Externalities

Copyright © 2019 Hal R. Varian

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Introduction
• In HE2001, we have seen that the market can work quite well:
• Perfect competition can lead to a pareto efficient allocation (FWT)
• Under the right initial redistribution, can maximise fairness or some desired SWF (SWT)

• One major reason why markets may not work so well as predicted is the presence of externalities.

What exactly are externalities?

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Externalities
Vaccination choices

Behaviour during the Blackpink concert.

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Externalities
• An externality is a cost or benefit imposed upon third parties by actions taken by an entity.

• An externally imposed benefit is a positive externality.

• An externally imposed cost is a negative externality.

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Some standard examples of
Externalities
• 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.

• Positive Externalities
• A well-maintained property next door, Improved driving habits, A scientific advance, Vaccinations,
Hygienic practices..

Can you think of any others?

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Externalities & Efficiency
• Externalities typically cause inefficiency. Either:
• Too much scarce resources are allocated activities with negative externalities
• Too little resources are allocated to activities which cause positive externalities.

• Why?
• Because individuals do not (completely) take into account how their actions affect others.

• We illustrate this next in a simple model using a supply/demand framework.

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A Simple Model of
Externalities

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Private Costs and Benefits
• Consumers of goods gain personal utility when consuming goods i.e. consumption has private
benefits.
• Marginal private benefits is approximated by the demand curve.

• Producers of goods pay costs when producing i.e production has private costs.
• Marginal private costs are approximated by the supply curve.

• In HE2001, we assumed that there are no other costs or benefits besides these private ones,
hence the sum of CS and PS approximates social welfare.
• But this is no longer the case when there are externalities!

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Social Costs and Benefits
• When there are externalities in production, marginal social costs marginal private costs (supply
curve).
• Social Costs = Private Costs + (Net) External Costs
• The net external cost is positive (negative) for negative (positive) externalities.

• When there are externalities in consumption, marginal social benefits marginal private benefits
(demand curve).
• Social Benefits= Private Benefits + (Net) External Benefits
• The net external benefit is negative (positive) for negative (positive) externalities.

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Externalities with Perfect
Competition
• In our Supply/Demand framework, this leads to deadweight welfare loss.

P MSC P
MC MC

DW loss
DW loss

MSB
MSB
MB
Q Q
Negative production externalities Positive consumption externalities
(over production) (under consumption)
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11
Pigouvian Taxes/Subsidies
Optimal tax (subsidy) is the
marginal external cost (benefit)
at the optimal level! Do you remember how to
draw the shifts of curves
with subsidies/taxes?
P MSC P
MC MC

Optimal per
unit tax on Optimal per unit
production subsidy on
consumption
MSB
MSB
MB
Q Q
Negative production externalities Positive consumption externalities
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Review Question 1
P
MC
Suppose that marginal external benefits on
consumption are not constant as in earlier illustrations.
What is the optimum subsidy for consumption in the
market?
(a)
1. (a)
(b) 2. (b)
MSB

MB
Q

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Solutions?
• Pigouvian taxes or subsidies help solve the problem by closing the gap between private costs
and social costs
• Consumers/Producers will now account for the proper costs and benefits of their own actions.
• Causing the creator of an externality to bear the full external cost or to enjoy the full external
benefit is called internalizing the externality.

• In the model, this involves shifting demand and supply curves to appropriate positions.
• In real-life: carbon taxes, alcohol tax, ERP, child subsidies.

However, not always feasible due to information constraints… Any alternatives?

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Externalities and
Property Rights

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A simple example…
• Alice’s vehicle repair shop and Teddy’s tea house are adjacent to each other.
• Alice’s profit schedule and most preferred option is as follows:

Alice’s o/p Marginal Profit Alice’s profit

0 - 0
1 90 90
2 60 150
3 10 160
4 -50 110

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A simple example…
• Suppose the noise from the vehicle repair ship hurts Teddy’s
tea house business. The more cars the auto body shop works
on, the more noise it generates, which hurts Teddy’s profit.

• Teddy’s profit schedule and most preferred option is as follows:

Alice’s o/p Marginal Teddy’s profit

Damage
0 - 230
1 20 210
2 40 170
3 70 100
4 100 0

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A simple example…
• What is the utilitarian (socially optimal) output level?

Alice’s o/p Alice’s profit Teddy’s profit Total profit

0 0 230 230
1 90 210 300
2 150 170 320
3 160 100 260
4 110 0 110

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A simple example…
What actually happens in this situation?

• Alice chooses an output of 3 while the social optimal level is an output of 2.

This is not an efficient outcome!

• Why? Because she does not take into account how noise from her shop affects Teddy’s tea
house.

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Externalities and Property Rights
• Coase (1960): Maybe the main problem here is not the externality per se, but some missing
markets… What if noise pollution was tradeable?

• This is meaningful only if property rights are well defined

• Holders of property rights have the exclusive privilege to own and use it.
• A trading agreement reached is hence enforceable.

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Externalities and Property Rights
• Suppose now, Alice and Teddy can bargain on the vehicle repair shop’s output level. Consider
the following 3 scenarios:

1. No property rights.

2. Teddy owns the property right to (not) pollute.

3. Alice owns the property right to pollute.

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No Property Rights
• Suppose the property right is not defined and/or the court does not enforce it.

• Then there is nothing to bargain about.

• Regardless of any informal “agreement”, Alice keeps producing any level she wants, knowing that
there won’t be any (legal) consequence.
• They won’t pay anything to each other, knowing that any informal agreement would be violated
anyways.

• Outcome: Alice works 3 cars, and the total profit is 260.

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Teddy has the Property Right.
• Now suppose that the court grants Teddy the property right (not) to have noise pollution. If he wishes, he
can force Alice to work his initially preferred option of 0 cars.

• But this is not ideal as he can do better by selling Alice the right to pollute a certain amount:
• Consider an agreement where Alice works 2 cars.
Teddy is willing to do so for at least 230-170=60.
Alice is willing to pay at most 150-0=150.
• They can agree on this at some price between 60 and 150.

• It is easy to see that any agreement which does not maximise their total profits will be pareto dominated
by one which maximises total profits.
• Final agreement: Alice allowed to produce 2 cars for some price between 60 and 150.

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Alice has the Property Right.
• Now suppose that the court grants Alice the property right to create noise pollution. This
means that she can work her initially preferred option of 3 cars.

• But this is not ideal as she can do better by selling Teddy part of the property rights.
• Consider an agreement where Alice reduces output to 2 cars.
Alice is willing to do so for at least 160-150=10.
Teddy is willing to pay at most 170-100=70.
• They can agree on this at some price between 10 and 70.

• Final agreement: Alice agrees to produce only 2 cars for some price between 10 and 70.

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Remarks
• Notice that in each case, the final agreement arrived at, is the socially optimal outcome.
• This demonstrates the results of the Coase Theorem.

Coase Theorem
If property rights are clearly defined and protected, there are no transactions costs (such as haggling
costs/information asymmetry), and preferences are quasi-linear (no wealth effects), then the same socially
optimal outcome results, regardless of who is assigned the property right initially.

• Insight: most externality problems are due to an inadequate specification of property rights
and, consequently, an absence of markets in which trade can be used to internalize external
costs or benefits.

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Remarks
• Property rights creates a market for trading noise pollution rights.
• Restores complete markets!
• By the first welfare theorem, when we have complete markets, the competitive allocation is pareto
efficient.

• The theorem mentions quasi-linearity.. What are its implications?

• From HE2001, recall that with quasi-linearity, pareto efficient allocations (with transfers) must be
utilitarian (and socially optimal). If there is a unique utilitarian allocation of goods (besides money),
then no matter who we assign property rights to, we must arrive at this.

• What if preferences are not quasi-linear?

• Pareto efficient allocations (with transfers) may not be utilitarian.
I.e., depending on who we assign property rights to, a different pareto efficient allocation may be
attained.

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Review Question 2
Consider a similar scenario as before, but with different values as below. Suppose Teddy is
assigned property rights.
Alice’s o/p Alice’s profit Teddy’s profit Total profit
0 0 230 230
1 130 210 340
2 160 160 320
3 140 120 260
4 110 0 110

1) Which of this will be the outcome?

a) Alice produces 1 car. b) Alice produces 2 cars. c) Alice produces 3 cars.

2) Which of these are possible prices at which they can negotiate an agreement?
a) 65 b) 140 c) 100 d) 30 e) 160
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Externalities in the
Edgeworth Box

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Revisiting the Edgeworth box
• To visualize a more general case, let us consider a two-person economy with two commodities,
money and smoke (generated by consuming cigarettes)..
• Agent A is endowed with . Agent B is endowed with . Smoke intensity is measured on a scale from 0
(no smoke) to 1 (maximum concentration).

• Smoke is an externality which can be viewed as a purely public commodity.

• A commodity is purely public if

• it is consumed by everyone (nonexcludability), and
• everybody consumes the entire amount of the commodity (nonrivalry in consumption).

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Revisting the Edgeworth box
• Person A enjoys cigarettes (and hence smoke) and money, while Person B enjoys money, but
dislikes smoke.
• Common y-axis because smoke is like a public commodity.

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No Property Rights

Smoke is non tradeable

and (common) amount is
free to be chosen by
either of them, budget
line is vertical.
mA mB

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Inefficiency & Negative Externalities

• So, if A and B cannot trade money for changes in smoke intensity, then the outcome is inefficient.

• There is too much smoke (A’s most preferred choice) because B can’t control A’s actions.

• Neither agent A nor agent B owns the air in their room. What happens if this property right is
created and is assigned to one of them?

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Property Rights to Person A

Default “endowment” is 1
smoke because person A
likes smoke.

Since smoke is now tradeable at

some positive price, budget line
is now downward sloping.

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Property Rights to Person B

Default “endowment” is 0 smoke

because person B dislikes smoke.

Since smoke is now tradeable at

some positive price, budget line
is now downward sloping.

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Externalities & Property Rights
• Notice that the amount of smoking that occurs in equilibrium depends upon which agent is assigned the
property right.
• This happens because preferences are not quasi-linear in the past 2 slides.

• If preferences are quasi-linear:

MRS is constant with 𝑠 as 𝑚 changes

when preferences are quasi linear in
money..

The same amount of smoking results no

matter who is assigned the property right
i.e. the allocation of the (non-monetary)
good is unique. (see slide 25)

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 Merger and
Internalisation

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An example of externalities in
production
• Let us consider the following scenario where there are two firms, a steel mill and a nearby
fishery. A steel mill produces jointly steel and pollution, and pollution adversely affects a nearby
fishery.

• Both firms are price takers with and being the market price of steel and fish respectively.
• is the steel firm’s (private) cost of producing units of steel jointly with x units of pollution.
• is the fishery’s (private) cost of producing units of fish when the steel firm produces x units of
pollution.

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The Steel Firm
• The steel firm chooses and to maximises profits:

• The first order conditions give:

• Suppose and that

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The Fishery
• The fishery chooses to maximises profits:

• The first order conditions give:

• Suppose that pollution raises the marginal costs of fishing: and that

• Notice that the fishery produces less, and earns less profits as pollution increases.

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Equilibrium
• The steel firm ignoring its external cost inflicted upon the fishery, chooses and earning profits
of .

• The fishery taking into account , chooses earning profits of .

• Total profits are $45 across the two firms.

This does not maximise social welfare as we will see..

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New Equilibrium with Merger
• Suppose we now choose to maximise joint profits (social welfare):

• Using the first order conditions, and previous functional forms, we can show that the solution is:

• There is now less pollution and more fish produced! Total profits are now which is larger than before! The
previous outcome was not pareto efficient!

• Maximising joint profits is the same as saying that the steel and fish firms are one entity, so by merging the
2 firms, we have improved outcomes!
• The reason is that merger causes the steel firm to internalizes its externality.

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Summary
• The issue of externalities can be viewed two ways
• It is a lack of proper incentives
• It is a lack of proper markets

• In line with this, externalities can be addressed through

• Taxes and subsidies which create the appropriate incentives.
• Creation of property rights which allows of trading of externalities. (Coase theorem)

• In the case of firms, mergers are a possible solution, especially when there are fewer
stakeholders.

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Summary
• But each of these has its own problems!

• Setting the correct incentives requires accurate knowledge!

• Property rights rely on the free market and require less knowledge, but:
• Defining property rights can be difficult and costly: How can one define the rights to be healthy/COVID free?
• Bargaining can be difficult if many parties are involved: Amongst others, who benefits the most from my vaccination?
• When externalities are “global”, hard to enforce: Can one country have jurisdiction on the vaccination policies of other
countries?

• Mergers may also face similar coordination issues: agreeing on a share of joint profits can be
hard..

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Readings
• Varian Chapter 35

Related articles
• Coasean economic in Irvine, California
• Lobsterman versus Whalers
• Carbon Pricing

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