1. 7.2 Externalities 7.2.1 Externalities and Missing Markets 7.2.2Coase Theorem 7.2.3Intervention 7.2.4Summary

2. Application “Councils chew over gum problems” BBC website 16 th January 2006 Its costs 3p to buy a stick of chewing gum but 10p to remove it from the streets. Oxford Street has 300,000 pieces a year 20 local councils banded together to ask for financial help to deal with the problem The pressure is on manufacturers to produce a non- sticky gum Will this solve the problem and who pays?

3. 7.2.1 Externalities and Missing Markets While we have analysed individual decisions we have tended to ignore their impact on others Often, decisions made by firms or individuals can have an effect on other firms or other individuals In economics we call these effects externalities and they can play a significant role in affecting the efficient allocation of resources

4. An externality is defined as: The direct effect of the actions of one economic agent on the welfare of another economic agent in a way that is not reflected in the market price Thus a benefit is not paid for or a cost is not borne. Four features can be noted: 1.Any agent can create an externality 2.There are always two sides to an externality – a creator and a receiver 3.Externalities can be positive or negative 4.Zero externality is generally inefficient

5. Pollution as an example of an externality There are external costs of producing pollution e.g. damage to the environment, health etc There are benefits too! Suppose we try to cut pollution: 1.Reducing pollution could require a cut in output and thus reduce producer surplus 2.Keeping output constant but reducing pollution through new technology would increase reduction costs and use up scarce resources

6. MC MB P* Q1 Pollution Cost Q2 Thus, consider the marginal costs and benefits:

7. But where will the firm produce? As the firm does not have to take into account external costs of pollution it will produce until marginal benefits are zero i.e. at Q2 The efficient outcome is that Q1 pollution is produced as that is where marginal cost equals marginal benefit Why does this divergence occur? It is due to the fact that there is a missing market

8. The missing market is for clean air and in effect its price is zero. If it was a market, the “price” would be P* If the market does not exist, there is no mechanism to allocate a commodity efficiently. As such, agents will use it to maximise their own private benefit. However if someone “owns” the commodity, then a market can be established and an efficient outcome can be achieved

9. 7.2.2 Coase Theorem Allocating ownership or property rights can allow us to find an optimal level of an externality Marginal social cost – the cost of an action which includes all the costs of production including any external costs borne by other agents Marginal social benefit – the benefit of an action which includes all the value of production including any external benefits enjoyed by other agents Need to consider social as opposed to private outcomes

10. S = PMC MB P1 Q1 Steel £ SMC = PMC + MD P* Q* MD

11. Output of steel is too high at Q1 (like pollution was too high at Q2 in the earlier diagram) If forestry managers own clean air rights they can get steel producer to “pay to pollute” Or If the steel firm owns the clean air, they can ask the forestry for payment not to pollute Either way we get to the efficient outcome of Q*P* - how?

12. S = PMC Q1 Steel £ SMC = PMC + MD Q* MR Assume price taking firm

13. 7.2.3 Intervention Governments can respond by intervening: 1. Regulation – e.g. carbon emissions limits for cars 2. Pigouvian taxes – A tax levied on polluters output by an amount just equal to the marginal damage it inflicts at the efficient level 3. Create a market – licences to pollute can be traded

14. S = PMC MB P1 Q1 Steel SMC P* Q* t S + t

15. 3. Create a market – licences to pollute can be traded S D No. of Licences Price p.a.

16. 7.2.4 Summary Externalities are not captured in private market outcomes They can be positive or negative Allocation of property rights in the Coase Theorem helps produce an efficient outcome If not, intervention can provide tax, permit and licence based solutions