Pollution and Spillover Costs Review for AP Economics

By — McGraw-Hill Professional
Updated on Mar 2, 2011

Review questions for this study guide can be found at:

Public Goods, Externalities, and the Role of Government Review Questions for AP Economics

Main Topics: Spillover Costs and Negative Externalities

Another kind of market failure occurs when there are additional costs associated with production of a good that are not reflected in the market price. Pollution of all kinds is a classic example.

Spillover Costs

Almost anyone who has dined at a restaurant has experienced secondhand smoke. Even a nonsmoker sitting in the nonsmoking section expects to come home smelling like an ashtray. While the smoker has chosen to pay the market price of tobacco, the nonsmoker also pays a price for that choice, either in minor disutility or worsened health. When one person's consumption of a good imposes disutility on a third party who has not directly purchased the good, there exist spillover coststhat are not reflected in the market price of that good. A situation in which polluters impose costs upon third parties is called a negative externality.

The existence of spillover costs from a negative externality means that not all of the costs of production are captured by the supply curve. In the Midwest, the burning of coal produces most electricity. The private cost of electricity production includes the coal, the labor, and capital at the plant. But the burning of coal imposes environmental costs in the form of air, water, and land pollution. These societal costs are not found in the market price (Pmkt) of booting up your PC or running the dishwasher. The difference between the private cost and the societal cost of producing electricity is seen in Figure 11.4. The private supply curve, which does not include the spillover costs, lies below the societal supply curve. The market produces Qmkt units of electricity, but the optimal amount is less at Qsocial. Because the market produces more than the socially optimal amount, it is said that there is an overallocation of resources to electricity production. In other words, society wants less than the market provides.

  • The existence of spillover costs in a market results in an overallocation of resources in that market. In other words, there is too much of a bad thing.

So how could cigarette smokers alleviate the discomfort that they impose upon their nonsmoking citizens? The aim of any such policy is to try to move the spillover costs away from the third party victims and back upon those who produce the externality.

Pollution and Spillover Costs

Pollution Taxes

Rather than allow the spillover costs to fall externally on members of society, the goal of pollution taxes is to internalize these costs by imposing a tax on the production or consumption of goods that create negative externalities. Our goal is to move the market equilibrium quantity closer to the socially optimal quantity of electricity. Suppose government imposes a tax, equal to the spillover cost, on every unit of coal that our power plant uses to produce electricity. This pollution tax results in an inward shift of the private supply curve so that it equals the social supply curve. See Figure 11.5. The price of using your PC has now increased, but now that price incorporates all of the costs of electricity, including the effects of pollution on the environment and human health.

In some cases, a tax may be imposed on consumers, if they are responsible for the negative externality. For example, in major metropolitan areas traffic is a serious problem and millions of commuters create significant amounts of pollution. We might increase the automobile registration tax, or create a system of toll highways so that the users of automobiles and the commuters themselves must pay an additional price for that behavior. We have seen that any time the price increases, quantity demanded (driving) must fall.

Be carefulwhen designing a tax to remedy a negative externality. We must tax those who are imposing the spillover costs on society. Would you tax the nonsmoker to fix the problem of secondhand smoke? Hardly.

Pollution and Spillover Costs

Review questions for this study guide can be found at:

Public Goods, Externalities, and the Role of Government Review Questions for AP Economics

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