Title: Externalities
1Externalities
- Today Markets without ownership usually lead to
inefficient outcomes
2Market failures
- Previously
- Monopolies
- Cartels
- Today Ending Unit 4
- Externalities
- Next week Beginning Unit 5
- Applications of externalities
3Today
- Externalities
- Inefficiencies without regulation
- The Coase theorem
- Optimal amount of externalities
- Some ways to reach more efficient solutions when
externalities are present - Examples
4Externalities Definition
- External cost (benefit)
- A cost (benefit) of an activity that falls on
people other than those who pursue the activity
(F/B p. 348) - What else is going on?
- There is often no formal market for the cost or
benefit in question - Private negotiation typically must occur to
increase efficiency
5A market without regulation
- Without regulation, consumers and producers only
look at private costs and private benefits in
order to decide on production and consumption
6A market without regulation
external cost per unit
- Notice that production of each unit of good leads
to external costs
7What is efficient?
- To find efficiency, we need to have no further
possibilities to have beneficial exchange of a
good or service - Social costs and benefits lead to overall
efficiency - Too much is produced to be efficient, since
social costs and benefits determine efficiency
8A market without regulation
external cost per unit
( Social MB)
- Where is Social MB equal to Social MC?
9A market without regulation
external cost per unit
( Social MB)
- Where is Social MB equal to Social MC? Quantity
E, Price B
10A market without regulation
Private market forces will produce up to quantity
F
external cost per unit
( Social MB)
- Production above quantity E results in lower
efficiency, since Social MB is less than Social MC
11A market without regulation
external cost per unit
( Social MB)
- Deadweight loss shaded
- These units produced have Social MC greater than
Social MB
12Why do we see inefficiencies?
- Often, negotiation is costly
- Example A polluter in the Los Angeles metro
area - Who owns the air? (Polluter or residents?)
- If the polluter owns the air, the firm will not
care about the residents - If the residents own the air, it is prohibitively
costly to negotiate with every person affected by
pollution
13Costly negotiation
- Negotiation is typically costly
- Remember, time is worth something
- Even if a resource is owned by someone, costly
negotiation can prevent better outcomes from
occurring
14Coase theorem
- The Coase theorem tells us the conditions needed
to guarantee that efficient outcomes can occur - People can negotiate costlessly
- The right can be purchased and sold
- Given the above conditions, efficient solutions
can be negotiated
Ronald Coase
15Coase theorem
- Notice that the Coase theorem addresses
efficiency - To get to efficiency, the quantity of most goods
and services produced is still positive - Example It is not efficient to get rid of all
pollution - If all pollution was gone, we could not live
(since we exhale CO2)
16Coase theorem and costly negotiation
- Since negotiation is typically costly, we need
government intervention to increase efficiency - Taxes
- Quotas
17Government intervention
- The government can estimate costs of negative
externalities at relatively low cost - Based on these external costs, they can set a tax
or quota to reduce the amount of the externality
to an efficient level
18A market with regulation Tax
With tax equal to distance of vertical arrow
The efficient solution is achieved
external cost per unit
( Social MB)
- The government can set a tax equal to the
external cost per unit
19A market with regulation Marketable permits
with resale
- An alternative to a tax is to sell or distribute
marketable permits - To be effective, these permits must be able to be
sold and resold - Sale of permits guarantees that producers with
lowest private MC can get permits
20A market with regulation Marketable permits to
sell
external cost per unit
( Social MB)
- Quantity of permits available E
- Low-cost producers will buy permits if they do
not have them
21A market with regulation Marketable permits to
sell
external cost per unit
( Social MB)
- Market price for the good will be B, since E
units are being produced
22Remember
- I have gone through the case where externalities
are costs - Externalities can be either costs or benefits,
however - When there are positive externalities, subsidies
can help to increase efficiency
23Examples of externalities as costs
- Particulate matter and gases released from
driving cars - Freeway noise
- Washing you car in your driveway, followed by
hosing the soap off - Soap goes into storm drains, polluting the ocean
24Examples of externalities as benefits
- Planting flowers in your front lawn
- Scientific research
- Finding information that is useful to a group of
people - Example One person finds the fastest route for
a trip that many people will be taking everyone
can use this information to their benefit
25Examples of externalitiesCost or benefit?
- Christmas decorations
- A fan blowing in a warm office building
- Use of perfume or cologne
26An algebraic example
- Suppose Private MC equals production ? MC Q
- Let Demand be denoted by P 100 Q
- Let External Cost be 10 per unit
27An algebraic example
MCSocial Q 10
MC Q
external cost per unit of 10
P 100 Q
- Translate equations and External Cost to our
graphical example
28An algebraic examplePrivate equilibrium
MC Q
P 100 Q
- Inefficient equilibrium w/o controls
- Set Q 100 Q ? Q 50 (quantity F)
29An algebraic exampleSocially optimal equilibrium
MCSocial Q 10
P 100 Q
- Socially optimal equilibrium Set
- Q 10 100 Q ? Q 45 (quantity E)
30An algebraic example Price
MCSocial Q 10
MC Q
Price B 55
external cost per unit of 10
Price C 50
P 100 Q
Recall E 45 and F 50
- Inefficient equilibrium, P Q ? P 50
- Socially optimal equilibrium, P Q 10 ? P 55
31This concludes basic externality theory
- Upcoming applications
- Wednesday
- Congestion in cities and on highways
- Friday
- Tragedy of the Commons
- Environmental and safety regulation
32Summary
- When external costs or benefits enter a market,
private equilibrium is usually inefficient - A tax or quota can be set to lead to efficient
equilibrium when a negative externality occurs - Subsidies can improve efficiency with positive
externalities