1. 1 External Costs

2. 2 Overview An externality is a situation where a third party is affected by an economic activity. The externality can be either positive or negative. External cost = negative externality = cost imposed on others. External benefit = positive externality = benefit imposed on others. (Don’t you love the smell of fresh baked donuts, even when you do not buy?) In this section we will explore the impact on the market when externalities exist.

3. 3 example - external cost $ Q 5 P = MR MCp QEQE

4. 4 example - external cost On the previous screen we have an example of a competitive firm in the candy market and the competitive price is $5 (remember competitive firms are price takers). The firm’s MC is labeled MCp for private marginal cost. The candy maker imposes costs on a doctor’s office due to the noise from making the candy, but the external cost is not shown yet. If left alone, the firm will produce the amount Q E, where MR = MCp.

5. 5 social cost $ Q 5 P = MR MCp QEQE MCs A B C D Qo

6. 6 social cost The social cost of an item that is produced not only includes the cost of the resources that go into the item, but also costs that third parties may incur. In our example here the doctor loses business because of the noise. MCs is the marginal social cost. The area between the MCp and the MCs is the amount of the third party cost – here a constant amount for every unit produced. In fact the area can be looked at as a per unit cost imposed on the doctor, added across all units produced.

7. 7 welfare implications The firm will produce Q E and thus producer surplus is A + C + D. The consumer surplus is ignored here. Since costs are imposed on a third party we have to include this in our calculation of welfare. It is actually a loss. MCs includes private costs and social costs. The area between the two MC’s is the external cost. The external cost is C + D + B. The net affect is A - B.

8. 8 welfare implications Society would be best off if the candy maker only made Qo units. This is where marginal value of units to the firm equals the marginal cost to society. BUT, the candy maker produces more, where MR = his own MC. The conclusion is that markets with an external cost have too much output produced from society’s point of view. If the candy maker could be induced to take account of the external costs imposed on the doctor, then output would be reduced to Qo. Let’s turn to several methods that would induce the candy maker to reduce output.

9. 9 Pigovian tax A Pigovian tax taxes the the candy maker by the amount of the externality produced. Thus the candy maker’s MC is shifted up to the MCs and output is reduced. There is still an externality, but the candy maker pays a tax in the same amount. Producer surplus = A minus loss to doctor = C plus tax revenue = C. Net welfare = A. Welfare is higher under the Pigovian tax than with the externality not internalized.

10. 10 liability rule An equivalent result to the Pigovian tax is a liability rule that holds the candy maker responsible for damages to the doctor. The candy maker would cause damage, but only that which results up to Qo. If any more is produced the cost of production plus the liability is too much (greater then the revenue that could be obtained).

11. 11 property right Another scenario would be to have the doctor have a property right to quiet around the office. If the candy maker wants to make noise he would have to pay for it. Presumably the candy maker would be charged in the amount of the damage to the doctor. The Pigovian tax, liability rule and property right all lead to the same outcome. Output is reduced to Qo and there is a higher social gain -> A relative to A - B.

12. 12 another view Recall that the candy maker would produce Q E and would have welfare A + C + D if the externality is not internalized. Also the doctor would lose B + C + D. Now say the doctor offers to pay the candy maker D + (1/2)B in exchange for reducing output to Qo. The doctor may agree to this because he reduces noise damage of D + B for only D + (1/2)B. The candy maker would agree to this because he receives a payment of D + (1/2)B in exchange for sacrificing only D in producer’s surplus.

13. 13 another view What is the net impact on each if the doctor makes this payment? The candy maker has A + C in surplus and D + (1/2)B. The candy maker would like this better than producing Q E. The doctor would only lose C + D + (1/2)B. The net affect on welfare is A. So, we see in this example that if the candy maker is given a property right the doctor will find it in his interest to pay the candy maker to reduce production.

14. 14 side payments Let’s assume that for every unit of candy made the doctor has a cost of $2. The doctor would then be willing to pay up to $2 per unit to reduce noise. Let’s say the doctor pays $2 per unit. Now the candy maker thinks to himself that for every candy unit I make I give up the ability to collect $2 from the doctor. This $2 opportunity cost pushes the private marginal cost up to the social marginal cost and output is reduced to Qo. The social gain to the candy maker is A + C + B + D. The social loss to the doctor C + D + B. The net welfare for society is A.

15. 15 Coase Theorem In the absence of transactions costs, the assignment of property rights has no effect on social welfare. The socially efficient outcome will be reached regardless of how property rights are assigned. This results because if the doctor is given the right he basically imposes the Pigovian tax and if the candy maker is given the right the doctor will make side payments. The assignment of property rights does not matter in terms of how much output is made. But it does matter to the people involved because one or the other will make out better financially.