CHAPTER 33 EXTERNALITIES

Consumer externality:  Consumer welfare affected by the actions of other economic agents;  Negative: smoker in the dormitory;  Positive: neighbor’s surveillance camera. Producer externality:  Production possibility affected by the actions of other economic agents;  Negative: pollution on farmers;  Positive: hi-tech companies in the Silicon Valley. No market for externality.

Pareto efficiency Pareto efficiency can be achieved by market if  Property rights are well-defined;  Property rights can be traded (unlikely). Example: smokers and nonsmokers  Two goods: air and a composite consumption good;  Two consumers.

Pareto efficiency

Trade always ends up with Pareto efficient allocations; The amount of externality generally depends on the ownership of property rights; Inefficiency arises when property rights cannot be traded.

Quasilinear preferences Quasilinear preferences:  The indifference curves are parallel to each other;  The contract curve is horizontal;  The Pareto efficient amount of externality is independent of the ownership of property rights.

Quasilinear preferences

Coase bargaining With well-defined property rights; One party initiate the bargaining process: a target level of externality, and a transfer; The outcome is always Pareto efficient; With quasilinear preferences, the amount of externality is unque. Similarities: 1 st degree price discrimination.

Coase bargaining

Production externalities Two producers: S and F; Outputs: s and f; Externality: x; Cost functions: c s (s, x), c f (f, x)  Pollution is bad for the fishery, but good for the steel plant.

Production externalities The competitive outcome:  The steel plant has the rights;  No trade or bargaining. The steel plant’s problem:  F.O.C.: The fishery’s problem:  F.O.C.:

Production externalities Pareto optimum: a joint venture by two firms. The new firm’s problem:  F.O.C.:

Production externalities

The competitive firm fails to incorporate the social cost of pollution: too much externalities; The joint venture internalizes externality: Pareto optimal amount of externality.

Cures of externality Pigouvian tax: taxing externality  The steel plant’s problem:  F.O.C.:  The F.O.C. for Pareto optimum:  Set the tax rate at:

Cures of externality The missing market: x is tradable at price q  The fishery sells pollution rights to the steel plant;  The steel plant’s problem: F.O.C.:  The fishery’s problem: F.O.C.:  Pareto optimum:

The tragedy of the commons Cows feeding on a grazing land; Number of cows: c; Marginal cost: a; Total yield: f(c)  Diminishing marginal returns: f>0; f  <0.

The tragedy of the commons Social optimum:  F.O.C.: MP(c * )=a Competitive outcome:  The yield of the each cow: f(c)/c;  Zero-profit condition: AP>MP: Why inefficiency: negative externality on other cows.

The tragedy of the commons