1 Externalities

2 Externalities  Externalities are a market failure (so Government intervention may be advisable).  Externalities imply that there will be a difference between private optimum and social optimum.  In a sense, this chapter is on private property (who has the right to what).

3 Externalities  An externality is a cost or a benefit imposed upon someone by actions taken by others, without compensation.  An externally imposed benefit is a positive externality.  An externally imposed cost is a negative externality.  There are consumption externalities and production externalities.

4 Externalities  The crucial feature of externalities is that they are goods/services which are valued by people but are not transacted in the market. Its main problem is therefore that the equilibrium allocation might not be efficient.  Externalities raise the problem of intertemporal/intergenerational justice. Which discount rate shall be used to value the future (probability of being alive, impatience, future preferences, …)?

5 Examples of Negative Externalities  Air pollution.  Water pollution.  Loud parties next door.  Traffic congestion.  Second-hand cigarette smoke.  Increased insurance premiums due to alcohol or tobacco consumption.  Obstructed view.

6 Examples of Positive Externalities  A well-maintained property next door that raises the market value of your property.  A pleasant cologne or scent worn by the person seated next to you.  Improved driving habits that reduce accident risks.  A scientific advance.  Education.  Vaccination.

7 Externalities and Efficiency  Crucially, an externality impacts a third party; i.e. somebody who is not a participant in the activity that produces the external cost or benefit (in that market).

8 Externalities and Efficiency  Externalities cause Pareto inefficiency; typically  too much scarce resource is allocated to an activity which causes a negative externality (because part of the social cost is not taken into account; the agent considers only its private costs)  too little resource is allocated to an activity which causes a positive externality (because part of the social benefit is not taken into account; the agent considers only its private benefits).

9 Externalities and Property Rights  Ronald Coase’s insight is that most externality problems are due to an inadequate specification of property rights and, consequently, an absence of markets in which trade can be used to internalize external costs or benefits.

10 Externalities and Property Rights  Causing a producer of an externality to bear the full external cost or to enjoy the full external benefit is called internalizing the externality.

11 Solutions  There are market solutions to externalities: since profits from coordination are greater than profits without, either firm has an incentive to buy out the other and internalize the externality.  There are Government solutions to externalities (e.g. pollution): - assign pollution rights (‘grandfathering’) - sell pollution rights (auctioning) - impose a tax on polluting emissions

12 Solutions  Pollution rights are set in an amount equivalent to the efficient pollution level.  Firms polluting above the rights they own must be highly penalized.  Assignment of pollution rights based on past emissions are a perverse incentive for firms to reduce these.  Free negotiation of rights among firms may lead to some of them accumulating rights in order to prevent entry.  The efficient value of the tax must equal the external marginal damage at the socially optimum pollution level.

13 Merger and Internalization  Suppose the two firms merge to become one.  Merger internalizes an externality and induces economic efficiency.  How else might internalization be caused so that efficiency can be achieved?

14 Coase and Production Externalities  Coase argues that the externality exists because neither the steel firm nor the fishery owns the water being polluted.  There is a missing market: the market for pollution. In this market some agents would be willing to pay to have the quantity of pollution produced reduced. Thus, pollution would have a negative price.

15 Coase and Production Externalities  Suppose the property right to the water is created and assigned to one of the firms. Does this induce efficiency?  Yes (assumption: no transaction costs).

16 Coase and Production Externalities  The Coase Theorem: when the parties affected by externalities can negotiate (almost) costlessly with one another, an efficient outcome results no matter how the law assigns responsibility for damages.  Requirements: clear definition of property rights, which may require easy access to courts.

17 Production Externalities and Pollution Rights  Instead of assigning property rights and letting firms bargain over amount of pollution, the Government may sell pollution rights.

18 Production Externalities and Taxes  Ensure that the firm covers the social cost it is generating by paying a tax on pollution.  The authorities problem is then to find the value of t that induces the firm to produce the optimum social amount of pollution.  The kind of tax that corrects an inefficient situation is known as a Pigouvian tax, after the economist Arthur Pigou.

19 The Tragedy of the Commons  Common resources: rival but not excludable.  The tragedy of the commons illustrates what happens in a society that lacks a well-developed institution of property rights.

20 The Tragedy of the Commons  Consider a grazing area owned “in common” by all members of a village.  Villagers graze cows on the common.  When c cows are grazed, total milk production is f(c), where f’>0 and f” 0 and f”<0.  How should the villagers graze their cows so as to maximize their overall income?

21 The Tragedy of the Commons  The economic profit from introducing one more cow is positive.  Entry continues until the economic profit of grazing another cow is zero.  Since nobody owns the common, entry is not restricted.  The commons are over-grazed, tragically.

22 The Tragedy of the Commons  The reason for the tragedy is that when a villager adds one more cow his income rises but every other villager’s income falls.  The villager who adds the extra cow takes no account of the cost inflicted upon the rest of the village.

23 The Tragedy of the Commons  Modern-day “tragedies of the commons” include  over-fishing the high seas  over-intensive use of public parks  urban traffic congestion.