PPA 723: Managerial Economics Lecture 18: Externalities The Maxwell School, Syracuse University Professor John Yinger

Managerial Economics, Lecture 18: Externalities Outline  What Are Externalities?  Externalities Lead to Inefficient Outcomes  Externalities and Monopoly  Externalities and Property Rights

Managerial Economics, Lecture 18: Externalities Externalities  An externality exists if  Someone's consumption or production activities inadvertently affect others.  The well-being of a consumer or the production capability of a firm is affected directly by actions of other consumers or firms, rather than indirectly through changes in prices.

Managerial Economics, Lecture 18: Externalities Positive & Negative Externalities  Externalities may help or harm others  An externality that harms someone is a negative externality.  Pollution and congestion are examples.  A positive externality benefits other.  Example: Painting your house (called the neighborhood effect).

Managerial Economics, Lecture 18: Externalities More Examples  A firm whose production process lets off fumes or particles that harm its neighbors is creating an externality.  A firm is not causing an externality when it harms a rival by selling extra output that lowers market price.  An individual is not causing an externality by stealing.

Managerial Economics, Lecture 18: Externalities Inefficiency of Competition with Externalities  Competitive firms and consumers do not have to pay for harms of their negative externalities (and do not receive compensation for their positive externalities).  So they do too much of the activities that cause negative externalities (and too little of those with positive externalities).

Managerial Economics, Lecture 18: Externalities Private vs. Social Costs  Private cost is cost to firm of production only, not including externalities:  Direct costs of labor, energy, and wood pulp.  But not indirect costs of harm from pollution associated with production.  Social cost equals private cost plus the cost of harms from externalities.

Managerial Economics, Lecture 18: Externalities Supply-and-Demand Analysis  A competitive market produces excessive production (and excessive pollution) because firms' private costs are less than social costs  A market sets supply (= private marginal cost) equal to demand (= marginal benefit).  The social optimum sets social marginal costs equal to marginal benefit.  These are different, so a competitive market with externalities has deadweight loss.

Managerial Economics, Lecture 18: Externalities Paper Mill: Assumptions  Competitive paper market.  Firms produce paper and a by-product, gunk, which causes air and water pollution that harms people who live near paper mills.  Each ton of paper produced increases the amount of gunk by 1 unit.  The only way to decrease volume of gunk is to reduce the amount of paper manufactured.  Paper firms do not have to pay for harm from pollution they cause.

Managerial Economics, Lecture 18: Externalities Figure Welfare Effects of Pollution in a Competitive Market Demand MC p MC g = Social Cost of Pollution MC g s = p + g 450 p s = 282 p c = Q c = 105Q s = e c e s A B F C D E H G Q, Tons of paper per day MC p Price of paper, p, $ per ton, Units of gunk per day G Deadweight Loss

Managerial Economics, Lecture 18: Externalities Analysis of Pollution Reduction  Another way to think about pollution is to consider the benefits and costs of reducing it.  In the simple case just considered, the cost is lost output, the benefit is lower health costs from pollution.

Managerial Economics, Lecture 18: Externalities Figure Cost-Benefit Analysis of Pollution (Reduction) Cost: less paper Benefit: less gunk Maximum net benefit G, Units of gunk per day Q, Tons of paper per day G, Units of gunk per day Q, Tons of paper per day (a) Cost and Benefit (b) Marginal Cost and Marginal Benefit 4,000 2, MC MB Benefit, Cost, $ Marginal benefit, Marginal cost, $

Managerial Economics, Lecture 18: Externalities Analysis of Pollution Reduction, 2  In the more general case, marginal benefits may decline more rapidly:  Health impacts may only appear at high concentrations, so there are not large benefits from continual reduction.  Marginal costs may increase more rapidly:  It is easy to eliminate the worst pollution, but often technologically difficult to get rid of it all—or getting rid of it all requires not producing things people value highly.  So it often is inefficient to eliminate all pollution of a given type.

Managerial Economics, Lecture 18: Externalities Optimal Pollution Reduction $ Pollution Reduction 100% MC MB Optimal0%

Managerial Economics, Lecture 18: Externalities Monopoly and Externalities  Monopoly output may be less than the social optimum even with an externality.  Competition is not necessarily better than a monopoly with an externality.

Managerial Economics, Lecture 18: Externalities Figure Monopoly, Competition, and Social Optimum with Pollution Q, Tons of paper per day DemandMR MC p g s = p + g e m e c e s e t AB C D Price of paper, p, $ per ton

Managerial Economics, Lecture 18: Externalities Allocating Property Rights  A property right is an exclusive privilege to use an asset.  The Coase Theorem: if property rights are clearly defined, optimal levels of pollution and output result from bargaining between a polluter and its victims.  Parties generally won’t negotiate unless property rights are clearly assigned.

Managerial Economics, Lecture 18: Externalities Coase Theorem Results  If there are no impediments to bargaining, assigning property rights results in an efficient outcome: joint surplus is maximized.  Efficiency is achieved regardless of who is assigned the property rights.  Who gets the property rights affects the income distribution (property rights are valuable).

Managerial Economics, Lecture 18: Externalities Alternative Property Rights  The right to be free from pollution  A firm cannot pollute unless it compensates its victims to their satisfaction.  The right to pollute  Firms will pollute unless compensated by victims for the profits it loses from stopping pollution.

Managerial Economics, Lecture 18: Externalities Problems with Coase Approach  The Coase approach works only if:  Property rights are clearly defined.  Parties can bargain successfully.  3 common causes of bargaining failure:  Transaction costs are very high.  Firms engage in strategic bargaining behavior.  Either side lacks information about costs or benefits.