Externalities
Today: Markets without ownership usually lead to
inefficient outcomes
Market failures
Previously Monopolies Cartels
Today: Ending Unit 4 Externalities
Next week: Beginning Unit 5 Applications of externalities
Today
Externalities Inefficiencies without regulation The Coase theorem
Optimal amount of externalities Some ways to reach more efficient
solutions when externalities are present
Examples
Externalities: Definition External cost (benefit)
“A cost (benefit) of an activity that falls on people other than those who pursue the activity” (F/B p. 348)
What else is going on? There is often no formal market for
the cost or benefit in question Private negotiation typically must
occur to increase efficiency
A market without regulation
Without regulation, consumers and producers only look at private costs and private benefits in order to decide on production and consumption
A market without regulation
Notice that production of each unit of good leads to external costs
external cost per unit
What is efficient?
To find efficiency, we need to have no further possibilities to have beneficial exchange of a good or service Social costs and benefits lead to overall
efficiency Too much is produced to be efficient,
since social costs and benefits determine efficiency
A market without regulation
Where is Social MB equal to Social MC?
external cost per unit
(= Social MB)
A market without regulation
Where is Social MB equal to Social MC? Quantity E, Price B
external cost per unit
(= Social MB)
A market without regulation
Production above quantity E results in lower efficiency, since Social MB is less than Social MC
external cost per unit
(= Social MB)
Private market forces will produce up to quantity F
A market without regulation
Deadweight loss shaded These units produced have Social MC
greater than Social MB
external cost per unit
(= Social MB)
Why do we see inefficiencies? Often, negotiation is costly Example: A polluter in the Los
Angeles metro area Who owns the air? (Polluter or
residents?) If the polluter owns the air, the firm will
not care about the residents If the residents own the air, it is
prohibitively costly to negotiate with every person affected by pollution
Costly negotiation
Negotiation is typically costly Remember, time is worth something
Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring
Coase theorem The Coase theorem tells us the
conditions needed to guarantee that efficient outcomes can occur People can negotiate costlessly The right can be purchased and
sold Given the above conditions,
efficient solutions can be negotiated
Ronald Coase
Coase theorem Notice that the Coase theorem
addresses efficiency To get to efficiency, the quantity of
most goods and services produced is still positive Example: It is not efficient to get rid of all
pollution If all pollution was gone, we could not live (since
we exhale CO2)
Coase theorem and costly negotiation
Since negotiation is typically costly, we need government intervention to increase efficiency Taxes Quotas
Government intervention
The government can estimate costs of negative externalities at relatively low cost
Based on these external costs, they can set a tax or quota to reduce the amount of the externality to an efficient level
A market with regulation: Tax
The government can set a tax equal to the external cost per unit
external cost per unit
(= Social MB)
With tax equal to distance of vertical arrow: The efficient solution is achieved
A market with regulation: Marketable permits with resale
An alternative to a tax is to sell or distribute marketable permits
To be effective, these permits must be able to be sold and resold Sale of permits guarantees that
producers with lowest private MC can get permits
A market with regulation: Marketable permits to sell
Quantity of permits available: E Low-cost producers will buy permits if
they do not have them
external cost per unit
(= Social MB)
A market with regulation: Marketable permits to sell
Market price for the good will be B, since E units are being produced
external cost per unit
(= Social MB)
Remember
I have gone through the case where externalities are costs
Externalities can be either costs or benefits, however
When there are positive externalities, subsidies can help to increase efficiency
Examples of externalities as costs
Particulate matter and gases released from driving cars
Freeway noise Washing you car in your driveway,
followed by hosing the soap off Soap goes into storm drains, polluting
the ocean
Examples of externalities as benefits
Planting flowers in your front lawn Scientific research Finding information that is useful
to a group of people Example: One person finds the
fastest route for a trip that many people will be taking; everyone can use this information to their benefit
Examples of externalities:Cost or benefit?
Christmas decorations A fan blowing in a warm office
building Use of perfume or cologne
An algebraic example
Suppose Private MC equals production MC = Q
Let Demand be denoted by P = 100 – Q
Let External Cost be $10 per unit
An algebraic example
Translate equations and External Cost to our graphical example
external cost per unit of $10
P = 100 – Q
MC = Q
MCSocial = Q + 10
An algebraic example:Private equilibrium
Inefficient equilibrium w/o controls:Set Q = 100 – Q Q = 50 (quantity F)
MC = Q
P = 100 – Q
An algebraic example:Socially optimal equilibrium
Socially optimal equilibrium: Set Q + 10 = 100 – Q Q = 45 (quantity E)
P = 100 – Q
MCSocial = Q + 10
An algebraic example: Price
Inefficient equilibrium, P = Q P = 50 Socially optimal equilibrium, P = Q + 10 P
= 55
external cost per unit of $10
P = 100 – Q
MC = Q
MCSocial = Q + 10
Price C = 50
Price B = 55
Recall E = 45 and F = 50
This concludes basic externality theory
Upcoming applications… Wednesday
Congestion in cities and on highways Friday
Tragedy of the Commons Environmental and safety regulation
Summary When external costs or benefits
enter a market, private equilibrium is usually inefficient
A tax or quota can be set to lead to efficient equilibrium when a negative externality occurs
Subsidies can improve efficiency with positive externalities