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

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Presentation on theme: "Externalities and Public Goods From free-riding to the Coase theorem."— Presentation transcript:

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

2 Externalities and Public Goods Up until now we have made several implicit assumptions when analysing agents 1.Agents are independent : their welfare depends only on their own consumption / production decisions But maybe peoples satisfaction/welfare depends indirectly on what other people decide? Does this influence the market outcome? How? How can these effects be taken into account?

3 Externalities and Public Goods 2.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 cant be divided, valued (priced), or exchanged on a market? What does economics have to say about these kinds of goods?

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

5 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.

6 Public goods and free riding Typology of goods Exclusion Possible? YesNo Rival? Yes Private Good Car, medical drugs Impure Public good Congested road 14 th July Fireworks No Club Good Pay per view TV, Patents Public Good Public lights Defence

7 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?

8 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?

9 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?

10 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

11 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

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

13 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 agents 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

14 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

15 Externalities and inefficiency q p* msC mpC q* q1q1 Marginal external cost The polluter pays principle internalises the externality by making the polluter carry the negative externality C

16 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!

17 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.

18 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

19 Externalities and inefficiency q p* msB mpB B q1q1 q* Example : intellectual property rights attempt to increase the marginal private benefit by capturing the externality Marginal external benefit

20 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

21 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

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

23 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

24 The Coase theorem Coases 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

25 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 ?

26 The Coase theorem In that case, a 2 nd 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)

27 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 doesnt 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


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