Chapter 3 Externality

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CHAPTER 2EXTERNALITIES: PROBLEMS

AND SOLUTIONS

Introduction

Externalities arise whenever the actions of one

party make another party worse or better off, yet

the first party neither bears the costs nor receives

the benefits of doing so.

As we will see, this represents a market failure for

which government action could be appropriate andimprove welfare.

EXTERNALITY

1. EXTERNALITY THEORY



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1. EXTERNALITY THEORY

Externalities can either be negative or positive, and they can

also arise on the supply side (production externalities) or the

demand side (consumption externalities).

A negative production externality is when a firm’s

production reduces the well-being of others who are not

compensated by the firm.

A negative consumption externality is when an

individual’s consumption reduces the well-being of others

who are not compensated by the individual.

The basic concepts in positive externalities mirror those in

negative externalities.

a, Economics of Negative Production Externalities

To understand the case of negative productionexternalities, consider the following example:

A profit-maximizing steel firm, as a by-product of its production,

dumps sludge into a river.

The fishermen downstream are harmed by this activity, as the fish

die and their profits fall.

This is a negative production externalities because:

Fishermen downstream are adversely affected.

And they are not compensated for this harm.

Figure 2Figure 2 illustrates each party’s incentives in this situation.



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Priceof steel

p 1

p 2

0 Q 2 Q 1 Q STEEL

D = PM B =

SMB

S =PMC

SMC = PMC +

MD

MD

Figure 2 Negative Production Externalities

b, Negative Consumption Externalities

We now move on to negative consumptionexternalities. Consider the following example:

A person at a restaurant smokes cigarettes.

That smoking has a negative effect on your enjoyment of

the restaurant meal.

In this case, the consumption of a good reduces the well-being of someone else.

Figure 3Figure 3 illustrates each party’s incentives in the

presence of a negative consumption externality.

Q CIGARETTES

Price of

cigarettes

0 Q 2

D =PMB

Q 1

p 1

S =PMC =SMC

SMB =PMB -MD

MDp 2

Figure 3 Negative Consumption Externalities



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c, Positive Externalities

Positive externalities can occur in production orconsumption.

A positive production externality is when a firm’s

production increases the well-being of others, but the firm

is not compensated by those others.

Research and development is a production externality.

A positive consumption externality is when an

individual’s consumption increases the well-being of others,

but the individual is not compensated by those others.

Nice landscaping could be a consumption externality.

c, Positive Externalities

Let’s consider positive production externalities.

Consider the following example:

A policeman buys donuts near your home.

As a consequence, the neighbors are safer because of the

policeman’s continued presence.

In this case, the production of donuts increases the well-being of the neighbors.

Figure 4Figure 4 illustrates each party’s incentives in the

presence of a positive production externality.

Q DONUTS

Price of

donuts

0 Q 2

D = PMB =

SMB

Q 1

p1

S = PMC

SMC = PMC -

EMB

EMB

p 2

Figure 4 Positive Production Externalities



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Positive Externalities

Finally, there can be positive consumptionexternalities.

A neighbor’s improved landscape is a good example

of this.

The graphical analysis is similar to negative

consumption externalities, except that the SMB

curve shifts outward, not inward.

Positive Externalities

The theory shows that when a negative externality

is present, the private market will produce too

much of the good, creating deadweight loss.

When a positive externality is present, the private

market produces too little of the good, again

creating deadweight loss.

EXTERNALITY

2. THE COASE THEOREM

The Solution for Private sector



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The Solution for Private Sector

The Coase Theorem: When there are well-definedproperty rights and costless bargaining, then

negotiations between the parties will bring about

the socially efficient level.

Thus, the role of government intervention may be

very limited—that of simply enforcing property

rights.

The Solution (Coase Theorem)

Consider the Coase Theorem in the context of the

negative production externality example from

before.

Give the fishermen property rights over the amount

of steel production.

Figure 5Figure 5 illustrates this scenario.

Q STEEL

Price

of steel

0 Q 2

D = PMB SMB

Q 1

p 1

S = PMC

SMC = PMC +

MD

MD

p 2

1 2

Figure 5 Negative Production Externalities and Bargaining



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The Solution (Coase theorem)

Through a process of bargaining, the steel firm willbribe the fishery to arrive at Q2, the socially optimal

level.

After that point, the MD exceeds ( PMB - PMC ), so

the steel firm cannot come up with a large enough

bribe to expand production further.


Another implication of the Coase Theorem is that

the efficient solution does not depend on which

party is assigned the property rights, as long as

someone is assigned them.

The direction in which the bribes go does depend

on the assignment, however. Now, let’s give the property rights to the steel firm

over the amount of steel production.

Figure 6Figure 6 illustrates this scenario.

Figure 6 Negative Production Externalities and Bargaining

Q STEEL

Price

of steel

0 Q 2

D=PMB=SMB

Q 1

p 1

S = PMC

SMC = PMC +

MD

MD

p 2



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Figure 6Figure 6 shows that even though the bargaining process is somewhat different, the socially efficient

quantity of Q2 is achieved.

Problems with Coasian Solutions

There are several problems with the Coase

Theorem, however.

The assignment problem

The holdout problem

The free rider problem

Transaction costs and negotiating problems


The “assignment problem” relates to two issues:

It can be difficult to truly assign blame.

It is hard to value the marginal damage in reality.



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The “holdout problem” arises when the property rights in question are held by more than one party.

The shared property rights give each party power over all

others.

This could lead to a breakdown in negotiations.


The “free rider” problem is that when an

investment has a personal cost but a common

benefit, individuals will underinvest.

For example, if the steel firm were assigned property

rights and you are the last (of many) fishermen to pay,

the bribe is larger than the marginal damage to you

personally.


Finally, it is hard to negotiate when there are large

numbers of individuals on one or both sides.



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In summary, the Coase Theorem is provocative, butperhaps not terribly relevant to many of the most

pressing environmental problems.

EXTERNALITY

3. SOLUTIONS OF THE PUBLIC

SECTOR

3. PUBLIC-SECTOR SOLUTIONS FOR

EXTERNALITIES

Coasian solutions are insufficient to deal with large

scale externalities. Public policy makes use of three

types of remedies to address negative externalities:

Corrective taxation

Subsidies

Regulation



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a, Corrective Taxation

The government can impose a “Pigouvian” tax

on the steel firm, which lower its output and

reduces deadweight loss.

If the per-unit tax equals the marginal damage at

the socially optimal quantity, the firm will cut

back to that point.

Figure 7Figure 7 illustrates such a tax.

Q STEEL

Priceof steel

0 Q 2

D = PMB =

SMB

Q 1

p 1

S=PMC

SMC =PMC +MD

p 2

S =PMC +tax

Figure 7 Pigouvian Tax

Corrective Taxation

The Pigouvian tax essentially shifts the private

marginal cost.

The firm cuts back output, which is a good thing

when there is a negative externality.



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Corrective Taxation

The steel firm’s privately optimal production solves:

When the tax equals MD, this becomes:

But this last equation is simply the one used to

determine the efficient level of production.

PMB PMC tax

PMB PMC MD SMC

b, Subsidies

The government can impose a “Pigouvian” subsidy

on producers of positive externalities, which

increases its output.

If the subsidy equals the external marginal benefit at

the socially optimal quantity, the firm will increase

production to that point. Figure 8Figure 8 illustrates such a subsidy.

Q DONUTS

Price of

donuts

0 Q 2

D = PM B =

SMB

Q 1

p 1

S = PMC

SMC =PMC -EMB

p 2

Figure 8 Pigouvian Subsidy



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Subsidies

The subsidy also shifts the private marginal cost. The firm cuts expand output, which is a good thing

when there is a positive externality.

Subsidies

The donut shop’s production solves:

When the subsidy equals EMB, this becomes:

But this last equation is simply the one used to

determine the efficient level of production.

PMB PMC subsidy

PMB PMC EMB SMC

c, Regulation

Finally, the government can impose quantity

regulation, rather than relying on the price

mechanism.

For example, return to the steel firm in Figure 9Figure 9.



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QSTEEL

Priceof steel

0 Q 2

D = PMB =

SMB

Q 1

p 1

S = PMC

SMC = PMC + MD

p 2

Figure 9 Quantity Regulation

Regulation

In an ideal world, Pigouvian taxation and quantity

regulation give identical policy outcomes.

In practice, there are complications that may make

taxes a more effective means of addressing

externalities.

Recap of Externalities:

Problems and Solutions

Externality theory

Private-sector solutions

Public-sector solutions



NEXT CHAPTER… PUBLIC GOODS

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Chapter 3 Externality