Externalities

1
Externalities
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What is an Externality?

• Formally it is a cost or benefit received by a
  person not involved in a market transaction, and
  therefore not reflected in the market price of
  the commodity being transacted.
• It is a third party effect, or
• it is a spillover, or
• an unintended side effect.

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About Externalities

• There are two types of externalities
• negative externalities, or external costs
• positive externalities, or external benefits
• When do externalities arise?
• Whenever someones actions affect another person
  and this impact is not considered in the
  decisions made by the person making these
  decisions

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Examples of Externalities

• Pollution
• Traffic
• Bees and Orchards
• Inoculations
• Public Goods

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Optimality

• In the case of externalities, private decision
  makingbased upon comparisons of MB vs. MCdont
  work out because of the cost or benefit affecting
  others
• We focus on Social Costs and Benefits
• Thus the comparison adds the external cost or
  benefit (at the margin) to the private cost
• So, we have MSB MSC

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The Correct Amount of an Externality

• Optimal quantity is a standard economic
  condition equating at the margin
• MSBMSC
• The standard approach to this is for the price to
  reflect the costs imposed on others
• This is usually called internalizing the
  externality

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How do we determine the Correct amount of an
Externality?
MSC
Price (/Unit)
MPC
P
External Cost
P0
DMB (MPBMSB)
Q of X
Q0
Q
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What causes an externality?

• Under what conditions would there be no
  externality problem?
• What is the real problem?
• Lack of a Market Lack of (Well Defined)
  Property Rights
• Alternative Viewpoint Ronald Coase
• The Coase Theorem

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Illustrating The Coase TheoremCattle in the Corn
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The Coase Theorem

• The Coase Theorem implies that externality
  problems can be handled through the market and
  through trade if property rights are well
  defined.
• Necessary conditions
• Zero Transactions Costs
• Income Effects are ignored

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A Numerical Example
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A Numerical Example
6
2
5
1
3
4
2
4
1
-1
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The Coase Theorem

• The theorem implies that through bargaining in
  the private market, externality problems can be
  remedied without government intervention.
• What is necessary is for the property rights to
  the activity that is the externality to be
  defined.
• The theorem states that it does not matter to
  whom the property rights are given, just that the
  rights be well defined.

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Solving Externality Problems

• Use Pollution as an example
• Alternatives
• Pigovian Tax
• Regulation
• Property Rights Approach

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Regulating PollutionQR Q
QR
MSC
Price (/Unit)
MPC
P
External Cost
P0
DMB (MPBMSB)
Q of X
Q0
Q
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Regulation of Pollution in the United States

• Command and Control Approach
• Technology Forcing
• Transition to Market Based Approaches
• Bubbles
• Offset
• A Market for Pollution Emission Rights
• Compare to Coase Theorem

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A Market for Emission Rights

• What are the steps to initiate a market for
  emission or pollution rights
• Set a target level of environmental quality
• Define this environmental quality in terms of a
  total amount of allowable emissions
• Translate these allowable emissions into specific
  amounts for each producer of pollution

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A Market for Emission Rights

• Call these allowable amounts a Permit
• Another problem how are these Permits
  distributed initially?
• Give them away The Grandfathering Approach
• Sell them The Auction Approach
• Note that there is a fixed quantityof these
  Permits

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A Market for Emission Rights

• How is the market defined?
• What is the commodity?
• Is there some time dimension for this commodity?
• (Does it last forever, 1 year, 5 years?
• Is there a geographic dimension for this
  commodity?

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A Market for Emission Rights

• What happens when a market is set up?
• What do firms consider?
• What is the cost of treating the pollution?
• What is the price of a pollution permit?
• Who Sells? Who Buys?

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A Market for Emission Rights
Price (/Unit)
MCA
Ppermits
MBp
Quantity of Pollution
Qa
Qp
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A Market for Emission Rights
Price (/Unit)
MCA
Ppermits
MBp
Quantity of Pollution
Qp
Qa
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A Market for Emission Rights
Price (/Unit)
MCA
Ppermits
MBp
Quantity of Pollution
Qa
Qp
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A Market for Emission Rights
Price (/Unit)
MCA
Ppermits
MBp
Quantity of Pollution
Qp
Qa