1. Externalities Today: Markets without ownership usually lead to inefficient outcomes

2. Market failures Previously Monopolies Cartels Today: Ending Unit 4 Externalities Next week: Beginning Unit 5 Applications of externalities

3. Today Externalities Inefficiencies without regulation The Coase theorem Optimal amount of externalities Some ways to reach more efficient solutions when externalities are present Examples

4. Externalities: Definition External cost (benefit) “A cost (benefit) of an activity that falls on people other than those who pursue the activity” (F/B p. 348) What else is going on? There is often no formal market for the cost or benefit in question Private negotiation typically must occur to increase efficiency

5. A market without regulation Without regulation, consumers and producers only look at private costs and private benefits in order to decide on production and consumption

6. A market without regulation Notice that production of each unit of good leads to external costs external cost per unit

7. What is efficient? To find efficiency, we need to have no further possibilities to have beneficial exchange of a good or service Social costs and benefits lead to overall efficiency Too much is produced to be efficient, since social costs and benefits determine efficiency

8. A market without regulation Where is Social MB equal to Social MC? external cost per unit (= Social MB)

9. A market without regulation Where is Social MB equal to Social MC? Quantity E, Price B external cost per unit (= Social MB)

10. A market without regulation Production above quantity E results in lower efficiency, since Social MB is less than Social MC external cost per unit (= Social MB) Private market forces will produce up to quantity F

11. A market without regulation Deadweight loss shaded These units produced have Social MC greater than Social MB external cost per unit (= Social MB)

12. Why do we see inefficiencies? Often, negotiation is costly Example: A polluter in the Los Angeles metro area Who owns the air? (Polluter or residents?) If the polluter owns the air, the firm will not care about the residents If the residents own the air, it is prohibitively costly to negotiate with every person affected by pollution

13. Costly negotiation Negotiation is typically costly Remember, time is worth something Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

14. Coase theorem The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur People can negotiate costlessly The right can be purchased and sold Given the above conditions, efficient solutions can be negotiated Ronald Coase

15. Coase theorem Notice that the Coase theorem addresses efficiency To get to efficiency, the quantity of most goods and services produced is still positive Example: It is not efficient to get rid of all pollution If all pollution was gone, we could not live (since we exhale CO 2 )

16. Coase theorem and costly negotiation Since negotiation is typically costly, we need government intervention to increase efficiency Taxes Quotas

17. Government intervention The government can estimate costs of negative externalities at relatively low cost Based on these external costs, they can set a tax or quota to reduce the amount of the externality to an efficient level

18. A market with regulation: Tax The government can set a tax equal to the external cost per unit external cost per unit (= Social MB) With tax equal to distance of vertical arrow: The efficient solution is achieved

19. A market with regulation: Marketable permits with resale An alternative to a tax is to sell or distribute marketable permits To be effective, these permits must be able to be sold and resold Sale of permits guarantees that producers with lowest private MC can get permits

20. A market with regulation: Marketable permits to sell Quantity of permits available: E Low-cost producers will buy permits if they do not have them external cost per unit (= Social MB)

21. A market with regulation: Marketable permits to sell Market price for the good will be B, since E units are being produced external cost per unit (= Social MB)

22. Remember I have gone through the case where externalities are costs Externalities can be either costs or benefits, however When there are positive externalities, subsidies can help to increase efficiency

23. Examples of externalities as costs Particulate matter and gases released from driving cars Freeway noise Washing you car in your driveway, followed by hosing the soap off Soap goes into storm drains, polluting the ocean

24. Examples of externalities as benefits Planting flowers in your front lawn Scientific research Finding information that is useful to a group of people Example: One person finds the fastest route for a trip that many people will be taking; everyone can use this information to their benefit

25. Examples of externalities: Cost or benefit? Christmas decorations A fan blowing in a warm office building Use of perfume or cologne

26. An algebraic example Suppose Private MC equals production  MC = Q Let Demand be denoted by P = 100 – Q Let External Cost be $10 per unit

27. An algebraic example Translate equations and External Cost to our graphical example external cost per unit of $10 P = 100 – Q MC = Q MC Social = Q + 10

28. An algebraic example: Private equilibrium Inefficient equilibrium w/o controls: Set Q = 100 – Q  Q = 50 (quantity F) MC = Q P = 100 – Q

29. An algebraic example: Socially optimal equilibrium Socially optimal equilibrium: Set Q + 10 = 100 – Q  Q = 45 (quantity E) P = 100 – Q MC Social = Q + 10

30. An algebraic example: Price Inefficient equilibrium, P = Q  P = 50 Socially optimal equilibrium, P = Q + 10  P = 55 external cost per unit of $10 P = 100 – Q MC = Q MC Social = Q + 10 Price C = 50 Price B = 55 Recall E = 45 and F = 50

31. This concludes basic externality theory Upcoming applications… Wednesday Congestion in cities and on highways Friday Tragedy of the Commons Environmental and safety regulation

32. Summary When external costs or benefits enter a market, private equilibrium is usually inefficient A tax or quota can be set to lead to efficient equilibrium when a negative externality occurs Subsidies can improve efficiency with positive externalities