Externalities and Public Goods

Externalities and Public Goods From free-riding to the Coase theorem

Externalities and Public Goods • Up until now we have made several implicit assumptions when analysing “agents” • Agents are independent : their welfare depends only on their own consumption / production decisions • But maybe people’s satisfaction/welfare depends indirectly on what other people decide? • Does this influence the market outcome? How? • How can these effects be taken into account?

Externalities and Public Goods • The characteristics of goods are “well behaved” • Goods and services are always clearly defined, dividable into measurable units and exchangeable on a specified market • But what about goods or services that can’t be divided, valued (priced), or exchanged on a market? • What does economics have to say about these kinds of goods?

Externalities and Public Goods Public goods and free riding Externalities and inefficiency The Coase theorem

Public goods and free riding • Goods can be classified according to two fundamental, intrinsic properties : • Rivalry : Two agents cannot simultaneously benefit from the consumption of a given unit of a good • Exclusion (through price): an agent can only dispose of a given unit of a good once he has paid its price. This concept is closely linked to the existence of property rights.

Public goods and free riding

Public goods and free riding A “pure” public good satisfies three conditions: 1. Impossibility of exclusion (possibility of freeriding) • One cannot restrict the use of the good to specific agents (i.e. To those who pay) • Examples: • Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?

Public goods and free riding A “pure” public good satisfies three conditions: 2. Non-congestion (Non-rivalry) • The satisfaction obtained from the good does not depend on the number of users • Examples: • Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?

Public goods and free riding A “pure” public good satisfies three conditions: 3. Compulsory consumption • The agent cannot decide not to consume the good (has no choice in the matter) • Examples: • Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?

Public goods and free riding • As a result, for public goods, the coordination of agents cannot happen on the market • Everybody is a consumer whether they want it or not. • A supplier of the public good cannot exclude people who refuse to pay the good (free riders) • This supplier has not way of recuperating his costs • There is a market failure on public goods: they will not be provided on a free market

Public goods and free riding • The central aspect of this was shown by Ronald Coase • Free-riding and externalities occur when property rights are either: • Not defined: who owns light of a lighthouse or the security provided by a police force? • Not enforceable: there is a lack of institutions to enforce the property rights (example: “free” internet downloads) • As a result, there is no market to extract compensation from freeriders

Externalities and inefficiency • An externality is a possible cause of market failures. • It corresponds to the direct (non-market) impact of an agents decision on another agent’s welfare • External economies, external effects, externalities • In production (the bees and orchard example) • In consumption (internet or telephone) • This impact can be negative or positive • Negative : leads to over-investment • Positive : leads to under-investment

Externalities and inefficiency • Definition of a negative externality • The Marginal social cost (msC) is larger that the marginal private cost (mpC) msC > mpC • In other words, I do not bear all the costs of my production/consumption decisions, • Some costs “leak” out and are borne by other agents

msC mpC Marginal external cost q1 q* Externalities and inefficiency C The polluter pays principle internalises the externality by making the polluter carry the negative externality p* q

Externalities and inefficiency • Example of negative production externalities • The effect of oil spills on local fishermen • My neighbour's trees shading my garden from the sun • Examples of negative consumption externalities • Smokers in restaurants • Neighbours playing techno very loudly at 3am!

Externalities and inefficiency • What policies can be used to remove the inefficiency ? • Regulation (emission standards, smoking bans) • Taxation (problem: what is the optimal level of taxes what is the size of the externality?) • Importantly, in terms of policy there is an optimal level of pollution !! • It is not socially desirable to reduce it to zero.

Externalities and inefficiency • Definition of a positive externality • The Marginal social benefit (msB) is larger that the marginal private benefit (mpB) msB > mpB • In other words, I do not reap all the benefits of my production/consumption decisions, • some benefits “leak” out and benefit other agents

Marginal external benefit msB mpB q1 q* Externalities and inefficiency B Example : intellectual property rights attempt to increase the marginal private benefit by capturing the externality p* q

Externalities and inefficiency • Example of positive production externalities • The classical bees/orchard example • Technological innovations (spillovers) • Examples of positive consumption externalities • Network goods (internet, telephone) • Homeownership • Education • Vaccination

Externalities and inefficiency • What policies can be used to remove the inefficiency ? • Subsidies (tax deductions on mortgages, public network infrastructure investment) • Intellectual property rights (IPR) • Regulations • As for the optimal level of pollution, there is an optimal level of intellectual protection! • It is not socially desirable to reduce IPR to zero

The Coase theorem • Named after Ronald Coase (Nobel 1991) • No state intervention is required to correct externalities if: • There are defined property rights (remember what was said above) • There are no transaction costs between agents • In this ideal case, all the state has to do is define some property rights, and the market will internalise the externality

The Coase theorem • Coase’s initial work: Radio stations • Initially, no frequency bands are defined: radio stations can interfere • Negative production externality • The state needs to create frequency bands • enforceable property rights • Interactions between agents produce : • The allocation of these bands between the various radio stations • The compensation of externalities is carried out by transactions between stations

The Coase theorem • In real life, however, transaction costs exist • Asymmetric/imperfect information about the externality • Proving the existence of an externality can take a lot of time and effort (see Erin Brockovich vs Pacific Gas), • Asymmetric relations between agents • Imagine a litigation between a big chemical consortium and a local association on pollution. • What is the likelihood of the association making its case with no external help ?

The Coase theorem • In that case, a 2nd role appears for the state: Reduce transactions costs between agents • Encourage the creation of consumers rights associations (increase coordination between agents) • Create environmental watchdogs with a monitoring mission (reduces the information asymmetries) • Reinforce legal / mediation /dispute resolution institutions (reduces the transaction costs)

The Coase theorem • This decentralised approach to reducing externalities is becoming increasingly popular • In theory it is cheaper: Taxes on pollution do provide an income, but monitoring costs are usually higher • In theory it is also more efficient: The state doesn’t need to figure out what the size of the externality is, which is a problem with taxation or regulation • Recent example: the market for Carbon dioxide

Externalities and Public Goods