Externalities and Public
Goods (Chp.-5 and Chp.-6)
Part-1
Externality Theory
• One of the answers to the question:
– “When should the government intervene in
the economy?”
• The general answer:
– When the market fails (the market economy
produces an outcome that does not maximize
social efficiency).
Externality Theory
• Externalities are one of the most common
ways the market economy fails.
• Externality: Externalities arise when the
actions of one party (consumer or
producer) make another party worse or
better-off, yet the first party neither bears
the costs nor receives the benefits of
doing so.
Externality Theory
• Externalities-Examples:
– Production Externalities
• Global warming (negative)
• Steel factory-pollution in the lake (negative)
• Innovations in the absence of copyright laws (positive)
– Consumer Externalities
• Global warming (negative)
• Measles epidemic in the U.S. between 1987 and 1990
(negative)
• Neighbor’s loud stereo (negative)
• Neighbor’s garden (positive)
Externality Theory
Negative Externalities
• Negative externality: When the actions of
one party (consumer or producer) make
another party worse-off, yet the first party
does not bear the costs of doing so.
– Consumer: negative consumer externality
– Production: negative production externality
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– The factory produces steel products as well
as ‘sludge’, a by-pass product that is useless
to the plant owners.
– Plant owners build a pipeline to a close-by
river and dump the sludge into the river.
– The sludge produced is directly proportional
to the steel production.
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– Farther downstream, there is a fishing area
where local fishermen catch fish for sale to
local restaurants.
– Externality: Increasing sludge in the river
decreases the fish population making the
fishermen worse-off, yet the steel plant bears
no cost.
Externality Theory
• Definitions:
– Private marginal cost: The direct cost to
producers of producing an additional unit of a
good.
– Social marginal cost: The private marginal
cost to producers plus any cost associated
with the production of the good that are
imposed on others (marginal damage).
Externality Theory
• Definitions:
– Private marginal benefit: The direct benefit
to consumers of consuming an additional unit
of a good by the consumer.
– Social marginal benefit: The private
marginal benefit to consumers plus any cost
associated with the consumption of the good
that are imposed on others.
Externality Theory
• Definitions:
– Social equilibrium takes place where
SMB = SMC
Externality Theory
Negative Production Externality
• Properties:
– Negative production externality implies:
• MD > 0
• SMC = PMC + MD > PMC
• SMB = PMB
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– Social equilibrium (in steel) in the absence of
externalities takes place when
SMB = SMC PMB = PMC
– Or, in other words private marginal cost
(supply curve) equals the private marginal
benefit.
PMC = PMB
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– Equilibrium (in steel) in the absence of
externalities
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– Equilibrium (in steel) in the presence of
negative production externalities:
• Now, the private marginal cost is not equal to the
cost of producing one unit of steel to the society.
• The society faces both the private marginal cost
(cost of producing one unit of steel to the factory)
and marginal damage to the society (cost of one
unit of steel to the fishermen).
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– (Social) equilibrium (in steel) in the presence
of negative production externalities takes
place when
PMB = SMB = SMC = PMC + MD
– Assume that each unit of sludge production
kills $100 worth of fish. In other words, the
cost to the fishermen of a unit of steel
production equals $100. (MD=$100)
Externality Theory
Negative Production Externality
• Example: steel factory-pollution in the lake
– Graphically,
Externality Theory
Negative Consumption Externality
• If the negative externality is caused by the
actions of consumers.
• Example: smoking in a restaurant
– In a restaurant that allows smoking, one’s
consumption of cigarettes might negatively
effect the well-being of another, yet the first
party is not punished for it.
– Assume that one pack of cigarettes smoked in
the restaurant damages others by 40 cents.
Externality Theory
Negative Consumption Externality
• Properties:
– Negative consumption externality implies:
• MD > 0
• SMC = PMC
• SMB = PMB – MD < PMB
Externality Theory
Negative Consumption Externality
• Example: smoking in a restaurant
– Social equilibrium takes place where
Externality Theory
Positive Externalities
• Positive externality: When the actions of
one party (consumer or producer) make
another party better-off, yet the first party
does not receive the benefits of doing so.
– Consumer: positive consumer externality
– Production: positive production externality
Externality Theory
Positive Production Externality
• Example: Innovations in the absence of
copyright laws
– Assume that one firm invests highly in R&D and
makes a new innovation.
– In the absence of copyright laws, this new innovation
is public in the sense that all other firms can benefit
from it without enduring the R & D costs.
– Therefore, the social marginal cost is less than the
private marginal cost (R&D costs endured by the first
firm).
Externality Theory
Positive Production Externality
• Properties:
– Positive production externality implies:
• MB > 0
• SMC = PMC – MB < PMC
• SMB = PMB
Externality Theory
Positive Consumption Externality
• Example: Neighbor’s lawn
– Assume that my neighbor improves his
landscaping around the house, which I like
better.
– Therefore, the social marginal benefit is
higher than the private marginal benefit (my
neighbor’s marginal benefit of the
improvement), since the improvement also
makes me better-off.
Externality Theory
Positive Production Externality
• Properties:
– Positive production externality implies:
• MB > 0
• SMC = PMC
• SMB = PMB + MB
Solutions to Negative Externalities
• Internalizing the externality: When either
the private negotiations or government
action lead the price to the party to fully
reflect the external costs or benefits of that
party’s actions.
Private-Sector Solutions to
Negative Externalities
• Coase Theorem (Part-1): When there are
well-defined property rights and costless
bargaining, negotiations between the party
creating the externality and the party
affected by the externality can bring about
the socially optimal market quantity.
Private-Sector Solutions to
Negative Externalities
• Steel production example:
– Assume that you assign the property rights of the river
to the fishermen and the firm started negotiations with
the fishermen in order to produce steel. (no sludge-no
steel)
– If the steel factory owner offers the fishermen at least
$100 per unit of steel (covers at least the marginal
damage to the fishermen), the fishermen will agree.
– As long as the steel factory does not incur losses with
this extra payment per unit, it will produce.
Private-Sector Solutions to
Negative Externalities
• Steel production example:
– Assume the firm offered $100/unit.
Private-Sector Solutions to
Negative Externalities
• Steel production example:
– Assume the firm offered $100/unit.
PMC (AN) = PMC (BN) + $100
PMC (AN) = PMC (BN) + MD = SMC
Private-Sector Solutions to
Negative Externalities
• Coase Theorem (Part-2): The efficient
solution to an externality does not depend
on which party is assigned the property
rights, as long as someone is assigned
those rights.
Private-Sector Solutions to
Negative Externalities
• Steel production example:
– Now, assume that you assign the property rights of
the river to the firm
– In this case, the fishermen might find it beneficial to
make an offer (per unit) to the firm to produce less.
– The maximum offer the fishermen will make is
$100/unit, since otherwise they will be worse-off with
the offer.
– Now, there is an incentive for the firm ($100/unit) not
to produce.
The Problems with the Coasian
Solution
• The Assignment Problem
– Who are we going to assign the blame to?
• Rivers can be long with multiple factories nearby.
– How do we determine the magnitude of the
damage?
• Can we trust the fishermen to reveal their losses
truthfully?
• Not necessarily.
The Problems with the Coasian
Solution
• The Holdout Problem: Shared ownership
of property rights gives each owner power
over all others.
– Assume 100 fishermen with 1$ damage per
unit of steel per fishermen.
– The fishermen gets paid $1/unit.
– The last fisherman to get the money might
ask for more than $1/unit.
The Problems with the Coasian
Solution
• The Free Rider Problem: When an investment
has a personal cost but a common benefit,
individuals will under-invest.
– Assume that the firm has the property rights to the
river and there are 100 fishermen each of whom
agrees to pay $1/unit to the firm to reduce production.
– The last fisherman to pay the money might no pay,
but still benefit from the reduction in production
caused by the payment made by the 99 previous
fishermen.
The Problems with the Coasian
Solution
• Transaction Costs and Negotiating
Problem
– There might be more than 1 firm and more
than 100 fishermen harder and costlier to
negotiate.
– Relies heavily on the well-designed nature of
the property rights.
• Disturbing neighbor