Section B

Managerial and individual decision problems
1.

Externalities and regulation
Applications and case studies: pollution control,
health care, education, sport and exercise,
transport
Suggested background reading






Allen et al. 2009. Managerial Economics. Norton.
Chapters 14-16
Kreps, D. M. 2004. Microeconomics for Managers.
Norton Chapters 14 & 18-19
Frank, R. H. 2008. Microeconomics and behaviour.
McGraw Hill. Chapters 6 & 17
Wall,S., Minocha, S. and Rees, B. 2010. International
Business, Pearson. Chapter 6
Grimes, P, Register, C. and Sharp, A. 2009. Economics of
Social Issues, McGraw Hill. Chapters 4, 6 and 15
Rasmusen, E. 2007. Games and Information, Blackwell.
Chapters 7-9
By the end of this section you
should be able to:


Explain what is meant by the economic concept of
an externality
Discuss efficiency and policy implications of
externalities in relation to the following:
1.
2.
3.
4.
5.
environmental issues (e.g. pollution and congestion)
health care
education
sport and exercise.
global labour markets
Reintroduction to externalities
(see e.g. Allen Chapter 16; Kreps chapter 14)

Externalities are usually associated with action
by a firm or consumer that affects the welfare of
others; positively or negatively e.g.:

Externalities in consumption


Smoking in an enclosed area, dumping your rubbish
(wrapping), driving your car/motorbike in a street with many
pedestrians, listening to loud music
Externalities in production



A firm polluting the air - affects health and environment
A firm polluting a river or lake – affects other firms and
consumers of water
A beekeeper benefitting from nearby orchard – an orchard
owner benefitting from the beekeeper’s bees
Other types of externalities

Open access goods/services (the tragedy of
the commons)
ocean fisheries- leads to over fishing,
 wild animals - extinction
 rain forests –over harvesting


Congestion externalities

e.g. driving at certain hours adds to the time
others take to travel

Roads = open access facility
More types of externalities

Public goods: non-excludable goods


non-rival, consumption by one person doesn’t affect the
consumption of others
Non-excludable – no restrictions on access


Network externalities e.g.:

Communications networks - the more users that join a
communications network the better for the existing
users/suppliers

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
e.g. national defence, clean air, polite behaviour
benefits from being able to contact more users, economies of scale,
Locational (cluster) networks: IT firms locating together
Standards externalities

The more firms that use the same way of producing or servicing
something (the standard) increases the market size for products
built/serviced to this standard

E.g. use of a particular technology
Inefficiency and externalities

When firms or consumers generate externalities,
the free market outcome may not be efficient



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It doesn’t maximise total surplus
Efficiency usually requires that:
Marginal consumer benefit (for all consumers)
= marginal cost of production (for all firms)
This will be achieved in a competitive market
equilibrium since consumer benefit is all private
and production costs are all private

The free market outcome ensures that marginal
private benefit (consumers) = marginal private
cost (firms)
Inefficiency and externalities

When there are externalities the free market
outcome is not efficient as private benefits/costs
are not equal to social benefits/costs



When there are consumption externalities, marginal
private consumer benefit is not the same as marginal
social (total) benefit
When there are production externalities firm’s private
marginal costs of production are not the same as the
marginal social (total) costs of production
The free market outcome doesn’t equate
marginal social benefits and marginal social
costs

Implies market failures - suggests a role for 3rd party
(e.g. government) intervention
Ways of dealing with
externalities


Governments intervention and regulation e.g.
supply of public goods, taxes/subsidies on
externalities, standards
Establishing property rights and bargaining; the
Coase theorem



e.g. establishing rights to clean water and air –not
easy
Social norms: confirming to or internalisation of
social pressures e.g. not dropping rubbish
Collective action through pressure groups
Applications

Consumption externalities


Mix of production and consumption
externalities


Health and education, transport (roads)
Sport and exercise, sports sector
Production externalities

Pollution