Externalities
Some of the examples are borrowed
from Robert Frank “Microeconomics
and Behavior”
Plan
4 Definition of externalities and examples
4 Responses to externalities
– private
• mergers (Coase Theorem)
• social conventions
– public (government)
• regulation
• taxes
• creation of markets
Externalities
4 Activity of one (firm or person) directly
affects another (firm or person) and is not
transmitted through prices (market
mechanism) is called an externality.
4 THIS VIOLATES THE ASSUMPTIONS
OF THE FIRST WELFARE THEOREM
4 Examples: sea pollution, noise, etc.
4 Externalities are reciprocal in nature.
1
Presence of Externalities May
lead to Inefficiency
$
MSC=MPC+MD
MPC
MD
MB
Q Actual
Q Eff
Q per year
Private Responses
4 Role of social conventions
– to be stable, they must be efficiently enforced
Coase’s Insight: Private
Response to Externalities
4 Example.
– Doctor and Confectioner operate in the
neighboring buildings.
– The machinery of the confectioner makes the
noise that prevents the doctor to examine
patients.
– The value of the damage from the noise to the
doctor is 60.
– The value of continuing to operate the business
for the Confectioner is 40.
2
Outcomes under two legal
regimes
Legal regime
(property
rights
assignment
Confectioner
is liable for
the noise
Outcome
Net benefit to
the doctor
Confectioner 60
shuts down
(to avoid
paying 60)
Confectioner Doctor pays 60-P
is not liable
the
confectioner
to shut down,
40<=P<=60
Net benefit Total net
to the
benefit
confectioner
0
60
P
60
Private Response to
Externalities. Scenario 2
4 Example.
– Doctor and Confectioner operate in the
neighboring buildings and Confectioner makes
the noise, as before.
– Now they realize that there is a soundproofing
device that will completely eliminate the noise
from the machines. The cost of the device is 20.
Outcomes under two legal
regimes
Legal regime
(property
rights
assignment
Confectioner
is liable for
the noise
Outcome
Net benefit to Net benefit Total net
the doctor
to the
benefit
confectioner
Confectioner 60
installs the
soundproofing
device
Confectioner Doctor pays 60-P
is not liable
the
confectioner
for the
installation,
20<=P<=60
40-20=20
80
40-20+P=
=20+P
80
3
The Coase Theorem
4 When the parties affected by externalities
can negotiate costlessly with one another,
an efficient outcome results no matter how
the law assigns responsibility for damages.
Coase’s Assumptions
4 Property rights are assigned
4 Low (no) bargaining costs
4 There is a reliable estimate of the costs and
benefits to each side and this is a common
knowledge among the negotiating parties
When the assumptions fail...
4 Negotiation may be very costly if involves
big groups of people.
4 Not all commodities (assets) may be
assigned property rights
4
The tragedy of Commons
4 Village of 6. Each can buy a steer to be
grazed on a common field. A steer costs
$100. It can be sold in year. It’s value
depends on the weight gained, which, in
turn, is a function of the number of steers
already in the field.
4 There is also a bond that costs $100 and
pays 12% a year.
Steer Prices as a function of
grazing density
No of
steers
1
2
3
4
5
6
Price
Revenue
MR
120
118
114
111
108
105
120
236
342
444
540
630
120
116
106
102
96
90
Are there too many steers in the
field?
4 Each villager will buy a steer as long as the
price he can sell it for is above $112
4 Thus, three steers will graze and three
villagers will buy the bonds. Total income
is 42+36=78
4 This is inefficient. It is better to buy only
two steers and four bonds generating village
income of 36+48=84.
5
Why does the inefficiency arise?
4 Due to the existence of externality.
– when a villager decides to buy a steer and let it
graze in the field, he does not take into account
the decrease in the value of the steers already in
the field.
How can the problem be
resolved?
4 Solution 1. Assignment of property rights.
– The field can be auctioned off
4 What is the price that will be paid for the field?
– Optimal number of steers in the field is two, so that an
investment of 200 will bring yearly income of 36
– An alternative way to invest 200 is to buy a bond, which will
yield 2*12=24 annually.
– Thus, owning a field gives the owner an excess income of
36-24=12 per year.
– This is equivalent to owning one bond that costs 100. So, the
price of the pastureland is 100.
Another solution for the tragedy
of commons
4 Impose a grazing fee for the steer owners.
4 What should be an optimal fee?
6
Other externalities
4 Positional externalities
– contests
– quality of education
4 Lotteries
– financing public expenditures by issuing
lotteries
Possible Government Responses
to Externalities
4 Regulation
– smoking in public areas
– constraints on design of houses in a
neighborhood
– pollution limits
– laws against violent behavior
4 Taxes
4 Creation of markets (some EPA practices)
Pigouvian Taxes
4 In the presence of externality a tax/subsidy
can be imposed, so that the party generating
the externality will “internalize” the effect
he produces on the other party.
4 Advantage: it does not require negotiation
between the parties, so it is applicable in the
cases, in which negotiation is impossible or
very expensive
7
Pigouvian Tax may lead to
inefficiency
4 Recall the Example.
– Doctor and Confectioner operate in the neighboring
buildings.
– The machinery of the confectioner makes the noise that
prevents the doctor to examine patients.
– The value of the damage from the noise to the doctor is
60. Doctor can rearrange his office to eliminate the
effect of the noise at a cost of 18.
– The value of continuing to operate the business for the
Confectioner is 40.
– The two can not negotiate
Outcomes under two legal
regimes
Legal regime Outcome
Net benefit to Net benefit Total net
the doctor
to the
benefit
confectioner
Confectioner
is liable the
tax in the
amount of 60
No tax
liability
60
Confectioner
shuts down
Doctor
60-18=42
rearranges his
office at his
own expense
0
60
40
82
Pigouvian tax may enhance
efficiency
4 If, instead, the confectioner could install the
soundproofing device at a low cost (say,10),
the presence of tax would have enhanced
efficiency.
4 In general, if negotiation is impractical,
taxing negative externality can lead to an
efficient outcome, if the party generating
the externality has a cheaper way to
eliminate it than the “victim”.
8
Taxing pollution may be better
than direct regulation
Both firms use technological process A. City council wants to
reduce the pollution by half. It can require each firm use C.
Process A
(smoke) (4 t)
B
(3 t)
C
(2 t)
D
(1 t)
E
(0 t)
Cost to 100
firm X
190
600
1200
2000
Cost to 50
firm Y
80
140
230
325
Taxing pollution may be better
than direct regulation
Alternatively, they can impose a tax T per ton of emitted
smoke. What is the appropriate level of T?
Process A
(smoke) (4 t)
B
(3 t)
C
(2 t)
D
(1 t)
E
(0 t)
Cost to 100
firm X
190
600
1200
2000
Cost to 50
firm Y
80
140
230
325
Costs of regulation and taxation
4 Regulation that requires to cut the pollution
for both firms by 1/2 (use process C) costs
600-100=500 for firm X and 140-50=90 for
firm Y, total cost being 590
4 Taxation will lead firm X to adopt process
B, which increases the cost by 90 and firm
Y to adopt process D, increasing its cost by
180. Total cost is 270<590.
9