EXTERNALITIES
PhD. Anto Bajo,
Faculty of Economics and Business,
University of Zagreb
Externalities
• Externalities - the effect that is the consequence of the action
of one individual directly on the welfare of other individuals,
during which this action is not produced via market prices.
• Unlike effects that are transmitted via market prices,
externalities have an unfavourable effect on economic
efficiency.
• Externalities are the consequence of inability to establish
property rights.
• One of the most important applications of the externalities
theory is in the debate on environmental quality.
Externalities
• Externalities appear always when the decision of the individual about
production or consumption directly affects production of consumption of
other individuals, but not via market mechanisms.
• Externalities represent a situation in which Pareto efficiency conditions are
distorted, prices do not reflect all cost-benefits, ie. there is no correlation
between private and social costs and benefits.
• In the situation in which externalities exist, the condition for socially
optimal production is equality of marginal social cost and marginal social
benefit.
• In conditions in which externalities exist, market mechanisms do not
produce and optimal solution and so state intervention is necessary either
by regulation, taxes or establishment of property rights.
1
Externalities
• The two basic kinds are external economies and external diseconomies
that appear in production and consumption.
• In a situation of the existence of external economies, the activities of
economic decision makers create benefits for others, who do not pay for
them
• In conditions of external diseconomies, the activities of the economic
decision makers create costs for others that are not reimbursed them.
Externalities
Characteristics of externalities:
• Can be produced by consumers and producers (firms)
• are reciprocal in nature.
• Can be positive.
• Public goods can be observed as special kind of externality.
Market failures
•
The private benefits is the benefit to the person or firm undertaking the activity of
steel production.
•
Social Benefit is the benefit to everyone in the society from the production of steel.
•
Since the only one that gets a benefit from the production of steel are the
consumers, in this case the private benefit is equal to social benefit.
•
The first set of cost of producing steel are private because the firm is the only
paying for them.
•
The second set of costs (health damages) are paid by everyone that lives in City
regardless of whether they work in the factory or not.
•
In this case: private cost < social cost
•
Private Cost: The cost to produce steel
•
Social Cost: The cost to produce steel, Health Damages to the city
2
Market failures
Social Cost:
Private Cost:
1) The cost to produce
steel
These are paid for by
the firm.
Private Benefit:
1) The cost to produce steel.
1) Using steel
2) Health Damage to City
Only consumers of
steel get it.
These are paid for by the firm and the
city
Private vs. social costs
Cigarettes
Willingness to Pay
Marginal Willingness
to Pay
Private Marginal
Benefit
1
5
5
5
2
9
4
4
3
12
3
3
4
14
2
2
Steel
Production
Total Cost
of
producing
steel
Marginal Cost
of producing
steel
Total Health
Damages and
annoyance to
City
(1)
Marginal Health
Damages and
annoyance to City
Total
Social
Cost
Social
Marginal Cost
(1+2)
(2)
1
2
2
1.5
1.5
3.5
3.5
2
4.5
2.5
3.0
1.5
7.5
4.0
3
7.5
3
4.5
1.5
12.0
4.5
4
11.5
4
6.0
1.5
17.5
5.5
The Nature of Externalities-Graphical Analysis
MSC = MPC + MD
$
MPC
h
d
g
c
0
Socially efficient output
MD
b f
a e
Q* Q1
MB
Q per year
Actual output
3
Externalities
During transition to an efficient level of production:
• A producer loses profit in the amount dcg
• A consumer makes a profit because of reduction of damage in the
amount abef which is the same as cdgh
• Net gain for society is the difference between cdgh and dcg, or dgh
Externalities
• Zero pollution is on the whole not socially desirable – it would on the
whole imply the prevention of production, an inefficient solution.
• In an estimate of the real marginal damage and benefit it is necessary to
detect and evaluate damage from pollution:
• Identify what activities produce pollution
• Determine damage caused by pollution
• Determine value of damage incurred (eg., purchase of houses and
flats)
Table 2. Air pollutants in 2015 (tones)
NH3 - Ammonia
EU-28
Belgium
Bulgaria
Czech Republic
Denmark
Germany
Estonia
Ireland
Greece
Spain
France
Croatia
Italy
Cyprus
Latvia
Lithuania
Luxembourg
Hungary
Malta
Netherlands
Austria
Poland
Portugal
Romania
Slovenia
Slovakia
Finland
Sweden
United Kingdom
Iceland
Liechtenstein
Norway
Switzerland
Turkey
Source: Eurostat,
2013
3.847.870
62.233
30.497
68.500
74.320
670.849
11.303
107.758
60.570
379.308
718.133
33.729
402.230
4.756
14.707
40.410
4.573
81.243
1.586
133.801
66.249
263.402
49.111
165.147
17.451
25.245
37.283
52.168
271.309
5.337
174
27.239
61.690
1.089.748
NOx - Nitrogen oxides
8.176.454
207.680
122.573
181.094
123.865
1.269.182
29.721
79.064
238.621
812.152
989.521
55.749
820.574
16.164
34.044
46.166
31.434
120.567
4.872
239.619
162.317
798.233
161.476
218.823
42.893
79.582
144.877
125.915
1.019.674
20.775
704
154.437
72.304
1.047.000
NMVOC - Non-methane
volatile organic compounds
7.004.930
137.430
88.832
136.397
114.431
1.138.241
32.931
90.001
144.765
550.801
758.380
46.072
905.539
6.681
87.448
63.394
7.650
120.400
3.318
149.682
126.341
635.776
169.630
322.953
33.324
63.204
94.558
173.756
802.997
5.402
417
133.737
84.139
868.184
SOx- Sulphur oxides
3.429.764
45.558
193.966
137.915
13.643
416.214
36.500
25.393
152.327
287.128
218.785
16.378
145.054
13.766
1.502
18.928
1.580
29.309
5.028
29.926
17.245
846.845
42.276
202.676
11.294
53.208
47.377
26.785
393.158
72.563
28
17.038
10.207
1.939.104
4
Source of pollution in 2013 (Eurostat, 2016)
Source: Eurostat, 2016
Avoiding inefficiencies created by externalities –
privat vs public responses
• Private response to externalities:
• Defining property rights
• Merging firms and internalizing externalities
• Application of social conventions and moral rules
• Public response to externalities:
•
•
•
•
Taxes
Subsidies
Market creation
Determination of property rights
• Regulation
Avoiding externalities: property rights
• Basic cause of externalities is lack
of property rights, a natural
manner for solving problems is
the privatisation of the relevant
resources.
Coase theorem
(as soon as property rights have been
established there is no longer any need for
government intervention to solve problems
of externalities)
MSC=MPC+MD
$
• Reasons for negotiation exist as
long as MD> (MB – MPC)
• Effective
solution
can
be
achieved irrespective of who the
property rights are allocated to.
The Coase theorem deals with
this.
MPC
MD
MB
0
Q*
Q
Q p.a.
5
Avoiding externalities: propery rights
Coase's theorem(1960), externalities do not contribute to a inefficient allocation of
resources until there are no transaction costs and that property rights are completely
defined.
In this situation, both parties, the party that produces the externalities and the party
that was affected, have a market incentives to negotiate about mutually useful trade.
According to the CT, the outcome of the process will be the same nevertheless who has
the right of veto over the use of the resources
Two reasons why society cannot always rely on the Coase theorem in the
settlement of the problem of externalities:
1. The theorem requires that negotiation costs be low
2. The theorem assumes that owners of resources can define the source that
damages their property and can legally prevent this damage.
The allocation of property rights affects distribution of income.
Avoiding inefficiencies created by
externalities: Taxes
• Pigou (1930s) - polluters produce too much because they
are faced with too low production costs and so to correct
this they can have taxes imposed on them which will
increase the price of inputs - Pigou tax
Pigou tax is the tax imposed on each unit of polluting
production in the amount equivalent to the marginal damage
at an efficient level of production
Public Responses to Externalities Taxes
MSC = MPC + MD
(MPC + cd)
$
Pigouvian
tax revenues
i
j
MPC
d
c
MD
MB
0
Q*
Q1
Q per year
6
Avoiding externalities – produced
inefficiencies: Taxes
• for the accomplishment of efficiency it is not necessary to give
compensation to pollution sufferers
• It is hard to find the appropriate tax rate
• The application of tax assumes that the polluter and the degree of
pollution are known.
• Solution: ie. special sales tax on the car
Preventing externalities – produced
inefficiencies: subsidies
• An efficient level of production can be achieved by paying producers not
to pollute (assuming a fixed number of polluters) - pollution subsidies
• For levels of production > Q* the opportunity cost of product (MPC + cd)
is greater than the marginal benefit (MB)
Public Responses to Externalities Subsidies
MSC = MPC + MD
(MPC + cd)
$
MPC
Pigouvian
subsidy
i
d
f
j
c
h
0
Q*
e
Q1
MD
MB
Q per year
7
Avoiding externalities
inefficiencies: subsidies
–
produced
• The consequences of taxes and subsidies to distribution are different for
instead of paying a tax ijcd the polluter receives a subsidy dfhc
• A subsidy leads to greater profits and in the long run production that
produces pollution will become attractive for an increasing number of
producers and this can lead to a growth of overall pollution
• For the payment of subsidy, taxes must be collected. Taxes produces costs
(reduce incentives for work and investment), which might exceed the
benefits from the removal of externalities
• Subsidies can be ethically undesirable
Avoiding externalities: Market creation
• The price that is paid for a license
to pollute – pollution fee
• A government can allocate
right to pollute by auction, or
allocate them to firms, which
then freely sell them –
consequences to distribution
different
the
can
can
the
are
Market of rights or licenses to
pollute
Dollars p.a.
• The state/government can improve
efficiency by selling licenses to
pollute and by creating a market
for clean air and water
SZ
P1
DZ
Z*
• Pollution
fees
reduce
the
uncertainty with respect to
ultimate quantity of pollution,
unlike a Pigou tax
Rights to produce SO2 (pp 100 million)
p.a.
Positive externalities – R&D
$
MC
b
a
MSB = MPB + MEB
MPB
MEB
R1
R*
R&D per year
8
Caution with subsidies
•
Requests for subsidies:
– Resources extracted from taxpayers
– Market is sometimes (not always) inefficient
A subsidy is appropriate only if the market does not allow those
performing the activity to capture the full marginal return.
9