externalities and public goods (chp.-5 and...

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 TheoryNegative 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 TheoryNegative 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.



– 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


• Properties:

– Negative production externality implies:

• MD > 0

• SMC = PMC + MD > PMC

• SMB = PMB



– 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



– Equilibrium (in steel) in the absence of externalities



– 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).


• 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)



– Graphically,

Externality TheoryNegative 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.


• Properties:

– Negative consumption externality implies:

• MD > 0

• SMC = PMC

• SMB = PMB – MD < PMB


• Example: smoking in a restaurant

– Social equilibrium takes place where

Externality TheoryPositive 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 TheoryPositive 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).


• Properties:

– Positive production externality implies:

• MB > 0

• SMC = PMC – MB < PMC

• SMB = PMB

Externality TheoryPositive 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.


• 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.


• 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.



– Assume the firm offered $100/unit.



– Assume the firm offered $100/unit.

PMC (AN) = PMC (BN) + $100

PMC (AN) = PMC (BN) + MD = SMC


• 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.



– 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 CoasianSolution

• 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 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 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.


• 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

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