Externalities
Econ 325
Martin Farnham
Externalities--Introduction
•  Externalities occur when some market
transaction involves costs and/or
benefits that accrue to people outside
the transaction
–  This means consumers and producers
aren’t taking all of the relevant costs and
benefits into account==>Social MB may not
equal Social MC in equilibrium.
–  In such a case, equilibrium is inefficient
Econ 325--Martin Farnham
2
Externalities--Introduction
•  Externalities can occur in production or
consumption
•  Externalities can be positive or negative
On Which Side is Externality?
Production
Consumption
Negative Pulp-mill pollution smoking; loud
music
Positive R&D spillovers,
Painting house;
agglomeration
gardening
Externalities--Introduction
•  Some more examples:
–  Positive Consumption externalities
•  Your attending party may add to festive atmosphere for
others
–  Negative Consumption externalities
•  Eating stinky food around the office, strong perfume,
cracking gum
–  Positive Production externalities
•  Beekeeping enhances pollination of neighboring crops
–  Negative Production externalities
•  Bees might sting neighbors too!
•  Pollution
Econ 325--Martin Farnham
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How Are Positive Externalities like Public
Goods?
•  Take healthcare: Basically a private good, but
has some public good aspects
–  Healthcare makes one person healthier, but also
reduces their likelihood of spreading disease
–  If you get healthcare, my reduced chance of
getting sick during office hours doesn’t deprive
anyone else around you from benefit of reduced
risk of disease (non-rival); you also can’t deny me
the benefits of your better health (non-excludable)
–  So healthcare has a public good component to it
–  aka positive externality
Econ 325--Martin Farnham
5
Negative Externalities--Public Bads
•  The reverse is true as well. If global
warming is a public bad, then reduction
of that is a public good.
–  Pollution contributes to a public bad
–  It can also be considered a negative
externality
–  So there is some overlap in the definitions.
Econ 325--Martin Farnham
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If consumers bid up the price of a
commodity, is this an externality?
•  Consider an art auction: I value a painting at $1000,
you value it at $800
•  We’re the two highest bidders.
•  My outbidding you reduces benefits to you by $800.
But I pay that $800 (and more) in outbidding you
–  I’m bearing the full cost of depriving you of that benefit
–  Not an externality!
–  If I lived in the apartment above you and let my bathtub
overflow so it leaked on the painting and destroyed it--that’s
an externality
Econ 325--Martin Farnham
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Externalities and Social Welfare in S-D
Context
•  For efficiency, we need MB=MC
–  Let’s be more specific: Want marginal
social benefit to equal marginal social cost
–  When no externality is present,
MSB=MPB=MB and MSC=MPC=MC
–  But with externality, private benefits and
costs may differ from social benefits and
costs
Econ 325--Martin Farnham
8
Externalities in S-D Context
•  For the sake of thinking about externalities,
let’s be very explicit
–  Marginal private benefit (MPB)=marginal
willingness to pay (demand curve)
–  Marginal private cost (MPC)=marginal cost of
producers (supply curve)
–  Marginal external benefit (MEB)=marginal benefit
accruing to outside parties (positive externality)
–  Marginal external cost (MEC)=marginal cost
accruing to outside parties (negative externality)
Econ 325--Martin Farnham
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Externalities in S-D Context
•  Consumption externalities are shown
with the MB curve
–  MSB=MPB+MEB-MEC
•  Production externalities are shown
through the MC curve
–  MSC=MPC-MEB+MEC
Econ 325--Martin Farnham
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Showing Externalities in S-D Context
•  Spz marginal external
benefit of an activity is
constant
Positive Consumption
Externality
–  Denote with horizontal
P
MEB curve
–  MSB curve will be
vertical shift of D curve
by amount of MEB
(vertical sum)
Peq
–  MSB=MPB+MEB
–  Note similarity to public
good
–  MSC=MPC because no
externality on production
Econ 325--Martin Farnham
side
S=MPC=MSC
MEB
MSB
D=MPB
Qeq Qeff
Q
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Showing Externalities in S-D Context
•  Now spz constant MEB
comes from production
activity; show with S
curve
–  Vertical shift (down) of S
curve by amount of MEB
–  MSC=MPC-MEB
–  MSB=MPB because no
externality on
consumption side
–  Too little produced in
equilibrium
Positive production
externality
P
S=MPC
MSC
Peq
MEB
D=MPB=MSB
Qeq Qeff
Econ 325--Martin Farnham
Q
12
Note that MEC or MEB need not be
constant
•  Could be increasing
P
•  Could start above
zero
MSC
P
MSC
S=MPC
MEC
Peq
MEC
S=MPC
Peq
D=MSB
Qeff Qeq
Q
Econ 325--Martin Farnham
D=MSB
Qeff
Qeq
Q
13
Consider a negative production externality
(MEC>0)
•  Equilibrium at Qeq where
S=D
•  But is this efficient?
–  MSC=MPC+MEC
–  MSC>MSB at Qeq implies
that too much is being
produced
–  Want MSC=MSB
–  Qeff is efficient level of
production
MSC
P
S=MPC
Peq
Econ 325--Martin Farnham
D=MSB
Qeff
Qeq
Q
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Negative Production Externality
•  Without a market intervention, too much of
this good will be produced.
•  How do we know it’s too much?
–  MSC>MSB in equilibrium; this means we could
reduce production by a little bit, and have social
welfare increase
–  Thus social welfare is not maximized in equilibrium
•  Let’s do the welfare analysis to prove this
Econ 325--Martin Farnham
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Neg Prod Externality--Welfare Analysis
•  Social Welfare In
Equilibrium
•  Area A: Total
consumption
benefits of Qeq
MSC
P
C
S=MPC
•  Area B: Total private variable
costs of producing Qeq
D=MSB
•  Area C: Total external costs
of producing Qeq
Peq
A
B
Qeff
Qeq
Q
Neg Prod Externality--Welfare Analysis
•  With negative production externality and
no government intervention,
•  SW=A-(B+C)
•  Or SW=CS+PS-TEC
–  TEC: total external cost
•  SW could actually be negative or zero (as it
appears it might be in this case)
Econ 325--Martin Farnham
17
Neg Production Externality--Welfare
Analysis
loss=
•  What does society gain
from moving from Qeq to
Qeff?
–  Loses total social
benefits of E
–  Gains total social cost
reduction equal to D
–  Net gain of F
–  Note that F is equilibrium
deadweight loss
–  Welfare society could
have if only it moved
from Qeq to Qeff.
E
=gain
P
D
MSC
S=MPC
F
Peq
Econ 325--Martin Farnham
D=MSB
Qeff
Qeq
Q
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Note the Opportunity to Pay Off
Producers/Consumers
•  Take last unit produced
–  No gain to firm or
consumers (Marginal
Producer Surplus=0;
Marginal Consumer
Surplus==0)
–  Big MEC to others
–  Could pay producers +
consumers anything
greater than 0 to
convince it not to
produce/consume last
unit
–  Coordination problem if
many people/firms
involved.
For all Q between Qeff and
Qeq, MEC≥MPS+MCS
MSC
P
S=MPC
Peq
MCS
MEC
MPS
D=MSB
Qeff
Qeq
Q
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This Points to A Couple Ways To Induce
Polluter to “Do the Right Thing”
1) Pay polluter not to pollute.
–  e.g. payment equal to MEC for each unit reduced
from Qeq
2) Charge the polluter for polluting
–  Impose a tax in order to reduce level of the
polluting activity
3) Convince yourself that these are equivalent.
–  A $5 per unit tax raises the opportunity cost of
each unit produced by $5.
–  A $5 per unit reward for not producing raises the
opportunity cost of each unit produced by $5
Econ 325--Martin Farnham
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Aside: Effect of a per unit tax on
output (assume no externality)
•  Suppose we force
suppliers to pay a per
unit tax of $t
•  Per unit tax imposed
on market
S(w/tax)
P
–  Shifts up firms’
“willingness to accept”
Peq+t
curve (Supply)
Pc
–  If they try to pass all of t
Peq
on to consumers, will be
Ps
faced with excess supply.
–  Forces consumer price to
fall; so producer price
falls too: Ps=Pc-t
Econ 325--Martin Farnham
Excess S
S
t
D
Q’eq
Qeq
Q
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Welfare Effects of a per unit Tax
•  Suppose original
equilibrium was
efficient (FFTWE
holds)
–  Social welfare is
maximized without
intervention
–  Tax can only make
things worse
•  Social welfare
without tax
P
CS
S
Peq
Econ 325--Martin Farnham
PS
D
Qeq
Q
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Welfare Effects of a per unit Tax
•  SW=CS+PS+GR
•  Social Welfare with
tax
–  GR: govt revenue
–  GR=t·Q’
•  Note that SW has
declined, due to the
reduction in quantity
–  Some CS was lost
without being recaptured
as GR
–  Some PS was lost
without being recaptured
as GR
–  Lost CS+Lost PS = DWL
P
Govt Revenue
S(w/tax)
CS
S
t
Pc
Peq
DWL
Ps
Econ 325--Martin Farnham
D
PS
Q’eq
Qeq
Q
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Using a per unit tax to correct
an externality
•  Tax is SW reducing for
market success
•  Can be SW improving
for mkt failure
–  w/neg externality, can
restore Qeff
–  Impose tax that sets
t=MEC at Qeff
CS=
PS=
P
GR=
TEC=
MSC
S(w/tax)
t=MEC(Qeff)
Pc
•  SW after tax equals
Peq
areas CS+PS+GR-TEC
Ps
•  Notice that the efficient
quantity involves
Q’eq=Qeff
positive amounts of
the
Econ 325--Martin Farnham
externality.
S=MPC
D=MSB
Qeq
Q
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SW With Tax-Corrected Externality
•  Social welfare in this
case is the area
shown to the right.
•  Social Welfare
SW
–  It’s CS plus the part
of GR not cancelled
out by TEC.
–  Note that PS is
cancelled out by part
of TEC
Econ 325--Martin Farnham
CS+GR+PS
=
-
TEC
25
To Impose Correct Tax, Need to be
able to measure MEC
•  Easier said than done!
–  Spz only one firm pollutes
•  Still need to be able to measure external effects of
pollution
•  How much damage in dollar terms does it really cost?
–  Very difficult to find out
–  Could conduct surveys, but people don’t have incentive to
tell truth; might need to develop means to induce people to
reveal their true valuation of the damages
–  Could try to infer value some other way (e.g. compare
house prices in polluted vs. non-polluted areas)
–  Now spz many firms pollute: hard to assign
damages if different firms pollute different amounts
Econ 325--Martin Farnham
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Externalities--Other Potential
Solutions
•  Other government interventions
•  Private market solutions
–  Assign property rights and allow bargaining
between players
•  Coase Theorem
–  Create market for the externality
–  Find other way to “internalize” externality
•  e.g. Have the apple grower buy the beekeeping
business
Econ 325--Martin Farnham
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Other Government Interventions to
Solve Externality Problem
•  Command and control
–  Govt could just tell firms where to produce
•  Taxes or subsidies
–  Neg externality: too much produced in equilibrium,
so tax it.
–  Positive externality: too little produced in
equilibrium, so subsidize it.
•  Price controls
–  Govt could set price at level that induces
production of efficient quantity
•  Quantity controls
–  Govt could set quota at efficient quantity
•  Won’t work for positive externality. Why?
Private Solutions--Coase Theorem
•  The fundamental problem with externalities is
a lack of assigned property rights
•  Take case of a river with two users (upstream
and downstream)
–  Upstream user values river as place to dump
factory outflow
–  Downstream user values river for clean water and
fishing
–  If neither owns the river, externality likely to be a
problem
Econ 325--Martin Farnham
29
Coase Theorem
•  Without clear property rights, upstream user
will dump waste in river, not taking into
account effect on downstream user
–  River will be “too” polluted
–  Could give river to upstream user
•  Let upstream user pollute; downstream user can pay
upstream user to pollute less
•  Will do so if MEC>(MB-MPC)
•  River will end up as clean as downstream user is willing
to pay for
Econ 325--Martin Farnham
30
Coase Theorem
–  Could give river to downstream user
•  Upstream user could pay downstream user for right to
pollute to some agreed-upon level
•  Will do so as long as (MB-MPC)>MEC
•  River will end up as polluted as upstream user is willing
to pay for
–  Regardless of who we give the property rights, the
outcome will be the same (and will be efficient)
•  Overall SW will be the same
•  Individual welfare will differ, depending on who gets
given the river
Econ 325--Martin Farnham
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Lina and the Dandelions
•  My friend Lina used to own a house
with a front lawn covered with
dandelions (type of weed)
–  She didn’t want to spray chemicals on her
lawn; didn’t mind the dandelions
–  Her neighbor demanded that she spray her
lawn (because seeds were blowing onto
the neighbor’s lawn)
–  How could Coase resolve this?
Econ 325--Martin Farnham
32
Lina and the Dandelions
•  Property rights are fairly clearly assigned
–  There’s no rule that says you must spray
dandelions (so Lina de facto “owned” the right to
let dandelion seeds float off her property)
–  Neighbor could have offered Lina compensation to
spray the dandelions
–  If neighbor valued unblemished lawn more than
Lina valued an organic lawn, Lina would have
sprayed
–  If Lina valued organic lawn more than neighbor
valued absence of dandelions, no spraying would
occur. That would be efficient.
Econ 325--Martin Farnham
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Problems with Coase Theorem
•  Coase Theorem is difficult to implement in
practice
–  Requires small number of players (to keep
bargaining costs low)
•  Good for solving roommate issues over smoking, loud
music, etc.; neighbors resolving conflicts
–  Must be able to identify the source of damages
•  (costless monitoring)
–  What if thousands of people fish in the river?
Hundreds of firms pollute it?
–  How do you assign property rights to air?
Econ 325--Martin Farnham
34
Problems with Coase Theorem
•  Textbook cites example of Zimbabwe giving
elephant herds to local villagers
–  They can hunt them if they want
–  They can preserve them (selectively harvest-typically by selling right to hunt one to Texas oil
barons)
–  But what if herd migrates? Some other people
might hunt them, and there may be no way to
catch them
–  Probably not as clean a case as textbook makes
out, but maybe worth a try
Econ 325--Martin Farnham
35
Lina and the Dandelions
•  Note that Coase isn’t a perfect fix here
either, if dandelions carry long distances
through the air, or if spraying comes
with its own MEC
–  Others may be affected by spraying or lack
thereof
–  Negotiations between all affected parties,
tracking source of seeds, etc. might be
difficult
Econ 325--Martin Farnham
36
Private Solutions--Mergers
•  Take a beekeeper located next to an apple
orchard (2 different firms)
–  Spz costs of apple production are decreasing in
the number of bees
–  Beekeeper doesn’t take this into account
–  Apple producer could pay beekeeper to keep more
bees (Coase)
–  Or apple producer could buy the beekeeper’s firm,
and operate both as one firm.
•  This “internalizes” the externality. Now the firm will take
into account all benefits (and costs) of beekeeping
•  Leads to efficient production (if apple orchard was only
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outside party affected by beekeeping)
Private Solutions--Social
Conventions
•  One way to manage externalities is to
stigmatize actions that lead to them
–  Example: politeness
•  Sometimes its inconvenient to be polite, but we’re taught
from a young age to be civil to others, even when we
have nothing to gain from it
•  There’s an externality associated with politeness; if you
don’t cut someone off in traffic, that person and possibly
others will be happier for it
•  By frowning on impolite behaviour, society (through
social institutions/norms/conventions) manages an
activity with an externality
Econ 325--Martin Farnham
38
Social Conventions
•  Cowardice is frowned upon, in part, because
it has a negative externality associated with it
–  A unit caught in an ambush will be killed or
captured if all members dive behind a rock and
hide
•  But there’s a strong incentive to hope that someone else
will stick their neck out and do the shooting
–  Risk-taking in the face of danger (sometimes
called “valour”) has big external benefits
–  Hence soldiers earn medals for valour (like
subsidizing activities with positive externalities)
and cowards earn ridicule (like taxing activities
with negative externalities)
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Social Conventions
•  During WWI, (some) women in Toronto would
hand out white feathers to young, able-bodied
men on the street
–  Feather symbolized cowardice (!)
•  Note that social sanction (praise or criticism
of actions with externalities), itself, involves a
contribution to a public good.
–  If you litter, I could walk over and have words with
you about it, or I could free ride and let someone
else do it, or just let it go (because it’s costly for
me to do)
–  No guarantee that social conventions will bring
about efficient levels of provision.
•  Another problem with norms: Don’t raise
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revenues! (economists prefer taxes)
Or Maybe Pressure to Contribute to
Public Goods comes from Higher Up
•  Have We Evolved to Believe in God?
•  Listen to an interesting piece on
National Public Radio
–  http://www.npr.org/templates/rundowns/
rundown.php?prgId=2
–  select August 30, 2010 at top of page
–  select “Is believing in God evolutionarily
advantageous?”
–  What does this have to do with public
goods provision?
Econ 325--Martin Farnham
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Creating a Market for an Externality
•  Pollution permits are example of this
•  Spz government knows what efficient total
level of pollution is
–  Could issue permits that each correspond to one
unit of pollution, where total number issued equals
total pollution government wants to allow
–  Install sensors on factory smokestacks
–  Sell permits to polluters; punish those whose
pollution exceeds permits
•  This has some advantages
Econ 325--Martin Farnham
42
Pollution Permits
–  Can collect revenue, while bringing about efficient
pollution reduction
–  Importantly, it keeps abatement costs low
•  Abatement: reduction of pollution
•  Imagine two types of firms; one finds it easy to reduce
pollution, one finds it hard (very costly)
•  From an efficiency perspective, we’d rather have the
firms that can easily reduce pollution do most of the
reduction
•  Permits allow high-cost abaters to pay low-cost abaters
to abate for them
Econ 325--Martin Farnham
43
Pollution Permits
•  Note that initial distribution of permits
(property rights) doesn’t effect efficiency
result
–  Could sell permits to firms
–  Could give permits to firms
•  Could distribute equally across firms
•  Could give all to one firm
–  As long as a market for the permits exists, firms
will buy the permits so long as the price of the
permit is less than their marginal abatement cost
•  Buy permits until P=MAC (marginal abatement cost)
Econ 325--Martin Farnham
44
Pollution Permits
•  One problem with pollution permits is
that there is an assumption that a ton of
pollution is the same regardless of
where it is emitted
–  Might want regional permit programs, if you
think it is more important to reduce
pollution in highly populated areas, or near
particularly valuable or sensitive wilderness
areas
Econ 325--Martin Farnham
45
Externalities and Fairness
•  Studies have shown that poor are
disproportionately subject to pollution
–  Not surprising, if clean air is a normal good
–  Rich may pay real estate premium to live in areas
with clean air and water
–  May be concerned that clean air is “fundamental
right”, not commodity
•  Interventions can reduce or increase fairness
–  Giving a rich factory owner rights to pollute
increases his/her wealth
–  But taxing factory owner will raise price of the
product sold--what if poor are primary consumers?
Externalities and Fairness
•  Interventions that lead to reductions in output
(in case of negative externalities) may lead to
workers being laid off
–  Difficult to assess the distributional impacts of
these attempts at achieving efficiency
–  Poor spend a large fraction of income on
transportation; so gas tax or carbon tax is likely to
hurt poor more than rich
–  This is not to say it shouldn’t be done. Other
redistributive measures could be combined with
correction of the externality to neutralize
distributional effects of correction
•  BC does this with Carbon Tax!
Econ 325--Martin Farnham
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