EXTERNALITIES An externality occurs when an activity generates unintended effects on others for which no payment or compensation is made. Externalities arise because of the absence of private property rights – if they existed payment/compensation would occur. They are an example of market failure. Externalities can be thought of as “missing markets”. Or, as unpriced goods and services. Externalities may be beneficial or harmful In the absence of corrective policy, the level of an activity that gives rise to a harmful/beneficial externality will be too high/low.

Externality Originating In BeneficialHarmful Production Activity Externality Honey production Pollination for fruit growing Fossil fuel combustion Atmospheric pollution Consumption Activity Externality Vaccination of one person Reduced risk of infection for rest of population High stereo volume in apartment Noise pollution A classification of externalities

Two ways of visually showing how externalities lead to a divergence between privately efficient (market) and socially efficient outcomes. In the diagrams, we have an adverse externality such that social costs exceed private costs.

B, C Q Q* B C SC = C + External cost Q **

Price Quantity per period PMC PMB P* Q* EMC SMC = PMC + EMC Q** P**

Note at Q* that SMC  SMB But it does at Q** (i.e. in the situation where the externality is internalised).

P Q S D P* Q* Consumer Surplus Producer Surplus Situation where no externality exists

P Q S = PMC D = SMB P* Q* SMC P** Q** The efficiency loss due to an externality

P Q S = PMC D = SMB Q* SMC P** Q** Consumer and producer surpluses with an externality CS

NB QQ* NB without externality Q ** NB incl externality NB0 NB1 NB2 Efficiency loss from ignoring externality = NB1 - NB2

Pollution Control: Two Questions for Public Policy 1.How much pollution should be allowed? What is the policy objective? 2. How to affect polluters’ behaviour so as to bring about the desired level of pollution? What policy instrument to use? We will answer these questions later.

PUBLIC GOODS/PUBLIC BADS External effects often have the characteristics of public goods/bads.

Public goods/bads have two characteristics 1.Non-rivalry – consumption by one agent does not reduce the amount available to others 2.Non-excludability – if provided for one agent, others cannot be excluded from consumption Examples of public goods – national defence, lighthouses, air pollution abatement. Examples of public bads – air pollution

High stereo volume in apartment Noise pollution Vaccination of one person Reduced risk of infection for rest of population Consumption Activity Externality Fossil fuel combustion Atmospheric pollution Honey production Pollination for fruit growing Production Activity Externality HarmfulBeneficial Externality Originating In All of these externalities are non-rivalous and non-excludable; so they are public (goods/bads) externalities.

PROBLEMS ASSOCIATED WITH PUBLIC GOODS/BADS 2.Because of non-rivalry and non excludability, the market cannot supply the right amount of public goods/bads – the free rider problem 3.Even if there were no free rider problem, non-rivalry may imply zero marginal costs. So efficient price is zero! (See the bridge example later in CBA). 2.It is difficult to estimate the marginal benefits (or marginal costs) associated with these goods. Why? Think about pollution abatement, as an example.

Marginal benefits of pollution abatement £

PROBLEMS ASSOCIATED WITH PUBLIC GOODS/BADS Pollution abatement. 2.There may be no market here; so nothing to observe directly. 3.Free rider issues again: will people reveal preferences? 4.Even if the good were traded, then market demand curves would not correctly express socially valuation. (Market demand curves are horizontal sums; we need vertical sums here).