Externalities
Externality
When the activity of one agent
unintentionally imposes costs on, or brings
benefits to, another agent.
A Negative Externality: Pollution
1. production
1. to production
2. to individual welfare
2. consumption
1. to production
2. to individual welfare
Positive Externalities
1. Bees and fruit trees
2. Neighbor’s garden
3. Vaccination, etc
Analysis of Pollution
• Private cost of production: A cost that is
borne by the producer.
– hired labor
– rental of machines and buildings
– material inputs
• Marginal private cost (MC): Cost of
producing an additional unit that is borne
by the producer.
• Marginal external Cost (MEC): The cost of
producing an additional unit that falls on
other agents than the producer. (i.e. Not
borne by the producer.)
• Marginal social cost (MSC): Marginal cost
of production imposed on whole society.
MSC = MC + MEC
Remark
To add them up, costs must be expressed in
same units.
• Convenient to use $.
• MC: Represents a true social cost in a well
functioning market.
– In LDCs, land, labor, and credit markets often
do not function well. (distortions)
– opportunity cost: value of the inputs in their
best alternative use.
Expressing MEC in $ assumes that external
costs have equivalent $ value.
• Easy in the case of production
externalities.
– lost fish due to river pollution
– lost agricultural output due to Global Warming
– lower value of houses due to polluted river
More complicated in the case of health
effects (scandalous to some)
• But we do it all the time!
– Organic food: too costly for most families
– Safety features in cars: value of life?
– No. of supervisors in kindergarten
– Choice of location within city.
– Doctors decide whether to prolong life or
not.
– Costs of medicines
– Building a school instead of a hospital.
REMEMBER
OPPORTUNITY COSTS
Back to
MSC = MC + MEC
• NB Graphic assumes that MC and MEC
increase with output.
• Unfettered market outcome:
• D measures marginal benefit of coffee
consumption (chap 6)
• External costs are not accounted for.
• Market yields inefficient outcome. Why?
• Social cost of production exceeds MB.
• Calculate deadweight loss.
• …
Some solutions to externalities
Property rights:
Legally established titles to the ownership,
use, and disposal of factors of production
and goods and services that are
enforceable in the courts.
The property rights solution
Example 1
• River with 500 houses and polluting mill upstream.
• Loss of rent: 1000$/house
• Assume: Riverside residents « own » rights to a clean
river.
• Mill must ask for permission to pollute river.
• House owners ask for at least 500000$/m. in
compensation. (Each owner would not accept less than
1000$/m)
• Mill pays to pollute only if benefits from pollution exceed
500000$/m
Efficiency restored
The property rights solution
Example 2
• Jane and Tarzan share office
• Jane’s benefit from smoking: 500$
– i.e. indifferent…
• Tarzan’s loss: 1000$
– i.e. indifferent…
• Nego: Tarzan offers 800$ to Jane for her to stop
smoking in office.
• gains from trade:
– Surplus Jane: 300$
– Surplus Tarzan: 200$
Efficient outcome
• Final allocation : no smoke.
• Q. Are the actual amounts paid relevant to
determine if outcome is efficient or not?
• Q. Why is Tarzan the one to pay?
• Try allocating the right to Tarzan…
The Coase Theorem
If transaction costs are negligible, resource
allocations will be efficient, regardless of
who owns the property rights. The initial
allocation of PR will, however, affect
wealth distribution.
• Right to jane implies +800$ for Jane and 800$ for tarzan, compared to right to
Tarzan. In both cases, there is no
smoking.
Reconsider ex 1
• What if mill can pollute at will?
Important implications
• If people can negotiate freely, direct gvt
intervention is not necessary to achieve
efficiency. All that is required is clear
definition of PR.
– Chicago school (in parts)
– Minimal state?
– laissez-faire economy?
• Q. Have you ever seen someone offer
money to a smoker in a resto?
• …
Transaction costs
• Can block gains from trade.
– lawyer fees
– negotiation failures
– large no of asymmetric parties
– costly enforcement
Sometimes, gvt must intervene to achieve
efficiency.
Remark:
M & A as solution to externalities
1. Mill buys out houses along river.
2. Bees and apple trees
Fundamentals of theory of firms:
contracts vs acquisition
• Why don’t we have one large firm that
produces everything?
–
–
Problems of control: Incentives to be efficient,
improve quality, etc.
Firm size represents a tradeoff between both
elements.
Internalization of externalities
• When previous externalities are now
accounted for, either through contract
nego (market creation), M&A, or other,
more direct, gvt intervention.
• NB M&A will not work in the ex of Tarzan
and Jane. Why? Should they get married?
Direct gvt interventions
•
4 types to consider here:
1.
2.
3.
4.
Command and control
taxes
Effluent charges
marketable permits
Command and Control
• forbid certain activities
• determine max amount of emissions
• Problems:
– No incentives to cut back further. No R&D.
– Restrictions may be too harsh.
Regulator needs a lot of info.
Taxes
• t = tax per extra unit of output
• Set t = MEC at efficient output level.
• graphic…
Emissions charges
• tax/unit of emissions
• Roughly similar to output taxes:
– Higher incentives to adopt cleaner techno.
– Gvt raises revenues while increasing
efficiency. (win-win)
• Economists usually prefer taxes to C&C.
Why?
Taxes are generally more efficient to achieve
same pollution objective.
Emissions charges vs C&C
• 2 firms
• Each 500 t/y of emissions
• Regulator’s objective: reduce total
emissions to 600t/y
C&C
• 300 t/y allowed each
Emissions Taxes
• 50000$/t of emissions
– firm A abates to 200t/y
– firm B abates to 400 t/y
– total still at 600 t/y
– NB Firms have different abatement costs
• Firm A abates more because it can do so
at lower cost.
With taxes, less info is required to achieve
same pollution objective at lower cost.
• Which is more fair?
Marketable Permits
• Problem with taxes: may be difficult to find
right tax level to achieve objective (trial
and error process)
• Marketable permits: Instead of setting a
limit to each individual firm, set global limit,
distribute corresponding permits, and let
firms exchange them.
Marketable Permits
• Give 300t/y of permits to each firm.
• B would save 1m$/y if it could emit 400t/y
• It would cost 0.5m$/y to A to reduce from
300t/y to 200t/y.
• B offers 0.75m$ to A to buy 100t/y of
emissions permits.
• Total pollution unchanged but total cost of
abatement is 0.5m$/y lower.
Marketable Permits
• Advantage over taxes is that there is no
need to know the right tax level to achieve
objective. No trial and error. The market
will determine the price of pollution by
itself.
• Efficient allocation is attained regardless of
initial distribution of pollution rights. (Does
this remind you of something?)
POSITIVE EXTERNALITIES
• private benefit: A benefit that the consumer of a good
receives.
• marginal private benefit (MB): The benefit from an
additional unit of a good or service that the consumer of
that good or service receives.
• external benefit: The benefit from a good or service that
somebody other than the consumer receives.
• marginal external benefit (MEB): The benefit from an
additional unit of a good or service that people other than
the consumer enjoy.
MSB = MB + MEB
Positive externality:
knowledge from education
• MB:
– better salaries
– more interesting job
– satisfied curiosity
(graphic)
knowledge from education
• External benefits:
– better choice of elected gvt
– more effective communication between
people
– more tolerance towards each other
– better citizens (environmental degradation,
crime rates, vandalism, etc)
– more support for higher quality TV, radio,
newspaper
– transfer of knowledge to others (LDCs…)
knowledge from education
1. add MSB curve to graphic
2. add private supply curve
Free market outcome is inefficient.
knowledge from education
• NB Calculation of deadweight loss is
independent of who pays for education. Given
quantity at 150, amount paid affects wealth
distribution but not relevant for efficiency.
• With positive externalities, free markets will
generally provide too little of the good or service.
Opposite of neg. ext.
• Market failures call for gvt intervention (as long
as it does not make things worse, which may be
the case (Chicago school)).
Positive externalities:
ideas
•
•
•
•
•
•
invention of wheel
discovery of medicine (penicillin)
trigonometry
rock music
electricity
light bulb
People often copy ideas of other without
paying for it.
ideas
•
•
Social benefit > private benefit
Free market supplies much too few ideas.
1.
2.
3.
4.
What can the gvt do?
public provision
private subsidies
vouchers
patents
Positive externalities:
gvt solutions
• Public provision: The good or service is
provided by a public authority (stateowned enterprise)
• NB Contrary to book, I’m not sure if it is
relevant to mention which part of revenue
comes from where.
(graphic)
Positive externalities:
gvt solutions
• Private subsidy: A payment by gvt to firms
per unit of output.
(graphic)
Public provision vs Private subsidy
•
•
Both efficient as per your model.
Additional issues concerning education:
1. monitoring of school performance
2. incentives to provide quality education
3. fairness
Positive externalities:
gvt solutions
• Vouchers: A token that gvt gives to
households, which can be used to buy a
specific good or service.
(graphic)
• Reduces problems of fairness and
incentives.
• Our university system?
Positive externalities:
gvt solutions
• Patents and copyrights: A gvt-sanctioned
exclusive right granted to the inventor of a good,
service, or productive process to produce, use,
and sell the invention for a number of years.
• Creation of PR over ideas (Intellectual PR)
• Once PR are defined, owner can exchange with
rest of society and reap total social benefits (or
part of external benefit). Coase theorem.
• Provides incentives to create valuable ideas
(R&D).
IPR
• Very important to understand prosperity in
last 200 years.
• Technological progress
• Comparatively small role played by natural
resources and colonization for
industrialized countries. (Though effects of
those may be important to explain poverty
in Africa. See my Intro à l’éco. du dével.)
IPR
• An institution that creates PR where none existed before.
• Institution: Rules of the game. (laws, social norms,
culture, religion) Requires definition and enforcement
(punishment).
• For markets to function properly, PR must be well
defined and enforced over valuable goods. Gvt
intervenes in
– theft
– contract violations
– land and house eviction
• In this respect, PR over ideas is really no different from
PR over other goods and services
IPR
• IPR is a market-based mechanism. (State could
also supply ideas through state research
institutes. Does it for fundamental research
because not directly profitable in market.)
• PR over ideas differ from PR on goods and
services in one important respect: They give a
monopoly to its owner. (chap 14)
• With monopoly, prices are too high. That’s why
IPR are limited in time. It’s a tradeoff.
• Problem in LDCs for medicines.
PR
• PR can also take the form of common
property. (next chapter)
Institutions are crucial to understand
difference between rich and poor
countries.