Basics Remedies Empirical & Behavioral
Lecture 9: Externalities
Johannes Spinnewijn
London School of Economics
Lecture Notes for Ec426
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Basics Remedies Empirical & Behavioral
Outline
Basic model
Policy Interventions
Measuring externalities / Behavioral internalities
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Basics Remedies Empirical & Behavioral
De…nition Model
De…nition Externalities
An externality arises whenever the utility or production
possibility of an agent depends directly on the actions of
another agent
Important distinction between “pecuniary” vs.
“non-pecuniary” externalities
Consuming an apple vs. consuming loud music
Operates through prices. Hence, distinction depends on market
in place
Coasian view: can convert all externalities into pecuniary
externalities with appropriate markets, property rights
Only non-pecuniary externalities justify policy intervention
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Basics Remedies Empirical & Behavioral
De…nition Model
Externalities: Main Questions
1
Theoretical: what is the best way to correct externalities and
move closer to the social optimum?
2
Empirical: how to measure the size of externalities (cannot
use standard revealed preference)?
3
Behavioral: what is the importance of internalities and how to
deal with them?
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Basics Remedies Empirical & Behavioral
De…nition Model
Model of Externalities
Firms produce x cars using c (x ) units of the numeraire y
Generates x units of pollution: P (x ) = x
Continuum of consumers with wealth Z and quasilinear utility:
u (x ) + y
d P (x )
where d = marginal damage (MD) of pollution
Let p denote the market price of cars
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Basics Remedies Empirical & Behavioral
De…nition Model
Model of Externalities: Equilibrium
Firms max pro…ts:
max px
c (x )
Consumers max utility, taking level of pollution as …xed:
max u (x ) + Z
px
Demand and supply satisfy
u 0 (x D ) = p = c 0 (x S )
At equilibrium price, PMB equals PMC:
u 0 (x D ) = c 0 (x S ),
but this is not Pareto e¢ cient.
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Basics Remedies Empirical & Behavioral
De…nition Model
Negative Production Externalities: Pollution
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Basics Remedies Empirical & Behavioral
De…nition Model
Model of Externalities: Deadweight Loss
Perturbation argument: can achieve Pareto-optimum by
reducing production. Consider a small change ∆x :
dUp = p
c 0 (x ) ∆x = 0
and
dUA
=
=
u 0 (x )
p ∆x
d ∆x
d ∆x > 0 if ∆x < 0
First Welfare Theorem does not hold!
Analogous result for consumption externalities. For instance,
UA (x, y ) = u (xA ) + yA
φ (xB )
UB (x, y ) = u (xB ) + yB
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Basics Remedies Empirical & Behavioral
Remedies for Externalities
1
A¤ecting Prices:
Coasian bargaining solution
Pigouvian corrective taxation
2
A¤ecting Quantities: Regulation
3
Price & Quantity: Permits (cap-and-trade)
) Equivalence between Price and Quantity policies breaks down
under uncertainty (Weitzman 1974)
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Basics Remedies Empirical & Behavioral
Coasian Solution
Externalities emerge because property rights are not well
de…ned. Establish property rights to create markets for
pollution.
Consider example of car producers polluting nearby river
if citizens own the river, in competitive equilibrium, …rms pay
d for every unit of pollution
marginal cost of production is now c 0 (x ) + d, leading to 1st
best
Symmetric solution when producers own river; assignment of
property rights a¤ects distribution but not e¢ ciency
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Basics Remedies Empirical & Behavioral
Coasian Solution: Limitations
1
Cost of bargaining
ex: air pollution – would require millions of agents to
coordinate and bargain
to reduce transactions costs, need an association/government
to represent agents
2
Uncertainty / asymmetric information: competitive
equilibrium can break down
often hard to identify precise source of damage
e.g. atmospheric pollution very di¤use, marginal damages
unclear
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Basics Remedies Empirical & Behavioral
Pigouvian Taxation
Impose tax t = MD (Q )
Restores Pareto e¢ ciency and maximizes social welfare
Practical limitations:
must know marginal damage function to set t
di¢ cult to measure the marginal damage in practice
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Basics Remedies Empirical & Behavioral
Pigouvian Tax
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Basics Remedies Empirical & Behavioral
Regulation: Command and Control
Must reduce pollution to set level or face legal sanctions
Same outcome as Pigouvian taxation: move people to x2
Practical Limitations
allocative ine¢ ciency ) solve through cap-and-trade system
dynamics: incentives to innovate?
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Basics Remedies Empirical & Behavioral
Externalities: Empirical Measurement
How to measure the cost of an externality? Absence of
markets makes that we cannot rely on prices, i.e., the revealed
value through market interactions.
Two approaches
Contingent valuation ) issues are quite clear
Indirect market-based methods ) precise, but incomplete (see
Edlin and Karaca-Mandic)
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Basics Remedies Empirical & Behavioral
Behavioral Internalities
People do not internalize all consequences of their actions on
themselves due to bounded rationality, unawareness,
inattention, ... ) “internalities”
For example, smoking cigarettes entails internal costs that
dwarf the external costs.
Current tax rate on cigarettes and alcohol is hard to be
explained by conventional Pigouvian argument
Q: Does "overconsumption" justify taxation? A: Highly
sensitive to positive&normative model.
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