1

Externalities

• When a private action has side effects that affect other people in important ways, we have the problem of externalities– By-product of a good or activity that affects

someone not immediately involved in transaction

2

The Private Solution to a Negative Externality

• Under certain conditions, inefficiency that would be caused by a negative externality will automatically be resolved by the parties themselves– The outcome is the efficient outcome

• Achieves maximization of total net benefits possible in the situation

3

The Coase Theorem

• What if building a theater would create $100,000 of benefits for some but $70,000 worth of harm for others?

• Whether the theater will or will not be built depends entirely on whether it is the efficient or inefficient outcome– Regardless of who holds the legal rights– Negative externality is solved by market– No government intervention is required, other

than the initial assignment of legal rights

4

The Coase Theorem

• The Coase Theorem—named after economist Ronald Coase– States that private market will solve externality

problem on its own, always arriving at the efficient outcome

• When side payments can be negotiated and arranged without cost

– While initial distribution of legal rights will determine allocation of gains and losses among the parties, it will not affect action taken

5

The Coase Theorem

• Requires that side payments can be arranged without cost—or, in practice, that cost is so low relative to gains or losses at stake that it doesn’t matter– This requirement is most likely to be satisfied when all of the following

conditions are present• Legal rights are clearly established• Legal rights can be easily transferred• The number of people involved is very small

• Unfortunately, many real world situations do not satisfy these conditions

• Biggest problem is applying Coase theorem to many real-world externalities is the third condition– Often, a large number of people are involved

• When many people are involved, achieving efficiency with side payments is plagued by an often insoluble problem– Free rider problem

6

The Free Rider Problem

• Occurs when efficient outcome requires a side payment but individual gainers—each obligated to pay a small share of the side payment—will not contribute

• If extensive enough—can shrink the side payment until it isn’t large enough to compensate losers and still leave gainers better off

• Stands in the way of many Pareto improvements– One of the main reasons why we typically turn to

government to deal with important externalities that affect many people

7

Market Externalities and Government Solutions

• A competitive market has many buyers and sellers– When a negative externality affects a market, the private solution

is unlikely to work

• A market with a negative externality associated with producing or consuming a good will produce more than the efficient quantity– Creating a welfare loss

• Unfortunately, with so many people involved, it would take too much time and trouble for individual producers and consumers to arrange appropriate side payments and production cutbacks– In any case, free rider problem would effectively destroy the

arrangement– Efficient outcome requires government intervention in the market

8

Figure 11a: A Tax on Producers to Correct a Negative Externality

100 125

D

S

$1.00A

MSC

C $0.50B

(a)

Millions of Gallons per Period

Dollars

2. The efficient quantity is here . . .

3. but the equilibrium quantity is here.

4. In equilibrium, the welfare loss is triangle ABC.

1. This market has a negative externality of $0.50 per unit.

9

Figure 11b: A Tax on Producers to Correct a Negative Externality

100 125

D

$1.00

$0.50B

(b)

Millions of Gallons per Period

Dollars

$1.30

$0.80

SBefore Tax

SAfter Tax

6. shifts the supply curve upward . . .

7. and moves the equilibrium to the efficient quantity.

5. A tax per unit on producers, equal to the negative externality per unit,

A

10

Taxing a Negative Externality

• Government could use a tax on producers to move gasoline market to point B• Payment of the externality tax is shared between consumers and producers,

as is the payment of any tax, and will depend on elasticities of supply and demand

– A tax on each unit of a good, equal to the external harm it causes, can correct a negative externality and bring market to an efficient output level

• Consider the logic of this result– Tax cures the inefficiency because it forces market to internalize the externality

• To take account of the harm caused by gasoline

• Suggests that a tax on consumers of gasoline would work just as well as a tax on producers

• Taxes to correct negative externalities have been used in countries around the world

– In United States, however, taxes designed to correct negative externalities are less common

11

Regulation and Tradable Permits

• A tax is not only way to correct a negative externality– Government can also use regulation to move a market closer to

the efficient point

• In last two decades, U.S. government has relied increasingly on an innovative technique to reduce several types of pollution – Tradable permits

• License that allows a company to release a unit of pollution into the environment over some period of time

– Firms can trade their permits in an organized market

• Left to itself, a market with a negative externality will produce too much output– Taxes, regulation, and tradable permits are examples of

government intervention to decrease output toward efficient level

12

Dealing with a Positive Externality

• What about the case of a positive externality?– By-product of an activity or a service benefits other

parties, rather than harms them

• A market with a positive externality associated with producing or consuming a good will produce less than the efficient quantity, creating a welfare loss

• A subsidy on each unit of a good, equal to the external benefits it creates, can correct a positive externality and bring the market to an efficient output level

13

Figure 12a: A Subsidy for Consumers to Correct a Positive Externality

800,000 1,000,000

D

S

$100,000MSBC

A

$30,000

2. The equilibrium quantity is here . . .

3. but the efficient quantity is here.

4. In equilibrium, the welfare loss is triangle ABC.

(a)

Number of Degrees per Year

Dollars

1.This market has a positive externality of $30,000 per college degree.

B

14

Figure 12b: A Subsidy for Consumers to Correct a Positive Externality

S

800,000 1,000,000

$100,000

B

A

$30,000

Number of Degrees per Year

Dollars

(b)

$114,000

$84,000

DBefore Subsidy

DAfter Subsidy

6. shifts the demand curve upward . . .

5. A subsidy per unit for consumers equal to the positive externality per unit . . .

7. and moves the market to the efficient quantity

15

Public Goods

• Pure private good– One that is both rivalrous and excludable– In absence of any significant market failure, private firms will provide these

goods at close to efficient levels• When a good is nonexcludable, people have an incentive to become

free riders– To let others pay for the good, so they can enjoy it without paying

• When a good is nonexcludable, private sector will generally be unable to provide it– In most cases, if we want such a good, government must provide it

• When a good or service is nonrivalrous, market cannot provide it efficiently– Rather, to achieve economic efficiency, good or service would have to be

provided free of charge• Pure public good

– One that is both nonrivalrous and nonexcludable

16

Figure 13: Pure Private, Pure Public and Mixed Goods

More Nonexcludable

More Excludable

More Rival More Nonrival

Mixed Good

Pure Private Good Mixed Good

Pure Public Good

• food, clothing, housing

• sold-out movie

• crowded highway

• newspaper

• software

• movie with empty seats

• uncrowded highway

• downloaded music file

• cable television

• urban park

• national defense, legal system

• police and fire protection• crowded

city streets• fish in international

waters

17

Mixed Goods

• Goods that appear in upper right and lower left corners of Figure 13 can be called mixed goods– Share features of both public and private goods

• These goods are becoming increasingly important in our society– Are responsible for some growing tension and

controversy

18

Excludable But Nonrivalrous Goods

• Goods near lower left hand corner are excludable but nonrivalrous– Includes most information products– Software is an essentially nonrivalrous good, but an excludable

one• Neither pure public nor pure private

– Digital music files are another example of this type of mixed good• Currently, music remains somewhat excludable

– It is against the law to make copyrighted music available online– Many people—either because of respect for the law, fear of getting

caught, lack of technical expertise, or scarce time—still prefer to buy their music from a store or online shipping service

– Music industry is desperately looking for ways to achieve greater excludability

• Has not yet found a good solution

19

Nonexcludable But Rivalrous Goods

• Tragedy of commons occurs when rivalrous but nonexcludable goods are overuse to detriment of all

• An economy with well-functioning, perfectly competitive markets tends to be economically efficient– Many types of government involvement are needed to ensure that markets

function well and to deal with market failures

• Cases of government involvement are not without controversy– Debates about public education, Social Security, international trade, and

immigration center on questions of proper role for government

• Some of the disagreement is over government’s role in bringing about a more fair economy– Also debate about the government’s role in bringing about economic

efficiency

20

Nonexcludable But Rivalrous Goods

• Information problems– While government may be able to move us closer to efficiency, it can also fall short

or overshoot based on inaccurate information

• Incentive problems for government– Government officials are agents of the general public, and are supposed to serve

public interest• However, they can be influenced by lobbies for special interest groups

• In order for government to have the funds it needs to support markets and do other things, it must raise revenue through taxes

• Inherent problem with provision of public goods that almost guarantees dissatisfaction about them

• Other important roles for government besides fostering efficiency– Equity, fairness, justice, and more

• Anyone studying role of government in the economies is struck by one glaring fact

– Most economic activity is carried out among private individuals

21

Using the Theory: Traffic as a Market Failure

• Almost everyone in United States has been caught in a traffic jam in some large town or city at some point in their lives

• Problem in most cities is getting worse– Consider London, for example

• Traffic congestion has worsened dramatically in recent decades, especially in the historic inner city

• Traffic is an externality problem– When you decide to take your car onto a city street, your decision

is based on the costs and benefits to you• Traffic can be viewed as a mixed good

– Can the government solve the problem?• Some cities, such as New York, do charge tolls for cars that enter via

bridges or tunnels– But entry tolls are problematic, and are rarely set high enough to solve the

problem

22

Using the Theory: Traffic as a Market Failure

• A bigger problem– Political damage to any elected representative who would propose

a fee high enough to be efficient for a good that has traditionally been free

• All of this conventional political wisdom may have changed in early 2003– In early 2003, Ken Livingstone, the Mayor of London, decided to

take a chance• His administration established a 5£ (about $8) per day user fee on any

automobile that appeared in the 8 square mile boundary of London’s inner city

• On the first day the fee applied, traffic dropped about 25%– 60,000 fewer cars entered the area than on a normal day– Officials in New York, Paris, Los Angeles, and other large cities

around the world have been studying London’s success