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Externalities. Externality. When the activity of one agent unintentionally imposes costs on, or brings benefits to, another agent. A Negative Externality: Pollution. production to production to individual welfare consumption to production to individual welfare. Positive Externalities.

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When the activity of one agent unintentionally imposes costs on, or brings benefits to, another agent.

a negative externality pollution
A Negative Externality: Pollution
  • production
    • to production
    • to individual welfare
  • consumption
    • to production
    • to individual welfare
positive externalities
Positive Externalities
  • Bees and fruit trees
  • Neighbor’s garden
  • Vaccination, etc
analysis of pollution
Analysis of Pollution
  • Private cost of production: A cost that is borne by the producer.
    • hired labor
    • rental of machines and buildings
    • material inputs
  • Marginal private cost (MC): Cost of producing an additional unit that is borne by the producer.
Marginal external Cost (MEC): The cost of producing an additional unit that falls on other agents than the producer. (i.e. Not borne by the producer.)
  • Marginal social cost (MSC): Marginal cost of production imposed on whole society.



To add them up, costs must be expressed in same units.

  • Convenient to use $.
  • MC: Represents a true social cost in a well functioning market.
    • In LDCs, land, labor, and credit markets often do not function well. (distortions)
    • opportunity cost: value of the inputs in their best alternative use.
Expressing MEC in $ assumes that external costs have equivalent $ value.
  • Easy in the case of production externalities.
    • lost fish due to river pollution
    • lost agricultural output due to Global Warming
    • lower value of houses due to polluted river
More complicated in the case of health effects (scandalous to some)

But we do it all the time!

Organic food: too costly for most families

Safety features in cars: value of life?

No. of supervisors in kindergarten

Choice of location within city.

Doctors decide whether to prolong life or not.

Costs of medicines

Building a school instead of a hospital.



back to msc mc mec
Back to MSC = MC + MEC
  • NB Graphic assumes that MC and MEC increase with output.
  • Unfettered market outcome:
  • D measures marginal benefit of coffee consumption (chap 6)
  • External costs are not accounted for.
  • Market yields inefficient outcome. Why?
Social cost of production exceeds MB.
  • Calculate deadweight loss.
some solutions to externalities
Some solutions to externalities

Property rights:

Legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.

the property rights solution example 1
The property rights solutionExample 1
  • River with 500 houses and polluting mill upstream.
  • Loss of rent: 1000$/house
  • Assume: Riverside residents « own » rights to a clean river.
  • Mill must ask for permission to pollute river.
  • House owners ask for at least 500000$/m. in compensation. (Each owner would not accept less than 1000$/m)
  • Mill pays to pollute only if benefits from pollution exceed 500000$/m

Efficiency restored

the property rights solution example 2
The property rights solutionExample 2
  • Jane and Tarzan share office
  • Jane’s benefit from smoking: 500$
    • i.e. indifferent…
  • Tarzan’s loss: 1000$
    • i.e. indifferent…
  • Nego: Tarzan offers 800$ to Jane for her to stop smoking in office.
  • gains from trade:
    • Surplus Jane: 300$
    • Surplus Tarzan: 200$
Efficient outcome
  • Final allocation : no smoke.
  • Q. Are the actual amounts paid relevant to determine if outcome is efficient or not?
  • Q. Why is Tarzan the one to pay?
the coase theorem
The Coase Theorem

If transaction costs are negligible, resource allocations will be efficient, regardless of who owns the property rights. The initial allocation of PR will, however, affect wealth distribution.

  • Right to jane implies +800$ for Jane and -800$ for tarzan, compared to right to Tarzan. In both cases, there is no smoking.
reconsider ex 1
Reconsider ex 1
  • What if mill can pollute at will?
important implications
Important implications
  • If people can negotiate freely, direct gvt intervention is not necessary to achieve efficiency. All that is required is clear definition of PR.
    • Chicago school (in parts)
    • Minimal state?
    • laissez-faire economy?
transaction costs
Transaction costs
  • Can block gains from trade.
    • lawyer fees
    • negotiation failures
    • large no of asymmetric parties
    • costly enforcement

Sometimes, gvt must intervene to achieve efficiency.

remark m a as solution to externalities
Remark:M & A as solution to externalities
  • Mill buys out houses along river.
  • Bees and apple trees

Fundamentals of theory of firms:

contracts vs acquisition

  • Why don’t we have one large firm that produces everything?
    • Problems of control: Incentives to be efficient, improve quality, etc.
    • Firm size represents a tradeoff between both elements.
internalization of externalities
Internalization of externalities
  • When previous externalities are now accounted for, either through contract nego (market creation), M&A, or other, more direct, gvt intervention.
  • NB M&A will not work in the ex of Tarzan and Jane. Why? Should they get married?
direct gvt interventions
Direct gvt interventions
  • 4 types to consider here:
    • Command and control
    • taxes
    • Effluent charges
    • marketable permits
command and control
Command and Control
  • forbid certain activities
  • determine max amount of emissions
  • Problems:
    • No incentives to cut back further. No R&D.
    • Restrictions may be too harsh.

Regulator needs a lot of info.

  • t = tax per extra unit of output
  • Set t = MEC at efficient output level.
  • graphic…
emissions charges
Emissions charges
  • tax/unit of emissions
  • Roughly similar to output taxes:
    • Higher incentives to adopt cleaner techno.
    • Gvt raises revenues while increasing efficiency. (win-win)
  • Economists usually prefer taxes to C&C. Why?

Taxes are generally more efficient to achieve same pollution objective.

emissions charges vs c c
Emissions charges vs C&C
  • 2 firms
  • Each 500 t/y of emissions
  • Regulator’s objective: reduce total emissions to 600t/y
  • 300 t/y allowed each
emissions taxes
Emissions Taxes
  • 50000$/t of emissions
    • firm A abates to 200t/y
    • firm B abates to 400 t/y
    • total still at 600 t/y
    • NB Firms have different abatement costs
  • Firm A abates more because it can do so at lower cost.

With taxes, less info is required to achieve same pollution objective at lower cost.

  • Which is more fair?
marketable permits
Marketable Permits
  • Problem with taxes: may be difficult to find right tax level to achieve objective (trial and error process)
  • Marketable permits: Instead of setting a limit to each individual firm, set global limit, distribute corresponding permits, and let firms exchange them.
marketable permits33
Marketable Permits
  • Give 300t/y of permits to each firm.
  • B would save 1m$/y if it could emit 400t/y
  • It would cost 0.5m$/y to A to reduce from 300t/y to 200t/y.
  • B offers 0.75m$ to A to buy 100t/y of emissions permits.
  • Total pollution unchanged but total cost of abatement is 0.5m$/y lower.
marketable permits34
Marketable Permits
  • Advantage over taxes is that there is no need to know the right tax level to achieve objective. No trial and error. The market will determine the price of pollution by itself.
  • Efficient allocation is attained regardless of initial distribution of pollution rights. (Does this remind you of something?)
positive externalities35
  • private benefit: A benefit that the consumer of a good receives.
  • marginal private benefit (MB): The benefit from an additional unit of a good or service that the consumer of that good or service receives.
  • external benefit: The benefit from a good or service that somebody other than the consumer receives.
  • marginal external benefit (MEB): The benefit from an additional unit of a good or service that people other than the consumer enjoy.


positive externality knowledge from education
Positive externality:knowledge from education
  • MB:
    • better salaries
    • more interesting job
    • satisfied curiosity


knowledge from education
knowledge from education
  • External benefits:
    • better choice of elected gvt
    • more effective communication between people
    • more tolerance towards each other
    • better citizens (environmental degradation, crime rates, vandalism, etc)
    • more support for higher quality TV, radio, newspaper
    • transfer of knowledge to others (LDCs…)
knowledge from education38
knowledge from education
  • add MSB curve to graphic
  • add private supply curve

Free market outcome is inefficient.

knowledge from education39
knowledge from education
  • NB Calculation of deadweight loss is independent of who pays for education. Given quantity at 150, amount paid affects wealth distribution but not relevant for efficiency.
  • With positive externalities, free markets will generally provide too little of the good or service. Opposite of neg. ext.
  • Market failures call for gvt intervention (as long as it does not make things worse, which may be the case (Chicago school)).
positive externalities ideas
Positive externalities:ideas
  • invention of wheel
  • discovery of medicine (penicillin)
  • trigonometry
  • rock music
  • electricity
  • light bulb

People often copy ideas of other without paying for it.

  • Social benefit > private benefit
  • Free market supplies much too few ideas.

What can the gvt do?

  • public provision
  • private subsidies
  • vouchers
  • patents
positive externalities gvt solutions
Positive externalities:gvt solutions
  • Public provision: The good or service is provided by a public authority (state-owned enterprise)
  • NB Contrary to book, I’m not sure if it is relevant to mention which part of revenue comes from where.


positive externalities gvt solutions43
Positive externalities:gvt solutions
  • Private subsidy: A payment by gvt to firms per unit of output.


public provision vs private subsidy
Public provision vs Private subsidy
  • Both efficient as per your model.
  • Additional issues concerning education:
    • monitoring of school performance
    • incentives to provide quality education
    • fairness
positive externalities gvt solutions45
Positive externalities:gvt solutions
  • Vouchers: A token that gvt gives to households, which can be used to buy a specific good or service.


  • Reduces problems of fairness and incentives.
  • Our university system?
positive externalities gvt solutions46
Positive externalities:gvt solutions
  • Patents and copyrights: A gvt-sanctioned exclusive right granted to the inventor of a good, service, or productive process to produce, use, and sell the invention for a number of years.
  • Creation of PR over ideas (Intellectual PR)
  • Once PR are defined, owner can exchange with rest of society and reap total social benefits (or part of external benefit). Coase theorem.
  • Provides incentives to create valuable ideas (R&D).
  • Very important to understand prosperity in last 200 years.
  • Technological progress
  • Comparatively small role played by natural resources and colonization for industrialized countries. (Though effects of those may be important to explain poverty in Africa. See my Intro à l’éco. du dével.)
  • An institution that creates PR where none existed before.
  • Institution: Rules of the game. (laws, social norms, culture, religion) Requires definition and enforcement (punishment).
  • For markets to function properly, PR must be well defined and enforced over valuable goods. Gvt intervenes in
    • theft
    • contract violations
    • land and house eviction
  • In this respect, PR over ideas is really no different from PR over other goods and services
  • IPR is a market-based mechanism. (State could also supply ideas through state research institutes. Does it for fundamental research because not directly profitable in market.)
  • PR over ideas differ from PR on goods and services in one important respect: They give a monopoly to its owner. (chap 14)
  • With monopoly, prices are too high. That’s why IPR are limited in time. It’s a tradeoff.
  • Problem in LDCs for medicines.
  • PR can also take the form of common property. (next chapter)

Institutions are crucial to understand difference between rich and poor countries.