likely outcome might
be:
Don’tPlay Music
After 10pm
Play Music
After 10pm
Gains to Barack $50/month $70/month
Gains to Mitt $50/month $40/month

15. The Role of Property Rights
• Compare examples 1 and 3.
– Regardless of whom the law favors, the efficient outcome is
achieved.
– It didn’t matter whether Barack had the right to play music, the
efficient solution was always achieved.
• Compare examples 1 and 2
– Laws do matter for the distribution of the surplus.
– When Barack has the right to play music, he’s better off than
when the law requires him to stop playing music.

16. Legal Remedies
• The Coase Theorem tells us that efficient solutions to externalities
can be found when parties can easily (at no cost) negotiate with
each other.
• What role do laws play in dealing with externalities?
• Is there any need for government intervention?