Externalities

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Externalities

• ECO 230
• J.F. OConnor

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Topics

• Nature of externalities
• Why do externalities cause market failure
• Private solutions to an externality problem
• Failure of private solutions
• Government policies to solve externality problems

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Externality

• An externality arises when the actions of a
  person or business have an effect on a third
  party or bystander. An externality is positive if
  the effect on the bystander is beneficial and is
  negative if the effect is harmful
• Examples Acid rain, auto exhaust, barking dogs,
  basic research, education, loud and nasty music
  next door, cigarette smoke, wet lands, forests,
  plant emissions into air or water supplies.

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Essence of the Problem

• Person or firm making the decision does not take
  account of the effects of its actions on third
  parties.
• Plone producers use a pesticide which gets into
  the rivers and reduces the volume of fish that
  are caught
• A person investing in education does not take
  account of the benefits that education to other
  members of society

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Private vs. Social Cost

• We need to distinguish between the firms
  marginal cost, which we call the private marginal
  cost (PMC) and societys marginal cost (SMC)
  which is the sum of the PMC and the value of the
  fish lost by the additional unit of output of
  plones. For a competitive industry, the supply
  curve is the sum of the private marginal costs of
  the firms.

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Market Failure

• Market solution P PMC
• Socially efficient solution, P SMC
• Negative externality, PMCltSMC, so market solution
  gives more output and a lower price than is
  efficient. Hence, market failure.
• See graph. Market solution P.5, Q70
  Efficient solution P.7, Q60

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Positive Externality

• Apple trees provide bees with nectar for making
  honey. Apple trees generate a positive
  externality for bee keepers but apple growers
  dont take account of that in their decisions.
• Now, SMC lt PMC. Market solution gives less output
  and a higher price than is efficient
• See graph.

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Resolving Externality Problems

• Key is to internalize the cost or benefit of the
  externality.
• Alternatives private action or government
  action.
• Private solutions likely to work when bargaining
  or transaction costs are low. That is the essence
  of the Coase Theorem

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Solving the Plone Problem

• The plone firms
• 1. buy the fishing rights on the affected rivers
  
• 2. pay the fishermen 0.3 per unit of plones
• Government
• 1. Limits the output of plones by means of
  quotas
• 2. imposes a tax of 0.3 per unit on plone
  producers

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Private Solutions

• If the ownership of the fishing rights are clear
  and they can be purchased without major
  bargaining cost, then 1 will work.
• If fishermen are organized and negotiations
  between the parties are not too costly, 2 will
  work.
• If both industries are perfectly competitive,
  transaction costs are likely to be high

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Government Solutions

• Number 1 will be costly to administer and if
  quotas are not tradable will lead to
  inefficiencies over time. If trading of quotas is
  allowed, some of the inefficiencies are
  eliminated
• Number 2 will give a socially efficient outcome

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Solving the Apple Grower Problem

• Apple grower generates a positive externality and
  the beekeeper generates a positive externality
  for the apple grower, it seems likely that both
  can develop a mutually beneficial arrangement
  without incurring significant transaction cost.
• Other cases where private solution might work?

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Other Examples of Externalities

• Education
• Auto emissions of CO and CO2
• Power plant emissions of SO2
• Wetlands
• Forests
• Dogs moral suasion?
• Charitable giving

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Power Plant Pollution

• Command and control pollution quota or emission
  permit sets quantity of pollution
• Pigovian taxes sets price of pollution
• Tradable pollution quotas or permits
• Note the optimal level of pollution is not zero
• Economists favor taxes because it provides an
  incentive to find ways to avoid the tax by
  finding ways to reduce pollution

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Tradable Pollution Permits

• Non tradable permits provide no incentive to
  reduce pollution beyond the level in the permit.
• Steel mill and paper mill are both to reduce
  pollution to 300 tons of glop per year
• Steel mill wants to increase emissions by 100
  tons per year. Paper mill is willing to reduce
  its emission by 100 tons in return for a payment
  of 5 million. Should EPA allow the trade?
  (Voluntary trade is mutually beneficial!)

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Conclusions

• Encourage activities with positive externalities
• Discourage activities with negative externalities
• Key is to internalize the externality
• Private solutions likely to work if transaction
  costs are low
• Taxes are usually better than regulations
• Tradable permits better than regulations