7.2 Externalities

7.2.1 Externalities and Missing Markets

7.2.2 Coase Theorem

7.2.3 Intervention

7.2.4 Summary

Application

“Councils chew over gum problems” BBC website 16th January 2006

•Its costs 3p to buy a stick of chewing gum but 10p to remove it from the streets. Oxford Street has 300,000 pieces a year

•20 local councils banded together to ask for financial help to deal with the problem

•The pressure is on manufacturers to produce a non-sticky gum

•Will this solve the problem and who pays?

7.2.1 Externalities and Missing Markets

While we have analysed individual decisions we have tended to ignore their impact on others

Often, decisions made by firms or individuals can have an effect on other firms or other individuals

In economics we call these effects externalities and they can play a significant role in affecting the efficient allocation of resources

An externality is defined as:

The direct effect of the actions of one economic agent on the welfare of another economic agent in a way that is not reflected in the market price

Thus a benefit is not paid for or a cost is not borne.

Four features can be noted:

1. Any agent can create an externality

2. There are always two sides to an externality – a creator and a receiver

3. Externalities can be positive or negative

4. Zero externality is generally inefficient

Pollution as an example of an externality

There are external costs of producing pollution e.g. damage to the environment, health etc

There are benefits too!

Suppose we try to cut pollution:

1. Reducing pollution could require a cut in output and thus reduce producer surplus

2. Keeping output constant but reducing pollution through new technology would increase reduction costs and use up scarce resources

MC

MB

P*

Q1 Pollution

Cost

Q2

Thus, consider the marginal costs and benefits:

But where will the firm produce?

As the firm does not have to take into account external costs of pollution it will produce until marginal benefits are zero i.e. at Q2

The efficient outcome is that Q1 pollution is produced as that is where marginal cost equals marginal benefit

Why does this divergence occur? It is due to the fact that there is a missing market

The missing market is for clean air and in effect its price is zero. If it was a market, the “price” would be P*

If the market does not exist, there is no mechanism to allocate a commodity efficiently.

As such, agents will use it to maximise their own private benefit.

However if someone “owns” the commodity, then a market can be established and an efficient outcome can be achieved

7.2.2 Coase Theorem

Allocating ownership or property rights can allow us to find an optimal level of an externality

Marginal social cost – the cost of an action which includes all the costs of production including any external costs borne by other agents

Marginal social benefit – the benefit of an action which includes all the value of production including any external benefits enjoyed by other agents

Need to consider social as opposed to private outcomes

S = PMC

MB

P1

Q1 Steel

£ SMC = PMC + MD

P*

Q*

MD

Output of steel is too high at Q1 (like pollution was too high at Q2 in the earlier diagram)

If forestry managers own clean air rights they can get steel producer to “pay to pollute”

Or

If the steel firm owns the clean air, they can ask the forestry for payment not to pollute

Either way we get to the efficient outcome of Q*P* - how?

S = PMC

Q1 Steel

£ SMC = PMC + MD

Q*

MR

Assume price taking firm

7.2.3 Intervention

Governments can respond by intervening:

1. Regulation – e.g. carbon emissions limits for cars

2. Pigouvian taxes – A tax levied on polluters output by an amount just equal to the marginal damage it inflicts at the efficient level

3. Create a market – licences to pollute can be traded

S = PMC

MB

P1

Q1 Steel

SMC

P*

Q*

t

S + t

3. Create a market – licences to pollute can be traded

S

D

No. of Licences

Price p.a.

7.2.4 Summary

• Externalities are not captured in private market outcomes

• They can be positive or negative• Allocation of property rights in the Coase Theorem

helps produce an efficient outcome• If not, intervention can provide tax, permit and

licence based solutions