1 Intermediate Microeconomic Theory Externalities

2 Markets and Efficiency We have seen that markets can provide an efficient mechanism for allocating scarce resources. However, this result only holds when markets are perfect. (i) Tax revenue raised via lump-sum taxes, (ii) Producers and consumers are price takers, (iii) There are complete markets, (iv) There is no asymmetric information. We discussed why allocations can fail to be efficient if (i) and (ii) fail. What do we mean by (iii), and what if it fails?

3 Externalities What do we mean by an externality? What are some examples? Production Externalities? Consumption Externalities? Why might externalities lead to inefficiencies? How does this relate to a “missing market”?

4 Modeling an Externality Consider the neighbors Al and Bill Both have $64 a day to spend on stuff. Both also have 16 hours/day. Problem – while both like “stuff”, Al likes to listen to techno music, Bill likes silence. Utility functions U A = q A,c 0.5 q t 0.5 (or equivalently, U A = q A,c 0.5 (16-q s ) 0.5 ) U B = q B,c 0.5 q s 0.5 (or equivalently, U B = q B,c 0.5 (16-q t ) 0.5 )

5 Modeling an Externality In the absence of any regulation, what do you think will happen? What will this mean about their respective utilities? Is this Pareto Efficient?

6 Modeling an Externality If techno music were banned what will this mean about their respective utilities? Is this Pareto Efficient? How can we find a Pareto Efficient Allocation?

7 Modeling an Externality Suppose we set up a “market” where Bill could pay Al $p for each hour of silence (where p is determined by a competitive market). Now what would happen?

8 Modeling an Externality To solve this problem, let us set it up as follows: Al wants to maximize U A = q c,A 0.5 q t 0.5 subject to what budget constraint? What will this lead to in terms of Al’s demand for both goods? Bill wants to maximize U B = q c,B 0.5 q s 0.5 (q s is hrs of silence), subject to what budget constraint? What will this lead to in terms of Bill’s demand for both goods?

9 Modeling an Externality What will be the market clearing value of p? Given this p, what will be the utilities of each person? Will this allocation be efficient?

10 Modeling an Externality How would we show this graphically? So externality problem is just a missing market problem. Once market is set-up there are no problems any more, right?

11 Modeling an Externality Implicitly, this solution gave Al the property rights to the amount of “noise” in the air. Why shouldn’t Bill get those property rights? What would it mean to give Bill property rights?

12 Modeling an Externality If Bill has property rights: Al wants to maximize U A = q c,A 0.5 q t 0.5 subject to what budget constraint? What will this lead to in terms of Al’s demand for both goods? Bill wants to maximize U B = q c,B 0.5 q s 0.5 (q s is hrs of silence), subject to what budget constraint? What will this lead to in terms of Bill’s demand for both goods?

13 Modeling an Externality What will be the market clearing value of p? Given this p, what will be the utilities of each person? Will this allocation be efficient?

14 Modeling an Externality What would this look like graphically?

15 Externalities and Efficiency Clearly, such issues can arise in many other instances. When I consume an apple, it affects other people by using up some resources. However, I internalize these costs through having to forgo other consumption due to the price I have to pay. Under perfect markets, I pay the full societal cost of “producing” the apple When I consume more driving, I again use resources which otherwise you could have used (e.g. gas, the metal and leather in my SUV) I internalize these costs through having to forgo other consumption by paying the sticker prices for gas, car, etc. However, I also use other resources in consuming driving, namely clean air. I do not pay for these resources, so I overconsume relative to societal efficiency.

16 Externalities and Missing Markets So an externality can in a way be thought of as a missing market. If a market were developed, then the “externality” doesn’t lead to inefficiency, as entity originally producing externality internalizes the true social cost. This brings us back to the world of the First Welfare Theorem that competitive equilibria are Pareto Efficient.

17 The Coase Theorem Coase Theorem – In the absence of transactions cost, negotiations between individuals should lead to an efficient allocation regardless of how property rights are assigned. Essentially, given a market, the equilibrium price will cause person imposing the externality to internalize the social cost, once again making the marginal benefit of last unit consumed equal to the total cost of supplying that unit to the market. So why do we even talk about externalities?

18 Externalities and Missing Markets Missing market/Existence of externality: Utility for Al: 32 Utility for Bill: 0 Market Constraint (ban on techno): Utility for Al: 0 Utility for Bill: 32 Al has property rights: Utility for Al: 35 Utility for Bill: Bill has property rights: Utility for Al: Utility for Bill: 35

19 Coase Theorem In the presence of externalities, how property rights are distributed will affect distribution of wealth. Coase Theorem says nothing about what is a “just” distribution, it just gets us to efficiency (like with any other perfect markets argument). Therefore, courts can have a big impact on how societal welfare is allocated via their decisions on how property rights are determined in ambiguous situations. What else seems lacking in the “Coasian” picture of the world? Why the smoking ban in bars? Why is there still dog waste in my lawn? Why is the degradation of environment in China so extreme?

20 Coase Theorem Coase Theorem – In the absence of transactions cost, individuals should be able to negotiate to an efficient allocation regardless of how property rights are assigned. Should we expect transaction costs to always be low?

21 Externalities and Transactions Costs Consider something like the environment (See NYT article on pollution in China) A given polluter only affects each person a little bit. If all these people could get together, they could certainly pay off polluter until we reach efficiency. Problem is how do all these people get organized? Who will be in charge of organizing? In particular, the organizer must take on costs, but only gets a little bit of the benefit from organizing. This is a Public Goods problem.

22 Externality Policy So what should be done about externalities? Taxation? Double Dividend of taxation of externalities. How high should be tax? Think about the Al and Bill problem from before. Difficulties? Market Solutions?

23 Application: Emission Policy Why do economists tend to advocate for tradable emissions permits? In a way, it is similar to rent control discussion from awhile back. Under rent control, how could we make everyone better off? Analogue is often true for pollution control. First, figure out how much total pollution should be allowed. Either directly sell permits to companies via an auction, or give each firm a fixed amount of permits, then allow them to trade with each other. How is this better than just setting a pollution cap each firm must meet? What issue is still troublesome?

24 Externalities and ethics Thinking about externalities and transaction costs is also arguably related to ethics and morality. Why is it unethical to let your dog go in my lawn and not clean it up? Why is it unethical to talk in a movie? Why is it unethical for me to steal from you? Is it unethical for me to talk in Collins? Is it unethical for a poor person to steal food from a richer person?

25 Externalities and ethics One could argue that when parents, educators, interest groups, etc. “teach” some behavior to be unethical, they are often trying to force people to internalize the externality via the price of guilt. Is morality only thinking about externalities and efficiency? Consider story of run-away street car.