Externalities, Commons and Public Goods Perloff Chapter 18

Externalities When a person’s well being or a firm’s production capacity is affected directly by another’s actions. Negative Chemical plant dumping waste into a lake. Positive A firm installing shrubs and sculpture benefits its neighbours Firms selling extra output clearly affects other firms but through thte market, this is not an externality.

Marginal cost with and Externality Marginal Private Cost The additional cost incurred when an additional unit of output is produced. Marginal Social Cost The full cost incurred by all of society in producing another unit of output. MCs=MCp+MCg

Welfare Effects of Pollution ` Social Private Change CS A A+B+C+D B+C+D PSp B+C+F+G F+G+H H-B-C Cg C+G C+D+E+G+H D+E+H PSp-Cg B+F F-C-D-E -B-C-D-E Cs+PSs A+B+F A+B+F-E -E=DWL 450 Price of paper, p, $ per ton MC s = MC p + MC g A e MC p s p = 282 E s B C D p = 240 e c H c 198 G MC p MC g F 84 MC g 30 Demand Q = 84 Q = 105 225 s c Q , Tons of paper per day

Emissions Standard Regulate pollution (or output) in order to achieve the social optimum. In the paper example constrain output to 84 units per day. Need to know: Demand curve Marginal social cost curve Relationship between paper production and pollution. Enforcement is costly.

Emissions Fee Tax the pollution that is produced. Tax output (assuming a fixed relationship with pollution) Either: vary tax with output (t(Q)) fixed tax (t) Price of paper, p, $ per ton 450 MC s = MC p + t ( Q ) MC p + t p s = 282 e s MC p t = 84 MC p = 198 MC g MC g = 84 Demand Q = 84 225 s Q , Tons of paper per day

Cost benefit Analysis Compares the costs and benefits of a movement away from the market equilibrium. Costs: Reduced output of paper Consumer surplus reduced Producer surplus reduced Benefits Reduced costs of polution

CBA of polution (a) Cost and Benefit 4,000 Cost: less paper Benefit: less gunk 2,000 Maximum net benefit 105 84 63 Q , Tons of paper per day G , Units of gunk per day (b) Marginal Cost and Marginal Benefit 105 MC Marginal benefit, Marginal cost, $ 84 MB 105 84 Q , Tons of paper per day G , Units of gunk per day

Externality With Monopoly 450 Price of paper, p, $ per ton MC s = MC p + MC g e t 330 e 310 m e s 282 D MC p A B C 240 e c MC g Social welfare under social optimum is A+B+C, under monopoly is A+B, DW loss under monop is les than under competition. 30 MR Demand 60 70 84 105 225

Regulation of a Monopoly with an Externality It may be that the monopoly is preferable to competition if regulation is not possible. Charging a tax equal to the MC of pollution may reduce welfare if monopoly output is below social optimum. Achieving the social optimum may entail subsidisation of a monopoly.

Property rights An exclusive right to use an asset Private ownership of asset Right to be free of noise pollution Courts could be used to enforce the right You could sell the right to someone who wants to be noisy. In many cases the rights are not assigned.

Coase Theorem: No property Rights Boat firm: Boats rented per day 1 2 $0 $14 $15 Chemical firm: tonnes dumped per day. $0 $0 $0 $0 $10 $5 $10 $10 $10 $0 $2 -$3 Outcome fails to maximise the joint profits of both firms, it is therefore inefficient If property rights are with boat owner With no pollution boat firm makes $15 Boat firm needs to be paid enough to make at least $15 to allow pollution. The best the boat firm can do with polution is $10, it therefore needs at least $5 compensation If chem co produces 1 unit of pollution its profit is $10, if it produces 2 units its profit is $15 the max per unit it will pay is therefore $10 The best the chem company can do if it reduces polution is make 10$ The best the boat co can do is 15 when polution is reduced by 2. $15 $15 $15 If property rights are with boat owner: Minimum price per unit of pollution is $5 Maximum price is $10 If property rights are with chem. firm: Minimum price per unit of pollution is $5 Maximum price is $7.50

Coase theorem: Property rights with boat firm Pollution priced at $7 per tonne Boat firm: Boats rented per day 1 2 $0 $14 $15 Chemical firm: tonnes dumped per day. $0 $0 $0 $7 $17 $12 Boat firm realises that the polluter has a dominant strategy and rents one boat per day. Joint profits are now maximised. $3 $3 $3 $14 $16 $11 $1 $1 $1

Coase theorem: property rights with chemical firm Pollution priced at $6 per tonne Boat firm: Boats rented per day 1 2 -$12 $2 $3 Chemical firm: tonnes dumped per day. $12 $12 $12 -$6 $4 -$1 $16 $16 $16 $0 $2 -$3 $15 $15 $15

Coase Therorem: Summary Assigning property rights results in the efficient outcome. Efficiency is achieved regardless of who has the property rights. The distribution of welfare in the efficient outcome is dependent on the initial allocation of property rights.

Common Property Unlike private property people cannot be excluded. When deciding how much to use, people ignore the impacts on others so the resource is overused. Common pool, water, gas, oil. Internet Roads Fisheries

Public Goods Non-Excludability Non rivalry People cannot be prevented from consuming a good. Non rivalry The good is not used up when one person uses it.

Markets for public goods Only exist for excludable goods. Demand curve is the vertical summation of individual willingness-to-pay or demand curves 25 D Price of guard service, $ per hour 18 D 1 13 e e p s 10 Supply, MC 8 7 D 2 3 2 4 5 7 9 Guards per hour

Free riding Hiring two guards brings no extra benefit. Each guard costs £10, benefit of having a guard is $10 Both result in a Nash equilibrium of no guard.

Voting for the provision of a public good Traffic light costs $300, if it is installed each person’s taxes increase by $100. A person will vote for if they value the light more than $100. Thus lights are installed on corner A and C. Note that the value to society is greater than $300 on B where no light is installed and less than $300 on C where a light is installed. Thus voting does not always lead to the efficient outcome.