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