7.2 Externalities
7.2.1 Externalities and Missing Markets
7.2.2 Coase Theorem
7.2.3 Intervention
7.2.4 Summary
Application
“Councils chew over gum problems” BBC website 16th
January 2006
•Its costs 3p to buy a stick of chewing gum but 10p to
remove it from the streets. Oxford Street has 300,000
pieces a year
•20 local councils banded together to ask for financial
help to deal with the problem
•The pressure is on manufacturers to produce a nonsticky gum
•Will this solve the problem and who pays?
7.2.1 Externalities and Missing Markets
While we have analysed individual decisions we
have tended to ignore their impact on others
Often, decisions made by firms or individuals can
have an effect on other firms or other individuals
In economics we call these effects externalities and
they can play a significant role in affecting the efficient
allocation of resources
An externality is defined as:
The direct effect of the actions of one economic agent
on the welfare of another economic agent in a way
that is not reflected in the market price
Thus a benefit is not paid for or a cost is not borne.
Four features can be noted:
1. Any agent can create an externality
2. There are always two sides to an externality – a creator
and a receiver
3. Externalities can be positive or negative
4. Zero externality is generally inefficient
Pollution as an example of an externality
There are external costs of producing pollution e.g.
damage to the environment, health etc
There are benefits too!
Suppose we try to cut pollution:
1. Reducing pollution could require a cut in output and
thus reduce producer surplus
2. Keeping output constant but reducing pollution through
new technology would increase reduction costs and use
up scarce resources
Thus, consider the marginal costs and benefits:
Cost
MC
P*
MB
Q1
Q2
Pollution
The efficient outcome is that Q1 pollution is produced as
that is where marginal cost equals marginal benefit
But where will the firm produce?
As the firm does not have to take into account external
costs of pollution it will produce until marginal benefits
are zero i.e. at Q2
Why does this divergence occur? It is due to the fact
that there is a missing market
The missing market is for clean air and in effect its price
is zero. If it was a market, the “price” would be P*
If the market does not exist, there is no mechanism to
allocate a commodity efficiently.
As such, agents will use it to maximise their own private
benefit.
However if someone “owns” the commodity, then a
market can be established and an efficient outcome
can be achieved
7.2.2 Coase Theorem
Allocating ownership or property rights can allow us to
find an optimal level of an externality
Need to consider social as opposed to private outcomes
Marginal social cost – the cost of an action which
includes all the costs of production including any
external costs borne by other agents
Marginal social benefit – the benefit of an action which
includes all the value of production including any external
benefits enjoyed by other agents
£
SMC = PMC + MD
S = PMC
P*
P1
MD
MB
Q* Q1
Steel
Output of steel is too high at Q1 (like pollution was too
high at Q2 in the earlier diagram)
If forestry managers own clean air rights they can get
steel producer to “pay to pollute”
Or
If the steel firm owns the clean air, they can ask the
forestry for payment not to pollute
Either way we get to the efficient outcome of Q*P* how?
Assume price taking firm
£
SMC = PMC + MD
S = PMC
MR
Q*
Q1
Steel
7.2.3 Intervention
Governments can respond by intervening:
1. Regulation – e.g. carbon emissions limits for cars
2. Pigouvian taxes – A tax levied on polluters
output by an amount just equal to the marginal
damage it inflicts at the efficient level
3. Create a market – licences to pollute can be traded
SMC
S+t
S = PMC
P*
t
P1
MB
Q* Q1
Steel
3. Create a market – licences to pollute can be traded
Price p.a.
S
D
No. of Licences
7.2.4 Summary
• Externalities are not captured in private market
outcomes
• They can be positive or negative
• Allocation of property rights in the Coase Theorem
helps produce an efficient outcome
• If not, intervention can provide tax, permit and
licence based solutions