1. Department of Economics
EXTERNALITIES
E. Nketiah-Amponsah
Department of Economics
Room W.18

2. Real World Situation????
In the Real World, the conditions that satisfy perfectly competitive markets are not ideal
The presence of :
Externalities
Public Goods
Monopoly Power
Information Asymmetry
Risk and uncertainty
International trade taxes/subsidies
Market failure: A problem that arises when the competitive assumptions are violated. Market failure causes the market economy to deliver an outcome that does not maximize efficiency.

3. Real World Situation????
Thus, a violation of any of the competitive assumptions undermine the potency of the market to efficiently allocate goods and services (market failure).
When the market fails, there is a tendency for it to produce too much of some goods and an insufficient amount of others
In the extreme case of market failure, the market is non-existent , hence certain goods and services will not be produced at all.

4. Externality-What is it?
Externalities arise whenever the actions of one economic agent make another economic agent worse or better off, yet the first (primary) agent neither bears the costs nor receives the benefits of doing so.
An Externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside the activity or transaction (also called spillover effects or neighborhood effects).
An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander
A negative externality is a cost experienced by someone who is not a party to the transaction that produced it while a positive externality is a benefit experienced by someone who is not a party to the transaction that produced it

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.

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.

7. Externality-Why a Problem?
Externalities create a divergence/wedge between private costs and social costs on one hand and private benefits and social benefits on the other.
Social Cost = Private Cost +External Cost
Social Benefit = Private Benefit + External Benefit

8. Negative Production Externalities
Negative production externality: When a firm's production reduces the well-being of others who are not compensated by the firm.
Private Marginal Cost (PMC): The direct cost to producers of producing an additional unit of a good
Marginal Damage (MD): Any additional costs associated with the production of the good that are imposed on others but that producers do not pay.
Social Marginal Cost (SMC = PMC + MD): The private marginal cost to producers plus marginal damage
Example: steel plant pollutes a river but plant does not face any pollution regulation (and hence ignores pollution when deciding how much to produce)

9. Positive Externalities
Positive production externality: When a firm's production increases the well-being of others but the firm is not compensated by those benefiting from the firms production activities.
Example: Beehives of honey producers have a positive impact on pollination and agricultural output
Positive consumption externality: When an individual's con- sumption increases the well-being of others but the individual is not compensated by those others.
Example: Beautiful private garden that passers-by enjoy seeing

10. Competitive market vs. Social Optimum
Efficiency in competitive markets occurs where MB=MC (also P = MC). Where MB= private (max.) willingness to pay and MC= private (min.) willingness to sell.
More correctly, society will see the outcome as efficient where
Marginal Social Benefits (MSB) = Marginal Social Costs (MSC).
Externalities drive a wedge between private and social benefits and private and social costs.
MSC: The total cost to society's of producing an additional unit of a good or service
MSC is equal to the sum of the marginal costs (private) of producing the product and the correctly measured damage (external cost) involves in the production process.
MSB: Same principles apply

11. The yellow triangle is the consumer and producer surplus at Q1.
SMC = PMC + MD
Price Steel
S=PMC
The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q1.
The yellow triangle is the consumer and producer surplus at Q1.
The socially optimal level of production is at Q2, the intersection of SMC and SMB.
The steel firm overproduces from society’s viewpoint. p2
This framework does not capture the harm done to the fishery, however.
The marginal damage curve (MD) represents the fishery’s harm per unit.
The red triangle is the deadweight loss from the private production level.
The social marginal cost is the sum of PMC and MD, and represents the cost to society. p1 MD
D = PMB = SMB Q2 Q1
Qsteel
Presence of Externalities lead to Inefficiency: Negative Production Externalities

12. Externalities: Social Benefits vs Costs
Private Benefits + External Benefits = Social Benefits
Private Costs + External Costs (Marginal Damage) = Social Costs
Since external benefits and costs are not perceived by buyers and sellers they are not captured in markets.
Therefore, markets may fail to allocate resources efficiently when there is a spillover effect (be it positive or negative externalities).

13. Negative Externalities
Marginal Social Costs are greater than Marginal Private Costs.
For instance, pollution is a cost that may not be borne by (firms) sellers, but it is a cost nonetheless to society.
Private markets will overproduce (devote too many resources) to the production of goods with negative externalities.
Missing the extra costs, markets generate an outcome where MSC > MSB, signal that decreasing output will increase net social benefits.
Is zero pollution efficient?

14. Positive Externalities
Marginal Social Benefits are greater than Marginal Private Benefits.
For instance, education is a benefit not only to the individual but to society in general.
Private markets will under allocate (devote too few resources) to the production of goods with positive externalities (education). e
Missing the extra benefits, markets generate outcomes where MSB > MSC, a signal that increasing production will increase net social benefits.

15. Externalities: Examples Revisited
Case of Air Pollution
lack of private property right to the atmosphere
factory uses the atmosphere as an input for which it does not pay
society incurs a cost not accounted for by the factory
too much of good produced

16. Figure 2 Pollution and the Social Optimum
Price of
Social
cost
Aluminum
Cost of
pollution
Demand
(private value)
Supply
(private cost)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
Copyright © South-Western

17. Negative Externality From Pollution
Case of one firm

18. Negative Externality From Pollution
Case of two firms
9/20/2018

19. Externalities: Case of two firms
Based on the MB and MPC the firms will maximize profit at the point where the MB curve cut the MPC. This corresponds to the output levels X1 and Z1. Note that they are equal.
Suppose it is known that the marginal damage inflicted by these firms at the efficient level is d dollars.
From the societal point of view, efficiency requires that firm X and Z produce X* and Z* respectively.
The crucial observation is that efficiency does not require the firms to reduce their output equally.
The efficient reduction in production of firm Z exceeds that of firm X and this is due to the different MB schedules.
This implies that a regulation that mandates all firms to cut back production by equal amounts leads to some firms producing too much and others too little.

20. Externalities: Positive Externality
Case of Education
students receive private benefits from education
others receive benefit of associating with educated person
student cannot capture this public benefit
i.e., lacks property right needed to charge for this service to others
causes too little education to be consumed

21. Figure 3 Education and the Social Optimum
Positive Externality from Education
Price of
Education
Social
value
Supply
(private cost)
Demand
(private value)
QOPTIMUM
QMARKET
Quantity of
Education
Copyright © South-Western

22. Internalizing or Correcting Externalities
Internalization of an externality involves incorporating the external benefit or cost into the output and pricing decision so as to arrive at a social optimum (efficient outcome)
Internalization could take several forms
Market based instruments
Regulations/controls
Private Response to externalities

23. Government Intervention-Regulation
Government policies /Responses
Regulation: Command and Control
Each polluter has to cut pollution down to a certain level or use only appropriate production processes/techniques or else face legal sanctions.
Issues Arising:
requires pollution reducing capital, clean fuels, etc.
Limits to pollution
Specific technology requirements
Government production
lacks long run incentive to find better technology
same rules for all firms regardless of costs; a one cap fits all policy does not create the incentive to be innovative

24. Government Intervention-Cont.
Advantages of regulation:
Easier to enforce/administer.
Useful to quickly reduce pollution levels if the objective is to meet a certain salient and urgent target.
Easier to administer and politically more acceptable but may be inefficient
Disadvantages of regulation:
[Dynamic]: Discourages innovation: no monetary incentives to discover new technologies to reduce pollution further. With a tax, there is such an incentive.
[Heterogeneity]: Inefficient allocation when there is heterogeneity in costs of pollution abatement across .

25. Government Intervention-Cont.
Market Based instruments (Economic Solutions)
Taxes and Subsidies :
Pigouvian taxes: This is based on the polluter pays principle. Whoever pollutes must pay for the cost of pollution via taxation. Who should pay the tax or receive the subsidy? How much should be paid?
Tax /subsidy incidence is the same
Tradable Pollution Permits
Through the creation of a market: As already noted the inefficiencies associated with externalities can be linked to the absence of a market for the relevant resource. One way the government can enhance efficiency is to sell the right to use the resource.
In this way the government in effect creates a market for the pollution. The government can decide to sell the right to pollute the air/river etc. It will then allow firms to bid for the right to pollute the river.
-The higher the benefits from polluting, the more a firm is willing to pay for additional pollutants through trading of permits. The fee charged in this case is called discharge/effluent fee

26. Government Intervention-Cont.
Criticism of Economic Solutions to Pollution
To live is to pollute
The environment/biosphere has a natural carrying capacity

27. Pigouvian Taxes (An example)
In the presence of externality a tax/subsidy can be imposed, so that the party generating the externality will “internalize” the effect he exerts on the other party.
Advantage: it does not require negotiation between the parties, so it is applicable in cases, in which negotiation is impossible or is very expensive
Numerical examples will be discussed in class

28. The socially optimal level of production, Q2, then maximizes profits.
Pigouvian Tax
SMC=PMC+MD
Price of Steel
S=PMC+tax
S=PMC
The socially optimal level of production, Q2, then maximizes profits. p2
The steel firm initially produces at Q1, the intersection of PMC and PMB.
Imposing a tax equal to the MD shifts the PMC curve such that it equals SMC.
Imposing a tax shifts the PMC curve upward and reduces steel production. p1
D = PMB = SMB Q2 Q1 Q

29. Coase’s Insight: Private Response to Externalities
Coase’s Theorem : Based on the seminal publication “The Problem of Social Cost” published in the Journal of Law and Economics in 1960.
Under some circumstances it makes sense for the government to create conditions that allow a market to come into existence and then stay out of the market.
Recall that an externality is the consequence of the absence of property right definition.
Thus, a natural way to solve the externality problem is to put the resource in question into private hands (define property rights/ownership).
if negotiation costs are zero, private parties can resolve the problem of externalities.
An optimal compensatory payment (bribe) could that makes both parties better off.
Initial distribution of rights does not affect the efficient outcome, but it does determine who will pay or compensate whom.
Example of the herdsman and the farmland (Please, read the original article by Ronald Coarse- accompanying this lecture)
Assumptions
Low (no) bargaining costs
There is a reliable estimate of the costs and benefits to each side and this is a common knowledge among the negotiating parties

30. Coase’s Insight: Private Response to Externalities
A simplified Example.
Doctor and Mechanic Share an office building.
The Mechanic’s loud/noisy equipment or machinery disturbs the doctor’s medical practice.
The standard economic reasoning (at the time) was that the baker should have to compensate the doctor for the harm he was causing since he was ‘causing’ the externality.
Having the baker provide compensation would correct the externality
But is this reasoning fair or complete?
The value of the damage from the noise to the doctor is GH¢ 60.
The value of continuing to operate the business for the Mechanic is GH¢40.

31. Outcomes Under Two Legal Regimes

32. Two potential problems with Coase’s solution:
1. Cost of bargaining neglected. Cost of bargaining is very large when the number of agents involved is large. Example: air pollution, millions of people suffer from atmospheric pollution. Need an association to come in to bargain in the name of agents who are affected. This association is precisely the role of the government.
2. Asymmetric information problem: Resource owners need to be able to identify source of damage. For atmospheric pollution, difficult to identify precisely what harm each polluter is doing. Competitive equilibrium can break down if information is not perfect.