Externalities Today Markets without ownership usually lead to

Externalities Today: Markets without ownership usually lead to inefficient outcomes

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

Externalities: Definition n External cost (benefit) n n “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? n n There is often no formal market for the cost or benefit in question Private negotiation typically must occur to increase efficiency

A market without regulation n Without regulation, consumers and producers only look at private costs and private benefits in order to decide on production and consumption

A market without regulation external cost per unit n Notice that production of each unit of good leads to external costs

What is efficient? n To find efficiency, we need to have no further possibilities to have beneficial exchange of a good or service n n Social costs and benefits lead to overall efficiency Too much is produced to be efficient, since social costs and benefits determine efficiency

A market without regulation external cost per unit (= Social MB) n Where is Social MB equal to Social MC?

A market without regulation external cost per unit (= Social MB) n Where is Social MB equal to Social MC? Quantity E, Price B

A market without regulation Private market forces will produce up to quantity F external cost per unit (= Social MB) n Production above quantity E results in lower efficiency, since Social MB is less than Social MC

A market without regulation external cost per unit (= Social MB) n Deadweight loss shaded n These units produced have Social MC greater than Social MB

Why do we see inefficiencies? n n Often, negotiation is costly Example: A polluter in the Los Angeles metro area n n n 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

Costly negotiation n Negotiation is typically costly n n Remember, time is worth something Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

Coase theorem n The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur n n n People can negotiate costlessly The right can be purchased and sold Given the above conditions, efficient solutions can be negotiated Ronald Coase

Coase theorem n n Notice that the Coase theorem addresses efficiency To get to efficiency, the quantity of most goods and services produced is still positive n Example: It is not efficient to get rid of all pollution n If all pollution was gone, we could not live (since we exhale CO 2)

Coase theorem and costly negotiation n In the real world, the Coase theorem usually does not easily apply n n Negotiation is costly Government intervention can lead to increased efficiency n n Taxes Quotas

Government intervention n n 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

A market with regulation: Tax With tax equal to distance of vertical arrow: The efficient solution is achieved external cost per unit (= Social MB) n The government can set a tax equal to the external cost per unit

A market with regulation: Marketable permits with resale n n 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 n Sale of permits guarantees that producers with lowest private MC can get permits

A market with regulation: Marketable permits to sell external cost per unit (= Social MB) n n Quantity of permits available: E Low-cost producers will buy permits if they do not have them

A market with regulation: Marketable permits to sell external cost per unit (= Social MB) n Market price for the good will be B, since E units are being produced

Remember n n n 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

Examples of externalities as costs n n n Particulate matter and gases released from driving cars Freeway noise Washing you car in your driveway, followed by hosing the soap off n Soap goes into storm drains, polluting the ocean

Examples of externalities as benefits n n n Planting flowers in your front lawn Scientific research Finding information that is useful to a group of people n Example: One person finds the fastest route for a trip that many people will be taking; everyone can use this information to their benefit

Examples of externalities: Cost or benefit? n n n Christmas decorations A fan blowing in a warm office building Use of perfume or cologne

An algebraic example n n n Suppose Private MC equals production MC = Q Let Demand be denoted by P = 100 – Q Let External Cost be $10 per unit

An algebraic example MCSocial = Q + 10 MC = Q external cost per unit of $10 P = 100 – Q n Translate equations and External Cost to our graphical example

An algebraic example: Private equilibrium MC = Q P = 100 – Q n Inefficient equilibrium w/o controls: Set Q = 100 – Q Q = 50 (quantity F)

An algebraic example: Socially optimal equilibrium MCSocial = Q + 10 P = 100 – Q n n Socially optimal equilibrium: Set Q + 10 = 100 – Q Q = 45 (quantity E)

An algebraic example: Price MCSocial = Q + 10 MC = Q Price B = 55 Price C = 50 Recall E = 45 and F = 50 n n external cost per unit of $10 P = 100 – Q Inefficient equilibrium, P = Q P = 50 Socially optimal equilibrium, P = Q + 10 P = 55

Summary n n n 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