EXTERNALITIES

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS1

EXTERNALITIES


The fundamental theorem of welfare economics suggests that markets allocate resources efficiently.

The fact that the behavior of some people affects the welfare of others does not necessarily cause market failure. As long as the effects are transmitted via prices, markets are efficient.


When the activity of one entity (a person or a firm) directly affects the welfare of another in a way that it is not transmitted by market prices, that effect is called EXTERNALITY (because, one entity directly affects the welfare of another, that is external to it).

Unlike the effects which are transmitted by market prices, externalities adversely affect economic efficiency.


As long as someone owns a resource, its price reflects the value for alternative uses, and the resource is therefore used efficiently (at least in the absence of any other market failures).

In contrast, resources that are owned in common are abused because no one has an incentive to economize their use.


Properties of externalities:

1. can be produced by consumers and firms.

2. are reciprocal in nature.3. can be positive or negative.4. Public goods can be viewed as a

special kind of externality.

When an individual creates a positive externality with full effects felt by every person in the economy, the externality is a pure public good.

Implications of Negative externality


Private markets may not produce the socially efficient output level.

The model not only shows that efficiency will be inreased by producing Q2 rather than Q1 but provides a way to measure the benefits from doing so. Area A : lost profits for the producerArea A + B: gained benefits of the consumerA+ B: C ; Net gain : B

The production need not be zero due to the negative externality.


Private responses to externalities:

1. mergers: one way to deal with an externality is to internalise it by combining the involved parties.

Once the two firms merge, the externality is taken into account by the party that generates it. Then, it would not be an externality and so, it will not lead to inefficiency.


2. Social conventions: can be viewed as attempts to force people to take the externalities (that they generate) into account.

Some moral precepts may induce people to empathise with other and hence internalise the externalities their behaviour may create. In effect, these precepts correct for the absence of missing markets.


Public responses to externalities:In cases where individuals acting on their own cannot attain an efficient solution, there are several ways in whichgovernment can intervene.

1. Taxes:A Pigouvian tax is a tax levied on each unit of an output in an amount equal to the MD.


ab= Pigouian tax

tax increases MPC to (MPC+ab)

Q* is produced.

abdc= (ab) x Q*= tax revenue.


Tax revenue may be used on the party harmed but it may result in inefficiently large usage of the good.

Compensation to the victim is not necessary to achieve efficiency.

The tax approach assumes it is known who creates the externality and in what quantities.


Finding the correct tax rate may be hard. The government may instead levy a special sales tax.

This may not lead to the most efficient outcome but it will provide an improvement over the status-quo.


2. Subsidies: Assuming that the number of firms

creating the externality is fixed, the efficient level of production can be obtained by paying the polluter not to pollute.

It works just like tax as it increases the firm’s effective production.


The distributional consequences of tax and subsidy differ dramatically.

Tax = efba, paid by the producer.

Subsidy = abcd, received by the producer. For Q* to be produced.


The subsidy

1. Leads to higher profits, so in the long run more firms may produce this good so Q increases.

2. Leads to more taxes on someone. The distortion effects of these taxes may be greater than the externality itself.

1. May be ethically undesirable.


3. Creating a market:

The government may create a market by selling producers permits to create the externality.

The government announces it will sell permits for X of damage. Firms bid for the right to own these permissions to pollute, and the permissions go to the firms with the highest bids.


The fee charged is that which clears the market so the amount of pollution equals the level set by the government. The price paid for permission to pollute is called “effluent fee”.

The scheme also works if, instead of auctioning of the rights, the gov. assigns them to various firms that are then free to sell them to other firms. With the auction money goes to the government. With this one, money goes to firms that were lucky enough to be assigned the rights.


The Pigouian tax and the effluent fee achieve the efficient production. But the effluent fee reduces uncertainty about the ultimate level of externality.

If the government is certain about the shapes of MPC and MB, then it can safely predict the effects of a Pigouvian tax.


But if not, if there is lack of information, permits will obtain efficiency.

One problem is that incumbent firms might be able to buy rights in excess of firm’s cost minimizing requirements to deter other firms from entering the market.


4. Establish property rights:

A natural way to cure the problem is to put the resource in question into private hands. If rights are assigned to one party and the bargaining between parties are costless, the efficient outcome can be reached.

If producer has the right, consumer will pay producer to decrease production to the efficient level.


If consumer has the right, producer will pay consumer to increase production to the efficient level.

The efficient solution will be achieved independently of who is assigned the property rights, as long as someone is assigned those rights. (Coase Theorem, 1960)


Once property rights are established no government intervention is required to deal with externalities.

The theorem requires that the costs of bargaining do not deter the parties from finding their way to the efficient solution.


The theorem assumes resource owners can identify the source of damages to their property and legally prevent the damages.

The Coase Theorem is most relevant for cases in which only a few parties are involved and the sources of externality are well defined.


5) Regulation:Producer is told to reduce production

by a certain amount or else, face legal sanctions. Regulation is likely to be inefficient when there is more than one firm.

A regulation that mandates all firms to cut back by equal amounts leads to some firms producing too much and others too little.


Implications for income distribution:

Even knowing who is suffering from a given externality does not tell us how much it is worth to them to have it removed.

Suppose that large numbers of polluting firms are induced to reduce output by government policy. As these firms contract the demand for inputs they employ decreases, making the owners of these inputs worse off. So, it creates unemployment and lower wages; and therefore income inequality.


If polluting firms are forced to take into account MSC, their products tend to become more expensive.

So, buyers of these products are made worse off. If the commodities affected are consumed by high-income groups, income distribution improves and vice versa.


Positive Externality:

In subsidy, the source of subsidy must be considered. If it comes from taxes, it creates a redistribution of national income. The benefits and costs must be evaluated cautiously.


The precise nature of a beneficial externality must be determined. The fact that an activity is beneficial per se does not mean that a subsidy is required for efficiency.

A subsidy is appropriate only if the market does not allow those performing the activity to capture the full marginal return.


The presence of externalities destroys the 1st Fundamental Theorem of Welfare.

X: cigarettesY: Other goodsUA= U(XA, YA)UB= U(XB, YB)MRSA + [(dUB/dYB) / (dUB/dXA)] =

MRT


External effect on B shows the amount of other goods B would accept in turn for a marginal decrease in A’s cigarette consumption, it’s negative.

Bargaining makes sense when there are only a few individuals involved and the externality is depletable..

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