Externalities 1

Recall the miracle of the market – It produces the outcome that is efficient, provided several conditions are satisfied – Here’s another way of looking at why the markets produce efficient outcomes: If an allocation is inefficient, somebody can be made better off without harming anybody else. – Even if new allocation of goods (after exchange) makes somebody better off and somebody worse off, with the winner’s gain exceeding the loser’s loss (why), it is possible to imagine a monetary compensation to the loser that will make the loser want to participate in this exchange. That’s what a price does – it pays the compensation, thus inducing a (potential) “loser” to voluntarily participate in an efficiency‐enhancing activity. 2

Externality is an effect on one person by another such that the influenced person is not compensated (if the effect is negative) or charged if the effect is negative) One can think about externality as something happening outside a market (since there’s no price for it) Or one can think about an externality‐producing activity as such whose price does not correctly reflect MC and or MV – I want something from you, you give it to me, I give you money, and in the process, some 3rd party is injured. The former effects (on me and you) are internal to the market, the latter effect is external to the market that connects you and me, and is thus an externality. – Classic negative externality is pollution. I buy gas from the gas station (marketed), and drive to Kelowna, poisoning residents along the way (externality). – Classic positive externality is literacy. If you are literate, you raise the productivity of everyone around you. But, they don’t pay you to be literate It can be shown that people produce/consume too much (inefficiently large quantities) of a negative‐externality‐producing good It can be shown that people produce/consume too little (inefficiently low quantities) of a positive‐externality‐producing good 3

Various ways of looking at an externality provide the ideas for various ways of dealing with it – If we think about markets with externalities as those with wrong prices, we could correct the prices by introducing externality taxes With a negative externality, the market price is too low. One possibility is to introduce the missing market. But, perhaps it was missing for a reason, e.g., too complicated to create. The government can ‘fake it’ for us: tax the Vancouver drivers so that they drive less. This is often referred to as Pigouvian tax There can also be a Pigouvian subsidy 4

If we think of externalities as missing markets, we could try and create the markets for them – If there were a market for the effect under consideration, then there is no externality. – Missing market is the lack of a market for pollution reduction that residents of Abbotsford can buy which would curtail my driving. – You can use the missing market to imagine the Pareto (or Marshall) improvement that might be available, and consequently to see exactly why the situation with the externality is inefficient. – Improvement: Abbotsford residents each pay each Vancouver driver $10 to drive 10% less. We know that the Vancouverites are driving too much, because they don’t pay any attention to the health of those in Abbotsford. Alternatively, Vancouverites pay Abbotsford residents for the right to drive through Abbotsford Depends on who owns the air: is air supposed to be clean or dirty. If it is supposed to be clean, then effectively, the Abbotsford people own it, and the Vancouverites must pay to dirty it. If it is supposed to be dirty, then effectively the Vancouverites own it, and the Abbotsford guys must pay them to keep it clean. 5

Who should own the air? – Recall Coase Whoever can avoid externality at lower costs should bear the responsibility (pay the cost of externality) – But also think the cost of arranging the payments Usually imposing a tax is easier. – But Government could impose a rule, like, “don’t drive” or more likely “drive no more than certain amount.” – This would be regulation in form of either law or quota. 6

Some famous externalities: – Carbon dioxide Too much CO 2 in pour atmosphere People who produce stuff add a lot to it People who dig stuff up add even more to it A rising agreement is humans do create discernible effect on average temperature – global warming Create a market? – Too difficult – easy to cheat Tax the producers? – Need a world government to tax national governments – don’t have such Regulate? – International agreement is very hard to reach and easy to ignore – Kyoto has mostly failed BC Carbon taxes – tax the emission of CO 2, » by firms that emit CO 2 when they produce goods. » by people that emit CO 2 when they burn fossil fuels. – taxing emission will reduce emission 7

Alcohol – Drink and drive = higher probability of harm to somebody else – Excise tax – Legal age – Fines/licence/jail/crying on TV if DUI – Night buses Tobacco – Second‐hand smoke – Addictive at young age – Excise tax – Legal age – No display Speeding – Unsafe – Fines/licence – Could just make pay for harm Right incentives because skills are taken into account Wrong incentives because solvency 8