1. 1 The first welfare theorem: in an economy in which –all agent are price-takers –there are no externalities –there are no scale economies –information is symmetric between buyers and sellers market allocations are Pareto efficient. Recall our definition of Pareto efficiency: –An outcome is Pareto efficient if it is impossible to come up with an alternative outcome in which at least one person can be made better off without any one person being made worse off. Topic 2: Externalities

2. 2 Related terminology: a reallocation constitutes a Pareto improvement if it makes at least one individual better off and no individual worse off. Typically such reallocations are not possible. In almost any reallocation will be winners and losers. A reallocation is a potential Pareto improvement (PPI) if the winners could in principle compensate the losers and still be better-off. Thus, a reallocation is a PPI if the gains to the winners more than offset the losses to the losers. Such a reallocation is said to increase social surplus. Note that there is no requirement in the definition of PPI that the winners actually compensate the losers. The PPI criterion will be equivalent to the “surplus maximization” criterion. Topic 2: Externalities

3. 3 An externality (or external effect) is a cost or benefit associated with an action that is external to the agent taking that action. Externalities can be positive (an external benefit) or negative (an external cost). The archetypal negative externality is unpriced pollution: An action generates pollution and that pollution has an effect on other agents for which the polluting agent does not have to account. If an action has an associated externality then the privately optimal action may be inefficient from a social perspective. Topic 2: Externalities

4. 4 Private optimum Let PB(z) denote private benefit as a function of some action z (eg. benefit from driving a car z kilometers). Let PC(z) denote the private cost of z (eg. fuel and maintenance costs). An agent will choose a level of z that maximizes her private surplus (or private net benefit): PB(z) - PC(z) Under reasonable assumptions, we can often define the private optimum by zˆ : – MPB(zˆ) = MPC(zˆ) –where MPB denotes marginal private benefit and MPC denotes marginal private cost. Topic 2: Externalities

5. 5 Private Optimum is given by allocation zˆ Topic 2: Externalities z $ MPB zˆzˆ MPC If all assumptions from the first welfare theorem hold, this will also be the social optimum.

6. 6 Social optimum Suppose action z imposes an external cost D(z) and an external benefit G(z). Define the social cost of z: –SC(z) = PC(z) + D(z) and the social benefit of z: –SB(z) = PB(z) + G(z) The social optimum maximizes social surplus: –SB(z) - SC(z) Under reasonable assumptions we can often define the social optimum by z* : –MSB(z*) = MSC(z*) where MSB denotes marginal social benefit and MSC denotes marginal social cost. Topic 2: Externalities

7. 7 A positive externality That is G(z)>0, for simplicity assume D(z)=0. The difference between MSB and MPB is called marginal external benefit (MEB) The presence of the external benefit means: zˆ < z* –ie. the privately optimal level of activity is lower than the socially optimal level. Intuition: the agent does not take into account the external benefit she bestows on others when she chooses her action, and so her chosen level of the action is too low from a social perspective. Topic 2: Externalities

8. 8 Note that a forced reallocation from zˆ to z* would make the external agents better off but would make the source agent worse off. Topic 2: Externalities Thus, the reallocation would not be a Pareto improvement.

9. 9 Topic 2: Externalities Gain to external agents: areas A+B Loss to source agent: area B The gain to the external agents is greater than the loss to the source agent. Topic 2: Externalities The reallocation from zˆ to z* would be a potential Pareto improvement, since external agents could compensate the source agent for her loss and still be better off. Social surplus would increase by area A

10. 10 A negative externality That is D(z)>0, for simplicity assume G(z)=0. The difference between MSC and MPC is called marginal external cost (MEC) The presence of the external costs means: zˆ > z* –ie. the privately optimal level of activity is higher than the socially optimal level. The level of activity is too high from a social perspective. The agent does not take into account the external cost she bestows on others when she chooses her action. Topic 2: Externalities

11. 11 Topic 2: Externalities Note that a forced reallocation from zˆ to z* would make the external agents better off but would make the source agent worse off. Topic 2: Externalities Thus, the reallocation would not be a Pareto improvement.

12. 12 Topic 2: Externalities Gain to external agents (reduced external cost): areas A+B Loss to source agent (foregone private surplus): area A The gain to the external agents is greater than the loss to the source agent. Topic 2: Externalities The reallocation from zˆ to z* would be a potential Pareto improvement, since external agents could compensate the source agent for her loss and still be better off. Social surplus would increase by area B

13. 13 Some important examples of externalities a)Open Access Resources A resource to which many agents have access to. –Example: unregulated fisheries When one agent harvests fish, she draws down the stock of the resource, she does not take into account the cost she imposes on other agents in terms of reduced fishing productivity. Each agent engages in harvesting effort up to the point where MPC=MPB; but since MSC > MPC, each agent harvests too much from an efficiency perspective. Topic 2: Externalities

14. 14 This behaviour can lead to the depletion of the resource. Such an outcome is sometimes referred to as the “tragedy of the commons”. In principle the problem can be solved through the assignment of property rights (as with fishing licenses and timber licenses), but transaction costs (and “fairness issues”) often call for direct government intervention. Topic 2: Externalities

15. 15 b) Public goods Public goods are characterized by two features: –joint consumption possibilities: can be enjoyed by more than one agent simultaneously –high exclusion costs: is very costly to prevent agents from consuming the good Public goods are a kind of positive externality: the provision of the good by one agent bestows a positive benefit on other agents. The market provision of public goods (or more generally, the provision of public goods in private equilibria) tends to be inefficient. Why? MSB>MPB, and the external benefit cannot be priced because the good is non-excludable. Each agent has the possibility of free-riding (that is, not paying ) once the good has been provided. Topic 2: Externalities

16. 16 If two agents can potentially be better-off at some allocation than at the existing allocation, why don’t the agents themselves agree to a reallocation? Where is the need for government intervention? The so-called “Chicago view” is that there is no role for government intervention except to assign and enforce property rights. Why might the market not realize such gains even if property rights are assigned? The problem is transaction costs (Coase 1960). The cost of negotiating an agreement can more than offset the gains from the agreement; that is, the process of moving from one allocation to another is itself costly. Topic 2: Externalities

17. 17 The role for government intervention on efficiency grounds rests on the possibility – in some circumstances - of institutional advantage over the market. That is, in some cases government intervention may be able to achieve an efficiency-enhancing reallocation at lower transaction costs than the market (eg. global climate change agreements). The mere existence of externalities, and their adverse implications for the environment, is not enough to justify government intervention. Any proposed government intervention on efficiency grounds should be subject to the question: can the government do better than the market? In many aspects of environmental policy, the case for intervention is compelling. Topic 2: Externalities