McPeak
Lecture 12
PPA 723
Externalities.
An externality occurs when an
economic agent’s consumption or production activities confer a benefit or
impose a cost on other actors, and this benefit is conferred or this cost is
imposed outside of a market.
(that is to say it takes place in a
way other than through changing prices).
Alternatively, an externality occurs
when a person’s well-being or a firm’s production capability is directly
affected by the actions of other consumers or firms rather than indirectly
through changes in prices.
A consumption externality is an
externality generated by the consumption behavior of an economic actor.
Smoke
Drunken
louts
Loud
music
Vehicle
exhaust.
A production externality is an
externality generated by the production activity of a firm.
Smokestacks
Acid
rain
Noise
and shaking houses
Odors
Externalities can be positive or
negative.
An externality that harms others by
imposing a cost on them is a negative externality.
An externality that helps others by
conferring a benefit to them is a positive externality.
What is a positive externality to
one person can be a negative externality to another (wind chimes!!).
Positive externalities are sometimes
called spillovers.
Positive externalities play a prominent
role in growth theory and economic development.
Also can be used to explain endogenous neighborhood formation and the
persistence of poverty over time in specific areas.
We are going to focus mostly on
negative externalities here. Private
cost diverges from social cost in the presence of an externality, and in the
presence of a negative externality SC is greater than PC.
Pareto optimality. An allocation of resources is Pareto optimal
when it is not possible through any feasible changes in the resource allocation
to benefit one person without making at least one other person worse off.
If an allocation is not Pareto
optimal, it is not economically efficient.
An allocation is inefficient when it is possible through some feasible
change in the allocation of resources to make at least one person better off
without making any other person worse off.
If an economy does not arrive at a
Pareto optimal outcome, it has suffered from market failure.
In the presence of an externality,
the harmed party is theoretically willing to pay the harming party to reduce
the activity generating the externality, but no market exists for them to
conduct such an exchange.
We may have moral objections here,
but the idea is that I am made worse off by the externality, and there is some
cash value I am willing to pay to eliminate the source of this reduction in my
utility.
Market failure in a production
setting occurs when firms equate private marginal cost with price rather than
social marginal cost with price.
In a competitive market, more of the
good and more of the externality will be produced than is socially optimal
since private cost is less than social cost.
[show graph]
Welfare is maximized when price
equals social marginal cost.
1)
A competitive market may produce
negative externalities thus making the market equilibrium not socially optimal.
2)
The optimal amount of pollution is
greater than zero.
Can address by regulation.
Government can control the size of
the externality by imposing an emission standard that limits the quantity of
the externality imposing byproduct of production.
Can also charge an emissions fee,
that taxes the amount of the emission.
If such a tax is designed to fully
internalize the externality, it is called a Pigovian tax.
[show graph]
Taxes on fuels:
|
|
Externality as a % of price |
Tax as % of price |
|
Natural Gas |
1.1 |
6.4 |
|
Gasoline |
16.7 |
16.6 |
|
Diesel |
50.4 |
12.9 |
|
Coal |
528.0 |
35.9 |
Point source pollution is pollution
that can be traced to a single point – there is an identifiable source of the
pollution that can serve as the point of control. “It is coming from that smokestack over
there”
Non-point source pollution is pollution
that cannot be traced to a single point – multiple small sources make it hard
to identify where it originated. “It is coming from all these burping cattle”
Market structure and externalities.
Remember that a monopoly producer
selected an output level below the level that would be arrived at in a
competitive market, thus leading to deadweight loss of monopoly.
Remember that a producer that
generates negative externalities is producing more than is socially optimal,
since MSC>MPC.
Can these offset?
Potentially, yes.
[show graphs]
The monopoly output may be less than
the socially optimal level, equal to the socially optimal level, or greater
than the socially optimal level. It will
be less than would be generated in a perfectly competitive market.
The overall point is that in the
absence of externalities, social welfare is maximized under perfect
competition. This is not the case if
externalities are present.
Coase Theorem:
In the absence of transactions costs,
and with symmetric information, the initial assignment of property rights does
not matter in determining the efficient allocation of resources. [though it may matter from a distributional
standpoint]
Cattle owner and a crop grower.
1)
Is the right to grow crops without
bearing the costs of livestock damage?
2)
Is the right to graze without facing
limits imposed by individuals planting fields?
The rancher is liable to compensate
the farmer for damage in case one, the farmer is liable to compensate the rancher
in case two. From an efficiency
standpoint, the outcome will be the same.
Boat owner rents boats to cruise
about
Chemical firm dumps gunk in
They choose levels of production,
and have the following payoffs.
Initially, assume neither firm has
the right to compensation.
|
Boat
Company (boats used) |
||||
|
|
|
0 |
1 |
2 |
|
Chemical (tons dumped) |
0 |
0 0 |
0 14 |
0 15 |
|
1 |
10 0 |
10 10 |
10 5 |
|
|
2 |
15 0 |
15 2 |
15 -3 |
|
Chemical firm has dominant
strategy: BR to anything the boat firm
does is 2
Boat firm knows this, chooses
1. 1 boat, 2 tons gunk.
Now assign right to boat firm that
says they must be compensated at $7 per ton
|
Boat
Company |
||||
|
|
|
0 |
1 |
2 |
|
Chemical |
0 |
0 0 |
0 14 |
0 15 |
|
1 |
3 7 |
3 17 |
3 12 |
|
|
2 |
1 14 |
1 16 |
1 11 |
|
Chemical firm firm BR is always 1,
boat knows this, picks 1 boat. 1 boat 1
ton gunk.
Now assign chemical firm the right
to be compensated for any reduction in gunk emission from 2 tons at $6 per ton.
|
Boat
Company |
||||
|
|
|
0 |
1 |
2 |
|
Chemical |
0 |
12 -12 |
12 2 |
12 3 |
|
1 |
16 -6 |
16 4 |
16 -1 |
|
|
2 |
15 0 |
15 2 |
15 -3 |
|
Chemical firm firm BR is always 1,
boat knows this, picks 1 boat. 1 boat 1
ton gunk.
Why might such compensation schemes
not occur/ break down in reality?
1)
Transactions costs may be high. How to bargain on behalf of one party if they
are many?
2)
Lack of information. What are the costs? Do both sides know and agree on the MC of the
externality? Is the profit matrix agreed
upon?
Tragedy of the commons.
Where do we have common property
resources?
When a good is rival and has no
exclusion.
Rival means one actor’s consumption
of the good in question precludes another actor’s consumption of the good – the
good is depletable.
Exclusion means that others can be
prevented from consuming the good.
The fish in the ocean, the grass in
a pasture, the water in a river, the oil under the ground, a seat in the
lounge, a quick trip down a road, a quick download from the internet…
There is a distinction between a
commons and an open access resource. In
a commons, the number of users is defined, leading to greater cooperative
potential. In an open access situation,
there is no restriction on the number of users.
Commons – the academic village.
Open access –
Hardin provided the example of a
village commons where multiple users have the right to graze animals. There is an incentive problem in the
commons. Each user has an incentive to
add animals and does not take into account the externality imposed on others
brought about by adding this animal, only the direct costs they bear.
Note the distinction between an
appropriation externality and a provision externality.
An appropriation externality is a
static externality, and it is either your animals or my animals get the grass
to produce milk in this setting.
A provision externality is a dynamic
externality, and it is that together our animals impose a cost on the future
provision of the good produced in the commons, that is we can cause
environmental damage through overgrazing.
There is one pasture we share in
common, and let’s keep it simple and have it be just the two of us using this.
On this pasture, milk production as
a function of total herd size is as follows:
|
# of animals |
Liters of milk produced |
|
0 |
0 |
|
5 |
10 |
|
10 |
20 |
|
15 |
30 |
|
20 |
36 |
|
25 |
40 |
|
30 |
44 |
For each livestock owner, the share
of this total milk produced they receive is a function of your share of the
total herd. The cash value of milk is $1
per liter.
For each animal put on the pasture,
it costs $1 in private labor costs. (5
animals costs $5, 10 animals costs $10,…)
So if I have 5 animals and you have
5 animals, my payoff is (5/10)*20-5, or 5.
If you had 15 animals and I had 5, then it is (5/20)*36-5, or 4. We can develop the following matrix of payoffs.
, to give the general form.
|
|
0 |
5 |
10 |
15 |
|
0 |
0 0 |
0 5 |
0 10 |
0 15 |
|
5 |
5 0 |
5 5 |
5 10 |
4 12 |
|
10 |
10 0 |
10 5 |
8
8 |
6 9 |
|
15 |
15 0 |
12 4 |
9 6 |
7 7 |
(can
extend down here to 20 (16,0); 25 (15,0); 30 (14,0))
Can go through and identify best
response strategy. There is a Nash equilibrium
in pure strategies of 15, 15 with a payoff of 7 to each. Note however that if they could restrain
their stocking levels to 10, they would arrive at a Pareto improving outcome.
What if I privatize, and assign
exclusive rights to one of the individuals?
|
|
0 |
|
0 |
0 0 |
|
5 |
5 0 |
|
10 |
10 0 |
|
15 |
15 0 |
|
20 |
16 0 |
|
25 |
15 0 |
|
30 |
14 0 |
I arrive at the efficient stocking
level, as profit is maximized where total herd size for one individual is equal
to 20 and the total payoff is 16.
Not really very fair though, is it!
What about if we give the exclusive
land right to one of the herders on the condition that the other herder is
allowed to use the land if he pays 80 cents per animal to herder one?
Herder one puts ten animals on, gets
16 [ (10/20)*36-10+8] while herder two puts ten animals on and gets zero [
(10/20)*36-10-8]. So this is an
alternative that takes you to the efficient (though not very fair) outcome.
Also consider the possibility that
we develop an outside agency, say the state.
This agency is able to impose a herd size limit of 10 animals per person
and is capable of enforcing this.
Finally, consider the state charging
a user fee of 50 cents per animal in addition to the one dollar per animal
labor cost. The following payoff matrix
results.
|
|
0 |
5 |
10 |
15 |
|
0 |
0 0 |
0 2.5 |
0 5 |
0 7.5 |
|
5 |
2.5 0 |
2.5 2.5 |
2.5 5 |
1.5 4.5 |
|
10 |
5 0 |
5 2.5 |
3 3 |
1 1.5 |
|
15 |
7.5 0 |
4.5 1.5 |
1.5 1 |
-0.5 -0.5 |
This also takes us to the socially
efficient stocking level of 10, 10. Now
the state gets 10 in tax revenue as well.
[localized degradation paper]
Responses to the commons:
1)
Land tenure reform (assign rights –
think Coase)
2)
Limit use (restrict quantity – think
emissions standard)
3)
Charge fee that internalizes the
negative externality (think emissions fee).