Chapter 12: Externality

References:
–
–
–
1
Advanced Level Microeconomics, LAM pun-lee, CH
17
A-Level Microeconomics, CHAN & KWOK, CH 17
HKALE Microeconomics, LEUNG man-por, CH 18
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pareto-optimal Condition

Pareto-optimal condition is a state where:
–
–
2
it is no longer possible to reallocate the use
of resources so that one individual will gain
without loss to another
Product P = MUV = MC
CH12-Externality/Ver 2004
Mr. LAU san-fat
Market Failure

If the market is allowed to function
without any intervention, market failure
means
–
–
3
the Pareto-optimal condition is not reached
non-market institutions would provide a
more desirable result
CH12-Externality/Ver 2004
Mr. LAU san-fat
Externality
Externality occurs when the decisionmaker does not bear all of the costs or
reap all of the gains from his action
 As a result, in a competitive market too
much or too little of the good will be
produced from the point of view of society.

4
CH12-Externality/Ver 2004
Mr. LAU san-fat
Externality

Positive/Beneifical externality/Social
benefit:
–
5
If the world around the person making the
decision benefits more than he does, then
the good will be underconsumed and
underproduced by individual decision
makers.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Externality

Negative/Harmful externality/Social cost:
–
6
if the costs to the world exceed the costs to
the individual making the choice (pollution,
crime) then the good will be overconsumed
and overproduced from society's point of
view.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Private Cost vs. Social Cost
Private cost measures the value of the
highest-valued alternative uses of the
resources available to the decision maker
 Social cost measures the value of the
highest-valued alternative uses of the
resources available to the whole society.

7
CH12-Externality/Ver 2004
Mr. LAU san-fat
Private Cost vs. Social Cost

External/Spillover/Third-party cost or
harmful externality occurs when one
person's action imposes costs on others
without bearing the cost.
–

8
Social cost = private cost + external cost
The existence of external cost implies
that there is a divergence between
private and social costs.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Private Product vs. Social
Product
Private product measures the value of
the product to the decision maker.
 Social product measures the value of the
product to the whole society.

9
CH12-Externality/Ver 2004
Mr. LAU san-fat
Private Product vs. Social
Product

Social product or spillover/thirdparty/external benefit exists when one
person's action benefits others without
receiving payment.
–

10
Beneficial externality = private product + external
benefits
The existence of external benefit implies
that there is divergence between private
and social products.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Harmful Externality

11
With the existence of negative externality,
the marginal private cost (MPC) is
smaller than the marginal social cost
(MSC), resulting in overproduction.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Harmful Externality
P

MSC
A
Remarks:
–
–
MPC1
–
B
–
MUV
0
12
Qe Q1
Assuming MUV=MR
Qe = Pareto-optimal
output level
QeQ1 = overproduced
amount
AB = divergence
between private and
social costs
Qty
CH12-Externality/Ver 2004
Mr. LAU san-fat
Harmful Externality
P
MSC=MPC2

Traditional solution:
–
MPC1
–
MUV
0
13
Qe Q1
Government
intervention is required
(Pigovian) tax should
be imposed to raise the
MPC up to the level of
MSC and thus
eliminating the excess
output.
Qty
CH12-Externality/Ver 2004
Mr. LAU san-fat
Beneficial Externality
P
MC

Remarks:
–
A
–
B
–
MSP
MPP
0
14
Q1
Qe
Qe = Pareto-optimal
output level
Q1Qe =
underproduced amount
AB = divergence
between private and
social products
Qty
CH12-Externality/Ver 2004
Mr. LAU san-fat
Beneficial Externality
P
MC

Traditional solution:
–
A
–
B
MSP=MPP2
MPP
0
15
Q1
Qe
Government
intervention is required
Subsidy should be
granted to raise the
MPP up to the level of
MSP and thus avoiding
the underproduction.
Qty
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads

B
Assumptions:
–
Road ABD:

A
D

–
Road ACD:

C
16

–
straight but narrow & with
limited capacity
Traveling time: 1 hr
broad & uncrowded but
winding & poorly surfaced
Traveling time: 2 hrs
Average driving time is the
only cost of driving from A
to D
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads
Drivers originally will use Road ABD only
 If traffic increases to the point of
congestion on Road ABD, each road user
will slow down the speed of others, thus
imposing time cost upon one another

17
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads

18
Harmful externality occurs since the
driver only consider his or her private
time cost and ignores the time cost
imposed upon all other drivers, there is a
divergence between private and social
costs.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads
Time(hrs)
Road ABD
Time(hrs)
MC
Road ACD
AC = MC
AC
2
1
0

19
Q1 Q2 Q3
Users
0
Users
At Q1, congestion sets in Road ABD, an extra user
imposes external time cost on all other users, thus the
average time cost will increase
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads
Time(hrs)
Road ABD
Time(hrs)
MC
Road ACD
AC = MC
AC
2
1
0


20
Q1 Q2 Q3
Users
0
Users
With external costs, a road user considers now only the
average time cost instead of marginal time cost
Drivers after Q3 would choose Road ACD, resulting in
the AC in using both roads is the same, 2 hours.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads

Pigou's argument:
–
–
21
The Road ABD should be taxed to force
some drivers to use Road ACD
The diverted users lose nothing as they still
spend two hours to travel on the
uncongested Road ACD
CH12-Externality/Ver 2004
Mr. LAU san-fat
Pigou's Two Roads

Pigou's argument:
–
–
22
For those drivers still using Road ABD
(except for the marginal user) will still gain
as the time saved from being congestionfree is worth more than the amount they are
taxed.
The market fails to achieve the optimal
condition as it is still possible to make
someone better off without hurting others.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Knight's Attack on Pigou

Pigou did not specify the nature of
property rights governing the use of the
roads
–

23
No private property rights to roads
If the road is privately owned, a toll for its
use would be charged, which will be
equal to the difference between the
values of travel times for the two roads.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Knight's Attack on Pigou

24
At the margin, the value of travel time for
Road ACD and the value of travel time
plus the toll for Road ABD will be equal.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery
$

= rental value
W1
MC
MRP
0 Q1
25
Q2
ARP
Fishing
effort
If the fishing ground is
privately owned, the
equilibrium fishing effort is
Q1 and a rental value will
be received as the
TRP(=ARPxQ1)
>TFC(=MCxQ1, given
MC = W1.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery
$

ARP1
W1
MC
MRP
0 Q1
26
Q2
ARP
Fishing
effort
If the fishing ground is
commonly owned, an
individual fisherman will
enter only if the expected
average revenue product
(say ARP1) is larger than
the marginal cost (in
terms of the forgone
alternative earning in
using his or her labor)
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery


27
However, the entering of an extra fisherman
into the fishing ground will reduce the catch of
other fishermen, i.e. they have to bear a
spillover cost in fishing.
With external cost, there is a divergence
between private and social costs, the MRP is
thus less than the ARP.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery
$

Over-fishing
ARP1
W1
MC
MRP
0 Q1
28
Q2
ARP
Fishing
effort

A fisherman will enter the
fishing ground until the
falling ARP equals W1,
TRP equals
TVC(=MCxQ2), then the
rental value becomes
zero, i.e. the rent is
dissipated.
Over-fishing(Q1Q2)
occurs.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery

29
With private property rights, the owner of
the fishing ground has an incentive to
maximize rental value by restricting
fishing up to point at where the MRP
equals MC.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery

30
Question 1: Why are not all the fishing
grounds privatized to eliminate the
problem of negative externality in fishing?
Must overfishing lead to dissipation of
rent? Waste?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Gordon's Fishery
A property may be held in common
because the value of capturing its
potential rent is lower than the cost of
enforcing exclusivity or private property.
 With prohibitive huge transaction costs,
overfishing may be regarded as
economically unavoidable and
constitutes no wastage.

31
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

Ronald Coase assumes:
–
–
32
A farmer and a cattle-raiser share an
unfenced property line
The raiser's cattle eat or damage the
farmer's crops as they stray.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
0
1
2
3
4
0
4
8
12
16

33
MR
($)
TC
($)
0
1
3
6
10
MC
($)
Total
gain
($)
0
3
5
6
6
MG
($)
Total
crop
loss($)
2
0
1
3
6
10
MCL
($)
MSC
($)
6
Question 2: Fill in the table above.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8

34
Question 3: What is the size of herd if the
cattle-raiser ignores the crop damage?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8

35
The herd size is determined when MR = MC =
$4, i.e. four steers
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8

36
Question 4: What is the size of herd if the
cattle-raiser taking the external cost (crop loss)
into account?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8

37
The herd size is determined when MG = MCL =
$2, i.e. two steers
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

38
Question 5: What would possibly be
suggested in dealing with the cattleraising phenomenon?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

With Piguo's analysis:
–
–
–
39
If the cattle-raiser is not liable for the crop
damage, there are too many cattle raised
but too few the crop grow
Resources are misallocated
Government should intervene the market by
imposing taxes and subsidies, or legal
prohibition in order to eliminate the negative
externality.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

Case 1: if the farmer has the right to
restrain the cattle-raiser from damaging
his or her crops,
–
–
40
An exchange of the right allows mutual gains
The cattle-raiser has to compensate the
farmer for buying the right to allow his or her
steers to eat crops
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8

41
Question 6: What is then the optimal size of
herd?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8


42
An extra steer should be raised if its expected
MG  MCL
The optimal size is 2 steers as MG=MCL
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

Case 2: if the cattle-raiser has the right to
impose damage on the farmer,
–
–
–
43
An exchange of the right allows mutual gains
The farmer has to make compensation
(equals the forgone MG for not raising a
steer) to the cattle-raiser for buying the right
to avoid damage by reducing the herd size
By doing so, the farmer's marginal gain
equals the saved MCL.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8

44
Question 7: What is then the optimal size of
herd?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
Herd
size
TR
($)
MR
($)
TC
($)
MC
($)
Total
gain
($)
MG
($)
Total
crop
loss($)
MCL
($)
MSC
($)
0
1
2
3
4
0
4
8
12
16
0
4
4
4
4
0
1
3
6
10
0
1
2
3
4
0
3
5
6
6
0
3
2
1
0
0
1
3
6
10
0
1
2
3
4
0
2
4
6
8


45
Compensation should continue to be made if
the saved MCL  MG,
The optimal herd size is 2 steers as the saved
MCL = MG CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

46
Question 8: What happen if the farmer
and the cattle-raiser jointly own the land
for crop-farming and cattle-raising?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer
For joint ownership of a property, the
incentive to maximize wealth will
guarantee that an efficient allocation of
resources.
 This is simply because the decision of
either party will take the external cost into
account, i.e. the third party cost now is
internalized, eliminating the divergence
between private and social costs.

47
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

48
Question 9: Suppose that the farmer has
the right to restrain the cattle-raiser from
damaging his or her crops. The raiser
may choose to compensate the farmer or
erect fences to prevent his or her steers
from straying. Will the cattle-raiser
always choose to compensate?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Story of Cattle-raiser & Farmer

49
The cattle-raiser will choose to
compensate if the value of crop loss is
smaller than the cost of erecting fences;
vice versa.
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Coase Theorem

If property rights are well-defined and
transaction costs are zero, then
1.
2.
50
the allocation of resources will be identical,
regardless of the initial assignment of
property rights; and
the allocation of resources will be efficient,
so there is no problem of externality
CH12-Externality/Ver 2004
Mr. LAU san-fat
Coase's Insights



51
With the existence of externality, there
are potential gains from exchange.
Contractual re-arrangements allow the
market participants to capture these
gains
The initial assignment of property rights
will affect only income distribution
CH12-Externality/Ver 2004
Mr. LAU san-fat
Coase's Insights

52
With positive transaction costs in reality,
however, there is still no inefficiency
even if the output level exceeds the
optimal level because the saved
transaction costs are greater than the
potential gains from re-arranging
contractual arrangement.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Coase's Insights



53
We should consider both the total and
marginal effects of different social
arrangements for solving the problem of
externality
We should not just compare a state of
free market to some kind of ideal world
(without transaction costs)
Externality is reciprocal in nature
CH12-Externality/Ver 2004
Mr. LAU san-fat
Cheung's Elaboration

Two categories of transaction costs:
1.
2.
54
Those incurred in operating an institutional
arrangement
Those incurred in adopting or changing an
institution
CH12-Externality/Ver 2004
Mr. LAU san-fat
Cheung's Elaboration

Two sets of costs restraining institutional
change:
1.
2.
55
Those associated with information
gathering about alternative institutional
arrangements.
Those of persuading those members of
society whose real income would be
reduced by the change.
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Nature of Externality




56
Externality is universal and pervasive.
Externality is reciprocal in nature.
Externality arises from inadequate
definition of property rights
Externality implies the existence of
excessive transaction costs
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Role of Government


57
The basic role of the government is to
define clearly the property rights to
scarce resources and to protect and
uphold firmly the private property rights.
Government intervention should be
employed to correct externalities only if
her cost is less than that of employing
other social arrangements.
CH12-Externality/Ver 2004
Mr. LAU san-fat
Possible Solutions to
Externality
1.
Government intervention
–
–
–
–
–
58
Taxation and subsidization
Restricting output levels
Removing the firm to other location
Establishing public ownership
Defining or granting property rights and let
the market operate
CH12-Externality/Ver 2004
Mr. LAU san-fat
Possible Solutions to
Externality

59
Question 10: What are the possible
problems for having government
intervention in tackling the problem of
externality?
CH12-Externality/Ver 2004
Mr. LAU san-fat
Possible Solutions to
Externality

Possible problems with government
intervention:
–
–
60
High costs in identifying the levels of
divergences, calculating the associated
gains & costs in removing industries,
determining the appropriate output level
Government is not all-mighty and may
herself creates externality
CH12-Externality/Ver 2004
Mr. LAU san-fat
Possible Solutions to
Externality
2. Internalization or self-restraint
–
61
With prohibitive transaction costs in making
contractual re-arrangement, it is more
economically to reduce or eliminate the
externality by having self-restraint or
internalization (i.e. equalizing MPC with
MSC by taking the external costs into
account for calculating private marginal
cost).
CH12-Externality/Ver 2004
Mr. LAU san-fat
Possible Solutions to
Externality
3. By merging
–
62
Merging the parties concerned in an
externality by establishing joint ownership
has similar effect with internalization on
enhancing incentive to reduce or eliminate
the third party effect
CH12-Externality/Ver 2004
Mr. LAU san-fat
Possible Solutions to
Externality
4. By doing nothing
–
63
No action should be taken if the cost of
using any social arrangement to remove or
reduce the externality is higher than the
potential benefits.
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Fable of the Bees
The apple-grower's orchard provides
nectar for the beekeeper.
 Since the nectar is not marketed, the
orchard owner does not receive any
payment, resulting in too few trees will be
planted.

64
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Fable of the Bees
On the other hand, the bees in turn
pollinate the apple blossoms.
 Since the pollination service to the applegrower is not paid, resulting in too few
hives will be established.

65
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Fable of the Bees
The reciprocal external benefits illustrate
the problem of market failure and thus
government intervention is supposed to
be the way out.
 However, Prof Cheung found that the
invisible hand functions well for creating
active market dealings governing the
placement of beehives.

66
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Fable of the Bees

67
For plants that require pollination
services for fruit setting but yield little or
no honey, the orchard-owners pay
pollination fees to the beekeepers for the
privilege of having hives placed in their
orchards.
CH12-Externality/Ver 2004
Mr. LAU san-fat
The Fable of the Bees
For plants that yield honey but require no
pollination services, the beekeepers pay
apiary rents to the orchardists for the
right to place their hives in their orchards.
 For plants that yield honey and require
pollination services, no pollination fees or
apiary rents are charged.

68
CH12-Externality/Ver 2004
Mr. LAU san-fat
Further Reference Readings

張五常＜賣桔者言＞
1.
2.
69
如詩如畫的例子
從高斯定律看共產政制
CH12-Externality/Ver 2004
Mr. LAU san-fat