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14. Externalities Varian, Chapter 33. Types of externalities Consumption externalities –Consumption of a good by agent A has a direct impact on agent.

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Presentation on theme: "14. Externalities Varian, Chapter 33. Types of externalities Consumption externalities –Consumption of a good by agent A has a direct impact on agent."— Presentation transcript:

1 14. Externalities Varian, Chapter 33

2 Types of externalities Consumption externalities –Consumption of a good by agent A has a direct impact on agent B’s utility –E.g., smoking, loud music, tidy garden, etc. Production externalities –Actions by agent A have a direct impact on agent B’s production possibilities –E.g., bee-keeper and apple orchard, polluting firm and fisherman, etc.

3 Missing markets Person A x y Person B BxBx AyAy Endowment ByBy AxAx Contract curve The endowment point is not Pareto efficient. Allowing trade permits a Pareto improvement

4 Room-mates 2 agents A and B There are two “goods”: –Stuff – i.e., money: m A and m B : Endowments = $100 –Smoke – concentration: 0 ≤ s ≤ 1 A is a smoker: u A (m A,s) B is a non-smoker: u B (m B,t), where t = 1-s Note: s + t = 1

5 Edgeworth box Person A m s Person B B’s money Smoke A’s money

6 Rights and endowments Person A m s Person B B’s money Smoke A’s money $100 If B has the right to a smoke-free environment, endowment is at

7 Smokers’ rights Person A m s Person B B’s money Smoke A’s money $100 If A has the right to smoke as much as he wants, endowment is at

8 Neither endowment is necessarily Pareto efficient Person A m s Person B B’s money Smoke A’s money $100

9 Paying to smoke Person A m s Person B B’s money Smoke A’s money $100 Contract curve Allow trade, or make A pay B per unit of smoke

10 Paying for clean air Person A m s Person B B’s money Smoke A’s money $100 Contract curve Allow trade, or make B pay A per unit of smoke reduction

11 A and B care about who gets the property rights! Person A m s Person B B’s money Smoke A’s money $100 Pareto set

12 Quasi-linear preferences Person A m s Person B B’s money Smoke A’s money $100 Pareto set s*

13 The Coase Theorem Coase Theorem: If –property rights are well-defined, –bargaining over the externality is possible with sufficiently low transaction costs –the outcome will be efficient When preferences are quasi-linear, the allocation of property rights has no impact on the equilibrium quantity of smoke (s*)

14 Using demand curves Let’s assume quasi-linear preferences A’s utility: u A (m,s) = m A + v(s) A’s marginal benefit from smoke is v’(s) B’s utility: u B (m B,t) = m B + w(t) B’s marginal benefit of less smoke is w’(t)

15 Example: smoking A’s utility: u A (m,s) = m A + ln(s) m A = 50 B’s utility: u B (m B,t) = m B + 2ln(t) m B = 150 What are equilibrium s, t, m A, and m B if A has the right to smoke as much as he wants? What if B has the right to clean air?

16 s t Slope = marginal utility of smoky air Slope = marginal utility of less smoky air w(t)w(t) v(s)v(s) Agent A Agent B v’(s) w’(t) s t

17 Marginal costs and benefits Pareto efficiency requires v’(s) = w’(t) s 0 1 A’s marginal benefit Looks like a demand curve B’s marginal cost of smoke Looks like a supply curve 1-s=t s* Pigouvian tax on smokers

18 Pigouvian tax Definition: A tax on activities with negative externalities Double benefit –Reduce harm from negative externalities –Fund useful government spending Especially beneficial when Coase theorem does not apply

19 Example: smoking A’s utility: u A (m,s) = m A + ln(s) m A = 50 B’s utility: u B (m B,t) = m B + 2ln(t) m B = 150 ‘what sort of government tax on smoking x would lead to an efficient outcome? What are m A and m B in this outcome?

20 Allocating pollution amongst firms Suppose one unit of pollution is to be allocated between two firms s 0 1 Firm A’s marginal benefit Firm B’s marginal benefit 1-s s* Pigouvian tax on pollution

21 Pollution permits If A has all the permits, it sells 1-s* to B, at price p* If B has all the permits, it sells s* to A, at p* Only difference is which firm earns the profits from permit sales s 0 1 Firm A’s marginal benefit Firm B’s marginal benefit 1-s s* p*

22 Why don’t people cooperate? Two firms could merge so as to internalize the costs they impose on each other Room-mates can agree on smoking limits, or switch partners But there may be transactions costs that limit agents’ ability to trade –E.g., if the market is one-sided – one polluter and many pollutees


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