Eco205 Chapter 16 – Externalities and Public Goods 6 April 2013
An externality is an effect of one economic actor’s activities on another actor’s well-being that is not taken into account
by the normal operations of the price system
Externalities may be positive or negative.
Externalities between firms.
Externalities between firms and people.
Externalities between people.
Externalities are reciprocal in nature.
Externalities and Allocational Efficiency
For efficient allocation of resources, Price = social marginal cost of production (MSC)
Social cost is the cost of production that includes both input costs (private costs) plus the costs of the externality.
A firm will maximize profits by producing at Price = marginal private cost (MC)
If production involves a negative externality the marginal social cost is greater than the marginal private cost.
Therefore, profit maximizing behavior (P=MC) will lead to tooExternalities and Allocational Efficiencyhe allocatively
efficient outcome (P=MSC).
The vertical gap between the MCS and the MC curves Price,
measures the harm that producing an extra unit of Costs Note that there is a net gain MC (private)
to society. Consumer
charcoal imposes on eyeglass makers. At q*, the spending on the good falls.
social marginal cost of producing charcoal exceeds the
price people are willing to pay for this output (P*). B
Resources are misallocated, and production should be
reduced to q where social marginal cost and price are P* A E
equal. In making this reduction, the reduction in total
social costs (area ABq*q ) exceeds the reduction in C
total spending on charcoal (area AEq*q ). This
comparison shows that the allocation of resources is By less than the reduction
in total social costs.
improved by a reduction in charcoal output because
social costs are reduced to a greater extent than are q’ q* Output
consumers’ expenditures on charcoal. Consumers can reallocate their spending toward something else that involves
lower social costs than charcoal does. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Property Rights, Bargaining and the Coase Theorem
Property rights - The legal specification of who owns a good and the trades the owner is allowed to make with it
Common property - Property that may be used by anyone without cost
Private property - Property that is owned by specific people who may prevent others from using it
Costless Bargaining and Competitive Markets
Assume that property rights to the clean air are given to one of the firms, but bargaining over how the air is used is
With bargaining it is possible that the two firms will achieve the efficient level of output regardless of who “owns” the
The polluting firm would be willing to pay at most, P*-MC.
The injured firm would need to receive MSC – MC Coase Theorem
If bargaining is costless, the social cost of an externality will be taken into account by the parties, and the allocation of
resources will be the same no matter how property rights are assigned.
One possible problem with this are distributional effects. How do you equitably assign property rights?
Another problem has to do with the role of transaction costs - if the costs of striking bargains were high, the workings of
this voluntary exchange system might not be capable of achieving an efficient result
Externalities With High Transaction Costs
When transactions costs are high, externalities may cause real losses in economic welfare.
When transactions costs are low, careful specification of rights under property law can be used to achieve efficient
results because the Coase theorem applies. When transactions costs are high, the law of ‘‘torts’’ (harms) should be used
Externalities and Taxation
because lawsuits can get those who create externalities to recognize
the damage that they do. Hence, the possibility of legal redress MSC (social)
provides an important complement to the Coase theorem. Costs MC (private)
If the polluting firm can be sued for the cost it imposes, payment of
At q’ the cost imposed on
damages will increase the costs associated with production. the injured firm is MSC –
The private MC curve will shift up to MCS This is the amount of tax.
Tax = t The net price received by
MC and MCS represent the private and social marginal costs of P*-t the polluting firm is P*-t,
charcoal production, and the market price of charcoal is given by P*. which would “force” it to
An excise tax of amount t would reduce the net price received by the
firm to P* - t, and at that price the firm would choose to produce q . ’ q’ q* Output
The tax causes the firm to reduce its output to the socially optimal amount.© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
of P* - t and imposes external costs on eyeglass makers of t per unit. The per-unit tax is therefore exactly equal to the
extra costs that charcoal producers impose on eyeglass producers. The problem then for government reOptimal Pollution Abatement
decide on the proper level for such a Pigovian tax - A tax or subsidy on an externality that brings about an equality of
private and social marginal costs. MB,
MC At R , MB>MC so reduce MC
Regulation Of Externalities more pollution.
The curve MB in the figure shows the additional social benefits obtained by At RH, MC>MB so reduce
reducing such pollution by one more unit. Benefits include: improved health,
The optimal level is where
the availability of additional recreational or aesthetic benefits, and improved MB=MC.
production opportunities for other firms.
As for most economic activities, this provision of benefits is assumed to exhibit
diminishing returns—the curve MB slopes downward to reflect the fact that the MB