1. Externalities

2. What are externalities?
When one agent engages in behaviour that affects the utility/profit of some other agent, but does not take that cost or benefit into account.
Positive Externality—when that action increases the utility/profit of the other person
Negative Externality—when that action reduces the utility/profit of the other person

3. Externalities
Graphically, we analyse externalities as creating a disparity between private marginal benefit and social marginal benefit, or private marginal cost and social marginal cost.

4. Externalities
The efficient amount of any good is the quantity where supply=demand. In the case of an externality, we distinguish between private and social MC and private and social MB. Individuals act in accordance with their private benefits and costs, which may diverge from social benefits and costs. $
Supply=Σ Social MC P*
Demand=Σ Social MB Q* Q

5. Negative Externality in Production
Here, we illustrate a negative externality in production. This means that the private MC is lower than the social MC (think pollution, for example) $
Supply=Σ Social MC
Firms or individuals will overproduce the good in this case, and charge too low a price for the good.
PMC P*
The green area measures the social benefit to be had by correcting the externality P’
Demand=Σ Social MB Q* Q’ Q

6. Positive Externality in Production
Here, we illustrate a positive externality in production. This means that the private MC is greater than the social MC (for example, R&D with spillovers)
PMC $
Supply=Σ Social MC
Firms or individuals will underproduce the good and charge too high a price. P’
The green area measures the social benefit to be had by correcting the externality P*
Demand=Σ Social MB Q’ Q* Q

7. Negative Externality in Consumption
Here, we illustrate a negative externality in consumption. This means that the private MB is greater than the social MB (for example, alcohol and drink driving) $
Supply=Σ Social MC
Firms or individuals will overconsume the good because the price is too low. P’
The green area measures the social benefit to be had by correcting the externality P*
PMB
Demand=Σ Social MB Q* Q’ Q

8. Positive Externality in Consumption
Here, we illustrate a positive externality in consumption. This means that the private MB is less than the social MB (for example, education) $
Supply=Σ Social MC
Firms or individuals will underconsume the good because the price is too high.
The green area measures the social benefit to be had by correcting the externality P* P’
Demand=Σ Social MB
PMB Q’ Q* Q

9. Externalities and Public Goods
Analytically, externalities are very closely related to public goods.
Both are dealing with some non-excludable benefit or cost
Resolving externalities is often subject to free rider problem.

10. What causes externalities?
Missing markets are the primary cause of externalities
These markets are often missing because property rights do not exist—does this mean that externalities are political failures, not market failures?

11. Tragedy of the Commons
Tragedy of the commons describes a situation where two or more individuals impose bilateral negative externalities on each other by overusing some resource.
Examples of the Commons:
Fisheries
“Fiscal Commons”
Grazing

12. Tragedy of the Commons
Tragedy of the commons occurs because of the divergence between social and private cost…the majority of the costs are borne by someone else.
Tragedy of the Commons games are often described in terms of a prisoners’ dilemma

13. Tragedy of the Commons as a Prisoners’ Dilemma
2 Ranchers share a plot of land on which they can graze their cattle, and can choose to graze one herd or two herds on the plot.
2 herds total=fat cows, sell for $15 each for yummy steaks.
3 herds total=medium-sized cows, sell for $9 each for pet food.
4 herds total=skinny cows, sell for $5 each to McDonalds.

14. Tragedy of the Commons as Prisoners’ Dilemma
Rancher 2
1 Herd
2 Herds 15 18
1 Herd
Pareto Superior 15 9
Rancher 1 9 10
Nash Equilibrium
2 Herds 18 10

15. How to resolve Commons Problem?
Privatize!
Whereas each individual will behave strategically, if the plot of land is privately held, the value maximizing # of cows will be raised.
Examples:
Oyster Fisheries in the US
Elephants (2000 Contemporary Economic Policy journal)

16. CITESBAN-measures the effectiveness of the ivory ban
RIOTS-measurement of political stability
PURGES-measurement of political representativeness
DROUGHT-captures environmental effects
PROPERTY, COMMAID-dummy for 2 types of property rights regimes over elephants in Africa
PROAREA-Measures the geographic area covered by property rights regimes

17. Bilateral positive externalities
Also called “synergies”
Most famous example: Meade on Bees and Apples (1952)
Bees pollinate orchards, giving a benefit to orchard owners.
Orchards provide nectar for bees to turn into honey.

18. Bees and Apples
At this price of bees, beekeepers will have this many bees:
Which creates this much value in externalities to the orchard guy:
This, however, is inefficient, as the efficient quantity of bees is Q2: $
And the value of fixing (internalizing) the externality is this area:
The same analysis would apply to apples as well.
Price of Bees
MB to Beekeeper + MB to Orchard
MB to Beekeeper Q1 Q2 Q

19. How to resolve this Problem?
It would be efficient for the owner of the orchard to buy out the beekeeper, or vice versa
In the real world beekeepers and orchard owners contract with one another to internalize this externality (Cheung 1973)
Beekeepers would pay farmers to house their bees when pollination wasn't needed, and farmers would pay beekeepers in seasons when pollination was needed
This is more of a contractually based method of resolving externality problems.

20. Contractual Mechanisms
As seen before, efficient outcomes can cone about via common private ownership or via contracting around the externality
In either case the parties internalize the externality
Internalize—when a party creating an externality is made to bear part or all of the burden (or receive part or all of the benefit) of the externality created.
When externalities are internalized, the individual is facing the social benefit and cost functions.

21. Coase Theorem
When an externality is present, efficiency is achieved by assignment of property rights that allows creation of a market and bargaining over the division of the efficiency gains.
The efficient voluntary resolution of an externality problem is independent of who has the legal rights.

22. Coase Theorem
In other words: Given property rights and zero transactions costs, markets will resolve all externality problems.

23. Coase Theorem-Example
Cletus has a 60 kg rottweiler.
Cletus feeds his rottweiler lots of beer, and trains it to be a rather ill-tempered dog.
Every night, Cletus leaves his rottweiler in his yard to guard his two trucks on blocks in the front yard.
Cletus’ rottweiler is loud and very disturbing to his neighbour, Wilbur

24. Coase Theorem-Example
Assume Cletus values having a mean, drunk, loud guard dog at $500
Assume Wilbur values peace and quiet at $600
If Cletus has property rights over noise and such, Wilbur can pay him to shut his dog up.
If Wilbur has property rights, Cletus can’t afford to pay off Wilbur to let his dog bark.

25. Coase Theorem-Example
Now, let’s Cletus values having a mean, drunk, loud guard dog at $1000
If Cletus has property rights over noise and such, Wilbur can’t pay him to shut his dog up.
If Wilbur has property rights, Cletus easily pay off Wilbur to let his dog bark.

26. Coase Theorem-Example
Note that in all 4 cases, the efficient result was the market outcome.
The only difference between the scenarios was who had more stuff (income effects)

27. Coase Theorem and New Institutional Economics
Coase’s work was part of what gave rise to NIE and has strong implications for Law & Economics.
If there are transactions costs or wealth/income effects or negligence costs, then the initial allocation of property rights does indeed matter (NIE).
Efficient legal systems are those that allocate property rights in such a way that minimize or eliminate uninternalized externalities.

28. Coase Theorem
The Coase theorem implies that we should never observe an uncorrected externality because any externality that has existed will have been internalized to the mutual advantage of the affected parties.
Note that it does not say we will see no externalities! We will see the efficient amount of externalities!
When might the Coase theorem fail?

29. Failures of Coase Theorem
Dispute over legal rights—if legal and property rights are ill-defined, externalities will remain uninternalized.
Disputes over values of losses and gains—lead to negotiations and bargaining costs, or transactions costs.
Unwillingness to create markets (norms)
Collective action

30. Transactions Costs Bargaining costs Legal fees Translation fees
Brokerage fees
Overcoming free rider problems
Information acquisition costs
Lots of transactions costs out there

31. Other methods of Internalization
Locational choice leads to efficient market capitalization (sidenote: coming to a nuisance)
Refusal to accept compensation (NIMBY)
These have distributional effects—mostly concentrated on the poor.

32. Other methods of Internalization
Customs and social norms
Benevolence and consideration of others.

33. Public Policy and Externalities
Non-Market Solutions
Public Policy and Externalities

34. The Case for Government
At the very minimum, a government needs to provide a legal system that allows for Coasian bargains to be reached.
Further scope for government involvement is based on one of the following assumptions:
Government faces lower transactions costs
Government can overcome free-rider problems better
Governments can ignore inhibitions of people to participate in certain markets.

35. The Case for Government
As before, governments will still face large information problems.
Again, very few market prices for externalities, so much of the cost-benefit analysis will be indirect, and individuals have no incentive to reveal truthful information

36. Government Responses Pigovian Taxes/Subsidies Regulation Quotas
Tradable Permits

37. Pigovian Solution to a Negative Externality
Back to our example from before, where we had a negative externality in production. The efficient quantity is Q*, but markets produce Q’. What should the government do? $
Supply=Σ Social MC
PMC
The government wants to increase the cost to the firm of producing, and can do so by levying a tax. P*
A per unit tax of amount T=P*-P^ will reduce the quantity from Q’ to Q*. The government could achieve the same result by subsidizing not producing the amount from Q*-Q’ by the same amount P’ P^
Demand=Σ Social MB Q* Q’ Q

38. Where does the tax money go?
Should the revenue generated from a Pigovian tax go to those harmed by the externality?
Interestingly, the answer is no—this would create adverse incentives.
The fact that there are revenues from the corrective tax is simply incidental to the internalization of externalities.
The revenues can go to rectify past damages, however.

39. Adverse Incentives
What if we not only taxed the externality, but distributed those funds to those affected? $
Supply=Σ Social MC
The demand for these goods would actually rise, and quantity would increase as well!
Technically, it probably wouldn’t move all the way back out to Q’. However, you would also see people trying to become those affected by the externality, because they value the payoff more than they would be hurt by the externality (moving to a nuisance).
PMC P† P* D’ P’ P^
Demand=Σ Social MB Q* Q’ Q

40. Taxes or Subsidies
While in principle, taxes and subsidies lead to the same result, in practice subsidies are impractical.
To subsidize not creating an externality, the government needs to know the counterfactual—how much of the externality producing behaviour the individual would have done if not for the subsidy.
Obviously, you can’t just ask them!

41. Pigovian Solution to a Positive Externality
Here, we again see that individuals will consume an amount of this positive externality generating good Q’, while the efficient amount is Q* $
Supply=Σ Social MC
To induce individuals to consume an amount Q*, a subsidy of amount S=P*-P^ will induce people to increase their consumption to that amount.
Equivalently, a tax of the same amount could be levied for every unit of Q less than Q* consumed P* P’
Social MB P^
Private MB Q’ Q* Q

42. Pigovian Solution to a Positive Externality
What are a tax and subsidy doing?
The goal is not to make the private MB curve=the social MB curve—that is impossible! $
Supply=Σ Social MC
A per unit tax or subsidy simply shifts the Private MB or Private MC curve…while there is still an externality present, the efficient quantity is consumed P*
Social MB P’ P^
Private MB
Private MB +S Q’ Q* Q

43. Limitations of Pigovian Approach
Requires perfect information—the Government must know all of the relevant MB and MC curves, not only for society, but also for every participant.
Requires bureaucracy
If subsidies are used, taxes must be levied, which have an excess burden
We have already discussed the myriad problems befalling the second two limitations.

44. Example: Imperfect information
MSC
Here, we have 2 firms in an industry that pollute in order to produce some good. The top graph is firm A, which is a heavy polluter per unit of output. The bottom graph is firm B, and they are a relatively “clean” firm in terms of pollution/Q. Both face the same demand curve for their output. What is the optimal tax?
MPC’
MPC t1
It should be obvious that each firm should face a different tax rate: Firm A should pay a greater per unit tax than firm B, because it is efficient for Firm A to be cut their output by more than firm B. D Q* Q’
MSC
If the government doesn’t have this information, they can not levy the efficient tax. An inefficient tax may or may not be better than no tax at all!
MPC
MPC’ t2 D Q* Q’

45. Example: Imperfect information
Here, we have 2 firms in an industry that pollute in order to produce some good. The red lines are the optimal Quantity and taxes for the efficient firm, the blue lines for the inefficient firm. What if the government decided to just put the average tax in effect? Would that work?
MSC2
MSC1
We can see that while we have moved towards efficiency for the heavy polluter and for the industry in general, we have moved beyond efficiency for the low polluter.
MPC1&2
MPC1&2 t2 t1
Note also that this provides no incentive for firms to adopt low polluting technologies in the future—both the high and low polluter are affected identically. D Q*
Q’’ Q* Q’

46. Another Example: Imperfect information
Here, we have 2 individuals deciding how much education to get. The first one is a super genius who has the potential to improve the welfare of all of humanity, the second is a violent sociopath who is one reading of Nietzsche away from being the next Hitler. It should be obvious that for the first individual, we should subsidize his education, but for the second, perhaps a tax is a better option! MC
MSB
MPB Q’ Q*
Without perfect information about all of the individuals in question, the efficient subsidy is near impossible to discover, and an inefficient subsidy could be worse than no subsidy at all. MC
MPB
MSB Q* Q’

47. Limitations of Pigovian Approach
Requires perfect information—the Government must know all of the relevant MB and MC curves, not only for society, but also for every participant.
Without this information, Pigovian approach will certainly not be perfectly efficient, and is capable of being less efficient than unfettered market.
Assumption so far is that Pigovian taxes and subsidies are levied by benevolent central planner—what if we relax this assumption?

48. Pigovian taxes can “break” Coase Theorem
Factory imposes costs on houses of $60 K per year.
Govt imposes Pigovian taxes of $60K
Factory can install soundproofing for $80K
Houses still suffering -- they don't get the tax money
Houses offer $x>20K to install soundproofing
Factory installs soundproofing as then cheaper than paying pigovean taxes
But by definition costs of soundproofing are less than costs imposed by sound

49. Direct Regulation
An alternative to Pigovian subsidies and taxation is direct regulation.
Usually requires less information and less bureaucracy
Regulations simply identify allowable behaviours and sets penalties for non-compliance.

50. Pitfalls of Direct Regulation
“Command-and-Control” regulation leads to enormous rents
Regulation leads to red tape and inefficiency
Regulation stifles innovation in externality abatement/encouragement.
Regulators can become “captured”

51. Quotas
Quotas are a method of setting allowable limits on output or the usage of externality creating inputs.
Quotas vary in their effectiveness—it is possible to design a quota system that is efficient, and it is also possible to design a quota system that is worse than the problem you are trying to solve.

52. Quotas and Permits
Quotas or Permits can be created for either the good that creates the externality, or for the externality itself.
The first case leads to inefficiency, the second leads to efficiency.
Quotas and Permits can be auctioned by the government, sold on the market, or given away freely

53. Quotas Firms have 2 reasons to purchase quota rights.
To produce output
To prevent some competitor from producing output
A quota creates a monopoly rent for the firm to exploit!

54. Quotas
The red area signifies the profit earned by a monopolist, while the yellow are rents earned by all firms in the absence of one monopolist producer. It is clear that one monopolist will dominate any auction method.
To correct the externality associated with the production of this good, the government decides to sell a number of quotas Q*. This should eliminate the inefficient externality, noted by the green area.
How much would the quotas sell for at auction? One would like to think the quotas would sell to a large number of suppliers, who would each pay price P for the quotas:
SMC
Furthermore, we have moved to an even more inefficient state of the world than the one we started in. The purple area signifies the deadweight loss from monopoly, which (at least in this case) is bigger than the inefficiency from the externality!
But unfortunately, this won’t happen. The entirety of the quota will be purchased by one producer, because he is willing to pay up to the entire value of the monopoly rent he would receive as the sole seller!
PMC P
As a monopolist, he would produce QM<Q*, and the result is more inefficient than the problem we are trying to correct! D MR QM Q* Q’

55. Quotas Quotas, used like this, make little sense.
It is possible that an output quota will improve efficiency (theory of the second best), but it is also possible that it will not.
Quotas will achieve better results if the quota is a permit for the permissible amount of a polluting input to use, or better yet for the amount of pollution one is allowed to emit!

56. Input Quotas
Here, we have the derived demand for the use of some input that generates pollution. The ‘derived demand’ is the demand for that input. PM is the market price for the input, and at that price Q’ are purchased.
If the efficient amount of that input is Q*, the government issue that many input use permits to the market. Those permits will sell for a price PP-PM. PP PM
Derived Demand Q* Q’
Q of Polluting Input

57. Input Quotas In this case, who will get the quotas?
Those who can most profitably use the polluting inputs
In other words, those who create the highest valued output per unit of polluting input used.
Assuming one can correctly identify Q*, this approach is far better than taxation or regulation.
An even better approach is to sell (or distribute) pollution permits.

58. Tradeable Pollution Permits
Input quotas allocate input usage permits to those individuals/firms who generate the highest valued output per unit of input.
Pollution permits allocate pollution rights to those individuals/firms who generate the highest valued output per unit of pollution
Why is the second one better?

59. Input Quotas v. Pollution Permits
Quotas make people try to get more stuff out of their inputs, but the inputs themselves do not create the inefficiency, rather the way in which they are used does.
Pollution Permits promote innovation in reducing the externality created.

60. Distribution of Quotas to Current Polluters
One more method of allocating quotas is to simply give them to the individuals or firms currently polluting.
Has “fairness” properties
If these quotas are not tradeable/sellable, this will result in inefficiency.
Relatively clean firms will underproduce, relatively dirty firms will overproduce (very similar to case in which average tax rate is applied to heterogeneous firms).

61. Political Decisions
Each of these methods of dealing with externalities has costs and benefits—but which one is used is still a decision made through politics.

62. Pigovian Tax Government gets tax revenue
Maintains competitive markets in long run, but firms incur short run losses
Efficiency depends on government having perfect information

63. Regulation
Has potential to lead to monopolization or cartelization of industry
Provides no revenues to government
Increases costs of production
Efficiency depends on government having perfect information
Specific form of regulation may generate rents for other industries

64. Auction or Sale of Quota Rights
Government does not need perfect information
Firms incur one-time losses in purchasing these rights.
If rights are transferable, outcome will encourage efficiency over time as well

65. Giving away Quota rights
Generates rents for those given quotas
Inefficient if firms are heterogeneous and rights are non-transferable
Likely to be the approach most favoured by existing producers

66. Quotas in practice
Over the past 15 years or so there has been a lot of movement around the world away from regulation and Pigovian approaches to quotas and permits
In some countries, only individuals using the permits directly are permitted ownership (e.g. Canada)
Others, anybody can buy them—direct users, financial institutions, even conservationists (e.g. US)

67. Pollution Tax
Another more recent proposal is to directly tax the amount of a pollution generating input.
Recent proposals of carbon taxes are the most obvious application.
These taxes have many of the same advantages over Pigovian taxes and regulation as do tradeable permits, and in modern debates are often seen as being preferable to emissions trading.

68. Benefits of Pollution Tax
Has a broader scope for emissions reduction than emissions trading
A trading system is only viable among firms or countries, but not among individuals, meaning petrol, home heating oil, etc couldn’t be covered
Probably few transactions costs than emissions trading
No ability to “hoard” permits
Far simpler for policy makers to understand
Incremental changes more practical in the case of misjudgment of Q*

69. Downfalls of Pollution Tax
Incapable of “fixing” a certain economic/environmental outcome, whereas permits can
In fact, permits often lead to pollution less than capped amount.
Private industry prefers emissions trading to taxes
Rents going to industry is a method of “buying off” the inefficient producers, making them willing to agree to change.
Trading is better at dealing with more than 1 issue at the same time (e.g. the 6 GHGs mentioned in Kyoto protocol)
Permit prices automatically adjust to shocks/inflation, taxes do not.
Permits may have better scope for encouraging investment in green technology.
Permits better for international issues.

70. Benefits/Downfalls of Pollution Tax
Depends on who you ask sorts of issues:
Taxes generate revenues for governments.
Could be used to offset losses from distributional shocks due to tax and reduce other taxes.
Could be used for rent seeking and the flypaper effect could hold.
Technological change will affect permit prices
May induce holders of permits not to invest in technology, as it might reduce value of permits.
Would it not also induce non-holders to invest in technology?

71. International Problems
Many externalities are global in nature
Greenhouse effect
Biodiversity
Ozone layer
These problems tend to generate Prisoners’ Dilemma outcomes—countries want everyone else to stop polluting, but don’t want to do so themselves.

72. Environmental Quality as a normal or luxury good
Normal good—a good that you want more of as your income rises (∂Q/∂I>0)
Luxury good—a normal good of which your consumption rises at a faster rate than your income (∂Q/∂I>1)
Rich countries are far more interested in improving environmental quality than poor countries and developing countries
Run the risk of a “race to the bottom”

73. Race to the Bottom
What is a race to the bottom? In this context, the argument is this:
Rich countries have high environmental standards and higher costs
Poor countries have low environmental standards and lower costs
Rich countries, in order to compete with the poor countries, must abandon their environmental standards.

74. Race to the Bottom
Counter argument—If environmental quality is a normal (or luxury) good, as the poor countries develop they will want environmental reform too!
All of the policy instruments designed to prevent the race to the bottom (tariffs, import bans, etc) serve to keep the poor countries poor, and could potentially worsen the problems.

75. Prohibition of Markets

76. Prohibition of Markets
Pigovian taxes and regulations are often used to outlaw markets as well
Why?
Paternalism—the notion that people are incapable of making good decisions for themselves
Moral Externalities—Very slippery concept, everything becomes an externality

77. Prohibition of Markets
What types of markets are often prohibited?
Organs/blood
Sex
Drugs
People (voluntary and/or involuntary)
Babies
Gambling
Weapons
Opponents of these prohibitions often refer to these activities as “victimless crimes”

78. Prohibition of Markets
What is the economic case?
Addiction (drugs)
Public safety (seat belts/helmets)
Time inconsistency (slavery, selling babies or organs, drugs)
Information asymmetry (drugs, sex)

79. Black (Underground) Markets
Even if the government prohibits markets, markets will still obviously exist.
Participants in black markets often receive extremely high rates of return, accompanied by very high risk
Because contracts in black markets are not enforceable, black markets are often associated with violence.
Buyers and sellers have no incentive to develop reputational capital, and sell poor (or dangerous) products

80. Reputational Capital
Even without government regulation, a free markets would lead to better and safer products being available.
Lower HIV rates among prostitutes where prostitution is legal
Better quality and safer drugs where drugs are legal

81. Prohibition of Markets
Community values and social norms often dictate the extent to which markets are prohibited, and which markets are prohibited
Recall federalism—people often choose to live in societies where markets they want to participate in are not outlawed

82. Prohibition of Markets
Summing up—markets are prohibited for a number of reasons, mostly for moral reasons, but occasionally on efficiency grounds.
Even though a market is prohibited does not mean it will not exist
Even if you like the moral statement being made by such prohibitions, in many cases the cure is worse than the disease.