1 Externalities. 2 Externalities Externalities are a market failure (so Government intervention may be advisable). Externalities imply that there

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ExternalitiesExternalities

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ExternalitiesExternalities Externalities are a market failure (so Externalities are a market failure (so

Government intervention may be Government intervention may be advisable).advisable).

Externalities imply that there will be a Externalities imply that there will be a difference between private optimum and difference between private optimum and social optimum.social optimum.

In a sense, this chapter is on private In a sense, this chapter is on private property (who has the right to what).property (who has the right to what).

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ExternalitiesExternalities An An externalityexternality is a cost or a benefit is a cost or a benefit

imposed upon someone by actions taken imposed upon someone by actions taken by others, without compensation.by others, without compensation.

An externally imposed benefit is a An externally imposed benefit is a positive positive externalityexternality..

An externally imposed cost is a An externally imposed cost is a negative negative externalityexternality..

There are consumption externalities and There are consumption externalities and production externalities.production externalities.

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ExternalitiesExternalities The crucial feature of externalities is that they The crucial feature of externalities is that they

are goods/services which are valued by are goods/services which are valued by people but are not transacted in the market. people but are not transacted in the market. Its main problem is therefore that the Its main problem is therefore that the equilibrium allocation might not be efficient.equilibrium allocation might not be efficient.

Externalities raise the problem of Externalities raise the problem of intertemporal/intergenerational justice. Which intertemporal/intergenerational justice. Which discount rate shall be used to value the future discount rate shall be used to value the future (probability of being alive, impatience, future (probability of being alive, impatience, future preferences, …)?preferences, …)?

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Examples of Negative Examples of Negative ExternalitiesExternalities Air pollution.Air pollution. Water pollution.Water pollution. Loud parties next door.Loud parties next door. Traffic congestion.Traffic congestion. Second-hand cigarette smoke.Second-hand cigarette smoke. Increased insurance premiums due to Increased insurance premiums due to

alcohol or tobacco consumption.alcohol or tobacco consumption. Obstructed view.Obstructed view.

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Examples of Positive Examples of Positive ExternalitiesExternalities A well-maintained property next door that A well-maintained property next door that

raises the market value of your property.raises the market value of your property. A pleasant cologne or scent worn by the A pleasant cologne or scent worn by the

person seated next to you.person seated next to you. Improved driving habits that reduce accident Improved driving habits that reduce accident

risks.risks. A scientific advance.A scientific advance. Education.Education. Vaccination.Vaccination.

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Externalities and Externalities and EfficiencyEfficiency

Crucially, an externality impacts a Crucially, an externality impacts a third third partyparty; i.e. somebody who is not a ; i.e. somebody who is not a participant in the activity that produces participant in the activity that produces the external cost or benefit (in that the external cost or benefit (in that market).market).

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Externalities and Externalities and EfficiencyEfficiency

Externalities cause Pareto inefficiency; typicallyExternalities cause Pareto inefficiency; typically too much scarce resource is allocated to an activity too much scarce resource is allocated to an activity

which causes a negative externality (because part of which causes a negative externality (because part of the social cost is not taken into account; the agent the social cost is not taken into account; the agent considers only its private costs)considers only its private costs)

too little resource is allocated to an activity which too little resource is allocated to an activity which causes a positive externality (because part of the causes a positive externality (because part of the social benefit is not taken into account; the agent social benefit is not taken into account; the agent considers only its private benefits).considers only its private benefits).

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Externalities and Externalities and Property RightsProperty Rights

Ronald Coase’s insight is that most Ronald Coase’s insight is that most externality problems are due to an externality problems are due to an inadequate specification of property inadequate specification of property rights and, consequently, an absence of rights and, consequently, an absence of markets in which trade can be used to markets in which trade can be used to internalize external costs or benefits.internalize external costs or benefits.

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Externalities and Externalities and Property RightsProperty Rights

Causing a producer of an externality to Causing a producer of an externality to bear the full external cost or to enjoy the bear the full external cost or to enjoy the full external benefit is called full external benefit is called internalizing internalizing the externalitythe externality..

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SolutionsSolutions There are market solutions to externalities: There are market solutions to externalities:

since profits from coordination are greater than since profits from coordination are greater than profits without, either firm has an incentive to profits without, either firm has an incentive to buy out the other and internalize the externality.buy out the other and internalize the externality.

There are Government solutions to externalities There are Government solutions to externalities (e.g. pollution):(e.g. pollution):

- assign pollution rights (‘grandfathering’)- assign pollution rights (‘grandfathering’)

- sell pollution rights (auctioning)- sell pollution rights (auctioning)

- impose a tax on polluting emissions- impose a tax on polluting emissions

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SolutionsSolutions Pollution rights are set in an amount equivalent to the Pollution rights are set in an amount equivalent to the

efficient pollution level.efficient pollution level. Firms polluting above the rights they own must be highly Firms polluting above the rights they own must be highly

penalized.penalized. Assignment of pollution rights based on past emissions Assignment of pollution rights based on past emissions

are a perverse incentive for firms to reduce these. are a perverse incentive for firms to reduce these. Free negotiation of rights among firms may lead to Free negotiation of rights among firms may lead to

some of them accumulating rights in order to prevent some of them accumulating rights in order to prevent entry.entry.

The efficient value of the tax must equal the external The efficient value of the tax must equal the external marginal damage at the socially optimum pollution level.marginal damage at the socially optimum pollution level.

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Merger and Merger and InternalizationInternalization

Suppose the two firms merge to become Suppose the two firms merge to become one.one.

Merger internalizes an externality and Merger internalizes an externality and induces economic efficiency.induces economic efficiency.

How else might internalization be caused How else might internalization be caused so that efficiency can be achieved?so that efficiency can be achieved?

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Coase and Production Coase and Production ExternalitiesExternalities

Coase argues that the externality exists Coase argues that the externality exists because neither the steel firm nor the fishery because neither the steel firm nor the fishery owns the water being polluted.owns the water being polluted.

There is a missing market: the market for There is a missing market: the market for pollution. In this market some agents would be pollution. In this market some agents would be willing to pay to have the quantity of pollution willing to pay to have the quantity of pollution produced reduced. Thus, pollution would have produced reduced. Thus, pollution would have a negative price.a negative price.

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Suppose the property right to the water is Suppose the property right to the water is created and assigned to one of the firms. created and assigned to one of the firms. Does this induce efficiency?Does this induce efficiency?

Yes (assumption: no transaction costs).Yes (assumption: no transaction costs).

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The Coase Theorem: when the parties The Coase Theorem: when the parties affected by externalities can negotiate affected by externalities can negotiate (almost) costlessly with one another, an (almost) costlessly with one another, an efficient outcome results no matter how efficient outcome results no matter how the law assigns responsibility for the law assigns responsibility for damages.damages.

Requirements: clear definition of property Requirements: clear definition of property rights, which may require easy access to rights, which may require easy access to courts.courts.

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Production Externalities Production Externalities and Pollution Rightsand Pollution Rights

Instead of assigning property rights and Instead of assigning property rights and letting firms bargain over amount of letting firms bargain over amount of pollution, the Government may sell pollution, the Government may sell pollution rights.pollution rights.

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Production Externalities Production Externalities and Taxesand Taxes

Ensure that the firm covers the social cost it is Ensure that the firm covers the social cost it is generating by paying a tax on pollution.generating by paying a tax on pollution.

The authorities problem is then to find the The authorities problem is then to find the value of value of tt that induces the firm to produce the that induces the firm to produce the optimum social amount of pollution.optimum social amount of pollution.

The kind of tax that corrects an inefficient The kind of tax that corrects an inefficient situation is known as a Pigouvian tax, after the situation is known as a Pigouvian tax, after the economist Arthur Pigou.economist Arthur Pigou.

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The Tragedy of the The Tragedy of the CommonsCommons

Common resources: rival but not Common resources: rival but not excludable.excludable.

The tragedy of the commons illustrates The tragedy of the commons illustrates what happens in a society that lacks a what happens in a society that lacks a well-developed institution of property well-developed institution of property rights.rights.

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The Tragedy of the The Tragedy of the CommonsCommons Consider a grazing area owned “in Consider a grazing area owned “in

common” by all members of a village.common” by all members of a village. Villagers graze cows on the common.Villagers graze cows on the common. When c cows are grazed, total milk When c cows are grazed, total milk

production is f(c), where f’>0 and f”<0.production is f(c), where f’>0 and f”<0. How should the villagers graze their How should the villagers graze their

cows so as to maximize their overall cows so as to maximize their overall income?income?

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The economic profit from introducing one The economic profit from introducing one more cow is positive.more cow is positive.

Entry continues until the economic profit Entry continues until the economic profit of grazing another cow is zero.of grazing another cow is zero.

Since nobody owns the common, entry is Since nobody owns the common, entry is not restricted.not restricted.

The commons are over-grazed, The commons are over-grazed, tragically.tragically.

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The reason for the tragedy is that when a The reason for the tragedy is that when a villager adds one more cow his income villager adds one more cow his income rises but every other villager’s income rises but every other villager’s income falls.falls.

The villager who adds the extra cow The villager who adds the extra cow takes no account of the cost inflicted takes no account of the cost inflicted upon the rest of the village.upon the rest of the village.

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Modern-day “tragedies of the commons” Modern-day “tragedies of the commons” includeinclude over-fishing the high seasover-fishing the high seas over-intensive use of public parksover-intensive use of public parks urban traffic congestion. urban traffic congestion.

Documents

1 Externalities. 2 Externalities Externalities are a market failure (so Government intervention may be advisable). Externalities imply that there