Externalities
April 21, 2010
Externalities – 1
Waters
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
Drink waters out of thine own cistern, and
running waters out of thine own well. —
Proverbs 5:25
Externalities – 2
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
Water pollution
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
Water pollution
Air pollution
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
Water pollution
Air pollution
Noise pollution
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
•
Water pollution
Air pollution
Noise pollution
Waste pollution
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
•
•
Water pollution
Air pollution
Noise pollution
Waste pollution
Scenic view pollution
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
•
•
•
Water pollution
Air pollution
Noise pollution
Waste pollution
Scenic view pollution
Common pool resources
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
•
•
•
•
Water pollution
Air pollution
Noise pollution
Waste pollution
Scenic view pollution
Common pool resources
Congestion with excludable resources
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
•
•
•
•
•
Water pollution
Air pollution
Noise pollution
Waste pollution
Scenic view pollution
Common pool resources
Congestion with excludable resources
Congestion with non-excludable resources
Externalities – 3
Externalities
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
An externality exists whenever the welfare of some agent,
either a firm or a household, depends not only on his or her
activities, but also on activities under the control of some other
agent.
•
•
•
•
•
•
•
•
•
Water pollution
Air pollution
Noise pollution
Waste pollution
Scenic view pollution
Common pool resources
Congestion with excludable resources
Congestion with non-excludable resources
Angry dog
Externalities – 3
The Coase Theorem
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
Externalities – 4
The Coase Theorem
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
•
Nice cottage beside a train track.
Externalities – 4
The Coase Theorem
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
•
Nice cottage beside a train track.
•
Fresh white laundry hung out to dry
Externalities – 4
The Coase Theorem
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
•
Nice cottage beside a train track.
•
Fresh white laundry hung out to dry
•
Coal burning steam locomotive passing by
Externalities – 4
Graphical Analysis
Externalities – 5
Graphical Analysis
Price
MCPrivate
20
18
16
14
12
10
Demand
8
6
4
2
1
2
3
4
5
6
7
8
9 10
12
14
16
18
Quantity
Externalities – 5
Graphical Analysis
Price
MCSocial
MCPrivate
20
18
16
14
12
10
Demand
8
6
4
2
1
2
3
4
5
6
7
8
9 10
12
14
16
18
Quantity
Externalities – 5
Graphical Analysis
Price
MCSocial
MCPrivate
20
18
16
14
12
10
Demand
8
6
4
2
1
2
3
4
5
6
7
8
9 10
12
14
16
18
Quantity
Externalities – 5
Graphical Analysis
Price
20
18
16
14
12
10
Demand
8
6
4
2
1
2
3
4
5
6
7
8
9 10
12
14
16
18
Quantity
Externalities – 5
Graphical Analysis
Price
MCSocial
20
18
16
14
12
10
Demand
8
6
4
2
1
2
3
4
5
6
7
8
9 10
12
14
16
18
Quantity
Externalities – 5
Graphical Analysis
Price
MCSocial
20
18
16
14
12
10
Demand
8
6
4
2
1
2
3
4
5
6
7
8
9 10
12
14
16
18
Quantity
Externalities – 5
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
There are three requirements for a competitive equilibrium,
corresponding to the requirements that producers optimize,
consumers optimize, and that ”markets clear” at the equilibrium
prices. An equilibrium will then consist of a production plan yj for
each firm, a consumption vector xi for each consumer, and a price
vector p.
Externalities – 6
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
There are three requirements for a competitive equilibrium,
corresponding to the requirements that producers optimize,
consumers optimize, and that ”markets clear” at the equilibrium
prices. An equilibrium will then consist of a production plan yj for
each firm, a consumption vector xi for each consumer, and a price
vector p.
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
Externalities – 6
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
Externalities – 7
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
• For every firm the set of inputs used and outputs produced
maximize profit at those prices given the firms technology.
Specifically, for each firm j, yj ∗ solves
max
yj
"
L
X
ℓ=1
p∗ℓ yℓj
#
such that [y j ∈ Y j ]
Externalities – 7
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
• For every firm the set of inputs used and outputs produced
maximize profit at those prices given the firms technology.
Specifically, for each firm j, yj ∗ solves
max
yj
"
L
X
ℓ=1
p∗ℓ yℓj
#
such that [y j ∈ Y j ]
Externalities – 7
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
Externalities – 8
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
• For each consumer the consumption bundle is maximal for i in
the budget set defined by the initial endowment (valued at the
equilibrium prices) and their share of the profits of the J firms in
the economy. Specifically, for each consumer i, xi ∗ solves
max v i (xi )
xi
such that
L
X
ℓ=1
p∗ℓ xiℓ ≤
L
X
ℓ=1
p∗ℓ ωℓi +
J
X
θji p∗ℓ yℓj∗
j=1
Externalities – 8
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
Externalities – 9
Competitive Equilibrium
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
The allocation (x1∗ , x2∗ , . . . , xI∗ , y1∗ , y2∗ , . . . , yJ∗ ) and price vector
p∗ ∈ RL constitutes a competitive or Walrasian equilibrium if the
following conditions are satisfied.
• The total consumption of products by consumers is equal to initial
endowments plus the net output of firms. Specifically, for each
good ℓ = 1, 2, . . . , L,
I
X
ı=1
⇒
I
X
ı=1
xi∗
ℓ ≤
I
X
ωℓi +
yℓj∗
j=1
i=1
xi∗
ℓ ≤ ωℓ +
J
X
J
X
yℓj∗
j=1
Externalities – 9
First Theorem of Welfare Economics
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
If the price p∗ and allocation
∗
∗
∗
∗
∗
∗
x11 , x21 , . . . , xI1 , q 1 , q 2 , . . . , q J
constitute a competitive equilibrium, then this allocation is Pareto optimal
Externalities – 10
Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
If the various assumptions of the First Theorem of Welfare
Economics do not hold then we have what is called a market failure.
• Public goods
Externalities – 11
Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
If the various assumptions of the First Theorem of Welfare
Economics do not hold then we have what is called a market failure.
• Public goods
• Externalities
Externalities – 11
Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
If the various assumptions of the First Theorem of Welfare
Economics do not hold then we have what is called a market failure.
• Public goods
• Externalities
• Natural monopoly
Externalities – 11
Possible Solutions to Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
• Taxes
Externalities – 12
Possible Solutions to Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
• Taxes
• Subsidies
Externalities – 12
Possible Solutions to Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
• Taxes
• Subsidies
• Quotas
Externalities – 12
Possible Solutions to Market Failure
Externalities
• Waters
• Definition
• Coase Theorem
• Graph
• CE
• CE1
• CE2
• CE3
• First Theorem
• Market Failure
• Solutions
• Taxes
• Subsidies
• Quotas
• Tradable permits
Externalities – 12