Externalities

1
Externalities

• Today Markets without ownership usually lead to
  inefficient outcomes

2
Market failures

• Previously
• Monopolies
• Cartels
• Today Ending Unit 4
• Externalities
• Next week Beginning Unit 5
• Applications of externalities

3
Today

• Externalities
• Inefficiencies without regulation
• The Coase theorem
• Optimal amount of externalities
• Some ways to reach more efficient solutions when
  externalities are present
• Examples

4
Externalities 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

5
A market without regulation

• Without regulation, consumers and producers only
  look at private costs and private benefits in
  order to decide on production and consumption

6
A market without regulation
external cost per unit

• Notice that production of each unit of good leads
  to external costs

7
What 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

8
A market without regulation
external cost per unit
( Social MB)

• Where is Social MB equal to Social MC?

9
A market without regulation
external cost per unit
( Social MB)

• Where is Social MB equal to Social MC? Quantity
  E, Price B

10
A 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

11
A market without regulation
external cost per unit
( Social MB)

• Deadweight loss shaded
• These units produced have Social MC greater than
  Social MB

12
Why 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

13
Costly 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

14
Coase 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
15
Coase 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)

16
Coase theorem and costly negotiation

• Since negotiation is typically costly, we need
  government intervention to increase efficiency
• Taxes
• Quotas

17
Government 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

18
A 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

19
A 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

20
A 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

21
A 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

22
Remember

• 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

23
Examples 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

24
Examples 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

25
Examples of externalitiesCost or benefit?

• Christmas decorations
• A fan blowing in a warm office building
• Use of perfume or cologne

26
An algebraic example

• Suppose Private MC equals production ? MC Q
• Let Demand be denoted by P 100 Q
• Let External Cost be 10 per unit

27
An 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

28
An algebraic examplePrivate equilibrium
MC Q
P 100 Q

• Inefficient equilibrium w/o controls
• Set Q 100 Q ? Q 50 (quantity F)

29
An algebraic exampleSocially optimal equilibrium
MCSocial Q 10
P 100 Q

• Socially optimal equilibrium Set
• Q 10 100 Q ? Q 45 (quantity E)

30
An 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

31
This concludes basic externality theory

• Upcoming applications
• Wednesday
• Congestion in cities and on highways
• Friday
• Tragedy of the Commons
• Environmental and safety regulation

32
Summary

• 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