CHAPTER 2 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Introduction

Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so. As we will see, this represents a market failure for which government action could be appropriate and improve welfare.

EXTERNALITY

1. EXTERNALITY THEORY

1. EXTERNALITY THEORY

Externalities can either be negative or positive, and they can also arise on the supply side (production externalities) or the demand side (consumption externalities). A negative production externality is when a firms production reduces the well-being of others who are not compensated by the firm. A negative consumption externality is when an individuals consumption reduces the well-being of others who are not compensated by the individual. The basic concepts in positive externalities mirror those in negative externalities.

a, Economics of Negative Production Externalities

To understand the case of negative production externalities, consider the following example:

A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river. The fishermen downstream are harmed by this activity, as the fish die and their profits fall. Fishermen downstream are adversely affected. And they are not compensated for this harm.

This is a negative production externalities because:

Figure 2 illustrates each partys incentives in this situation.

Price of steel

SMC = PMC + MD

S=PMC

p2 p1 MD

D = PMB = SMB 0 Q2 Q1 QSTEEL

Figure 2

Negative Production Externalities

b, Negative Consumption Externalities

We now move on to negative consumption externalities. Consider the following example:

A person at a restaurant smokes cigarettes. That smoking has a negative effect on your enjoyment of the restaurant meal.

In this case, the consumption of a good reduces the well-being of someone else. Figure 3 illustrates each partys incentives in the presence of a negative consumption externality.

Price of cigarettes

S=PMC=SMC

p1 MD p2 D=PMB SMB=PMB-MD 0 Q2 Q1 QCIGARETTES

Figure 3

Negative Consumption Externalities

c, Positive Externalities

Positive externalities can occur in production or consumption. A positive production externality is when a firms production increases the well-being of others, but the firm is not compensated by those others.

Research and development is a production externality.

A positive consumption externality is when an individuals consumption increases the well-being of others, but the individual is not compensated by those others.

Nice landscaping could be a consumption externality.

c, Positive Externalities

Lets consider positive production externalities. Consider the following example:

A policeman buys donuts near your home. As a consequence, the neighbors are safer because of the policemans continued presence.

In this case, the production of donuts increases the well-being of the neighbors. Figure 4 illustrates each partys incentives in the presence of a positive production externality.

Price of donuts

S = PMC

p1 p2

SMC = PMC EMB EMB

D = PMB = SMB 0 Q1 Q2 QDONUTS

Figure 4

Positive Production Externalities

Positive Externalities

Finally, there can be positive consumption externalities. A neighbors improved landscape is a good example of this. The graphical analysis is similar to negative consumption externalities, except that the SMB curve shifts outward, not inward.

Positive Externalities

The theory shows that when a negative externality is present, the private market will produce too much of the good, creating deadweight loss. When a positive externality is present, the private market produces too little of the good, again creating deadweight loss.

EXTERNALITY

2. THE COASE THEOREM

The Solution for Private Sector

The Coase Theorem: When there are well-defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level. Thus, the role of government intervention may be very limitedthat of simply enforcing property rights.

The Solution (Coase Theorem)

Consider the Coase Theorem in the context of the negative production externality example from before. Give the fishermen property rights over the amount of steel production. Figure 5 illustrates this scenario.

Price of steel

SMC = PMC + MD

S = PMC

p2 p1 MD

D = PMB SMB 0 1 2 Q2 Q1 QSTEEL

Figure 5

Negative Production Externalities and Bargaining

The Solution (Coase theorem)

Through a process of bargaining, the steel firm will bribe the fishery to arrive at Q2, the socially optimal level. After that point, the MD exceeds (PMB - PMC), so the steel firm cannot come up with a large enough bribe to expand production further.

The Solution (Coase Theorem)

Another implication of the Coase Theorem is that the efficient solution does not depend on which party is assigned the property rights, as long as someone is assigned them. The direction in which the bribes go does depend on the assignment, however. Now, lets give the property rights to the steel firm over the amount of steel production. Figure 6 illustrates this scenario.

Price of steel

SMC = PMC + MD

S = PMC

p2 p1 MD

D=PMB=SMB

Q2

Q1

QSTEEL

Figure 6

Negative Production Externalities and Bargaining

The Solution (Coase Theorem)

Figure 6 shows that even though the bargaining process is somewhat different, the socially efficient quantity of Q2 is achieved.

Problems with Coasian Solutions

There are several problems with the Coase Theorem, however.

The assignment problem The holdout problem The free rider problem Transaction costs and negotiating problems

Problems with Coasian Solutions

The assignment problem relates to two issues:

It can be difficult to truly assign blame. It is hard to value the marginal damage in reality.

Problems with Coasian Solutions

The holdout problem arises when the property rights in question are held by more than one party.

The shared property rights give each party power over all others. This could lead to a breakdown in negotiations.

Problems with Coasian Solutions

The free rider problem is that when an investment has a personal cost but a common benefit, individuals will underinvest.

For example, if the steel firm were assigned property rights and you are the last (of many) fishermen to pay, the bribe is larger than the marginal damage to you personally.

Problems with Coasian Solutions

Finally, it is hard to negotiate when there are large numbers of individuals on one or both sides.

Problems with Coasian Solutions

In summary, the Coase Theorem is provocative, but perhaps not terribly relevant to many of the most pressing environmental problems.

EXTERNALITY

3. SOLUTIONS OF THE PUBLIC SECTOR

3. PUBLIC-SECTOR SOLUTIONS FOR EXTERNALITIES

Coasian solutions are insufficient to deal with large scale externalities. Public policy makes use of three types of remedies to address negative externalities:

Corrective taxation Subsidies Regulation

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a, Corrective Taxation

The government can impose a Pigouvian tax on the steel firm, which lower its output and reduces deadweight loss. If the per-unit tax equals the marginal damage at the socially optimal quantity, the firm will cut back to that point. Figure 7 illustrates such a tax.

Price of steel

SMC=PMC+MD S=PMC+tax S=PMC

p2 p1

D = PMB = SMB 0 Q2 Pigouvian Tax Q1 QSTEEL

Figure 7

Corrective Taxation

The Pigouvian tax essentially shifts the private marginal cost. The firm cuts back output, which is a good thing when there is a negative externality.

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Corrective Taxation

The steel firms privately optimal production solves:

PMB PMC tax

PMB PMC MD SMC

When the tax equals MD, this becomes:

b, Subsidies

The government can impose a Pigouvian subsidy on producers of positive externalities, which increases its output. If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point. Figure 8 illustrates such a subsidy.

Price of donuts

S = PMC

p1 p2

SMC=PMC-EMB

D = PMB = SMB 0 Figure 8 Q1 Pigouvian Subsidy Q2 QDONUTS

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Subsidies

The subsidy also shifts the private marginal cost. The firm cuts expand output, which is a good thing when there is a positive externality.

Subsidies

The donut shops production solves:

PMB PMC subsidy

When the subsidy equals EMB, this becomes:

PMB PMC EMB SMC

But this last equation is simply the one used to determine the efficient level of production.

c, Regulation

Finally, the government can impose quantity regulation, rather than relying on the price mechanism. For example, return to the steel firm in Figure 9. 9

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Price of steel

SMC = PMC + MD S = PMC

p2

p1

D = PMB = SMB 0 Q2 Q1 QSTEEL

Figure 9

Quantity Regulation

Regulation

In an ideal world, Pigouvian taxation and quantity regulation give identical policy outcomes. In practice, there are complications that may make taxes a more effective means of addressing externalities.

Recap of Externalities: Problems and Solutions

Externality theory Private-sector solutions Public-sector solutions

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NEXT CHAPTER PUBLIC GOODS

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