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Intermediate Microeconomic Theory

Externalities

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Markets and Efficiency

We have seen that markets can provide an efficient mechanism for allocating scarce resources.

However, this result only holds when markets are perfect.(i) Tax revenue raised via lump-sum taxes,(ii) Producers and consumers are price takers,(iii) There are complete markets,(iv) There is no asymmetric information.

We discussed why allocations can fail to be efficient if (i) and (ii) fail. What do we mean by (iii), and what if it

fails?

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Externalities

What do we mean by an externality?

What are some examples? Consumption Externalities?

Production Externalities?

Why might externalities lead to inefficiencies?

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Modeling an Externality

Consider Giganto Corp. They produce ballbearings which sell for $37/Kg. Their cost function: C(q) = q2/2 - 3q + 100 A byproduct of producing ballbearings is smoke: s = q/4 (cubic tons)

Bill’s utility function: U = -10s2 + c and he has $1200

How many lbs. of ballbearings will Giganto Corp. produce?

What will be Giganto Corp’s profits?

What will be Bill’s Utility?

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Modeling an Externality

Is this efficient? What if we capped emissions at s = 3, but then imposed a $620 tax on

Bill and gave proceeds to Giganto Corp to help defray their costs?

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Externalities and Efficiency

So in the presence of externalities, market solution doesn’t lead to efficient outcomes.

When making its production decision, Giganto Corp weighs its own benefits against his own costs, but does not take into account the total cost

to society.

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Externalities and Efficiency

Clearly, such issues can arise in many other instances.

When I consume an apple, it affects other people, by using up some resources. However, I internalize these costs through having to forgo other consumption

due to the price I have to pay. Under perfect markets, I pay the full societal cost of “producing” the apple

When I consume more driving, I again use resources which otherwise you could have used (gas, my SUV) I internalize these costs through having to forgo other consumption by paying

the sticker prices for gas, car, etc.. However, I also use other resources in consuming driving, namely clean air. I

do not pay for these resources, so I overconsume relative to societal efficiency.

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Externalities and Efficiency

So one way to increase efficiency might be through direct regulation.

What are difficulties with regulation?

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Externalities and Missing Markets

What if a market was set-up for less pollution? Bill could pay $p for each cubic ton less smoke than

Giganto currently produces. Giganto Corp. would be paid $p for each cubic ton less

smoke they produce.

How would this change things?

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Externalities and Missing Markets

So an externality can in a way be thought of as a missing market. If a market were developed, then the

“externality” doesn’t lead to inefficiency, as entity originally producing externality internalizes the true social cost.

This brings us back to the world of the First Welfare Theorem that competitive equilibria are Pareto Efficient.

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Externalities, Missing Markets, and Distribution One issue that comes up with regulation is why

should we take money away from Bill to pay Giganto Corp. to limit its emissions?

Similarly, why should Giganto Corp. be given the “property rights” to the air Bill breathes?

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Externalities and Missing Markets

What if instead, Bill were given property rights to the air, but could sell Giganto Corp permits to produce smoke. What would happen now?

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The Coase Theorem

Coase Theorem – In the absence of transactions cost, individuals should be able to negotiate to an efficient allocation regardless of how property rights are assigned.

Essentially, given a market, the equilibrium price will cause person imposing the externality to internalize the social cost, once again making the marginal benefit of last unit consumed equal to the total cost of supplying that unit to the market.

So why do we even talk about externalities?

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Coase Theorem

In the presence of externalities, how property rights are distributed will affect distribution of wealth. Coase Theorem says nothing about what is a “just” distribution, it just

gets us to efficiency (like with any other perfect markets argument).

What else seems lacking in the “Coasian” picture of the world? Why the smoking ban in bars? Why the regulation on car and factory emissions?

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Coase Theorem

Coase Theorem – In the absence of transactions cost, individuals should be able to negotiate to an efficient allocation regardless of how property rights are assigned.

Should we expect transaction costs to always be low?

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Externalities and Transactions Costs

Consider something like the environment (See NYT article) A given polluter only affects each person a little bit.

If all these people could get together, they could certainly pay off polluter until we reach efficiency.

Problem is how do all these people get organized? Who will be in charge of organizing?

In particular, the organizer must take on costs, but only gets a little bit of the benefit from organizing. This is a Public Goods problem.

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Externality Policy

So what should be done about externalities?

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Taxation and Externalities

What would be optimal tax to impose on Giganto Corp. for each cubic ton of smoke it produces?

Double Dividend of taxation of externalities.

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Production Externalities

The same logic applies when only looking at firms.

Example: Firm 1 dumps its waste from producing its

own output into river upstream from Firm 2.

Firm 2 uses river water for production and Firm 1’s pollution raises Firm 2’s costs of production.

How does this relate to our discussion of property rights?

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Production Externalities

Consider two firms:1. Firm 1: C1(q1) = 0.5q1

2 + 2q1 p1 = 10

2. Firm 2: C2(q2) = q22 - q2 + 1 + 2q1 p2 = 9

How much will firms produce in the absence of constraints?

How do we know this won’t be efficient?

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Production Externalities

Consider what production would be if one firm ran both plants.

Why will this lead to efficiency?

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Production Externalities

What policies can we use in the face of production externalities?

Encourage mergers?

Regulate pollution?

Taxation?

Re-allocate property rights and help set-up missing markets/reduce transaction costs to negotiation?

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Application: Emission Policy

Why are economists so into tradable emissions permits?

In a way, it is similar to rent control discussion from awhile back.

Under rent control, how could we make everyone better off?

Analogue is often true for pollution control.

First, figure out how much total pollution should be allowed. Either directly sell permits to companies via an auction, or give each firm

a fixed amount of permits, then allow them to trade with each other.

How is this better than just setting a pollution cap each firm must meet?

What issue is still troublesome?