ch32externalities-fyjrhrxq.pdf 11/9/2015 1 Chapter Thirty-Two Externalities Externalities An externality is a cost or a benefit imposed upon someone by actions taken by others. The cost or benefit is...

ch32externalities-fyjrhrxq.pdf 11/9/2015 1 Chapter Thirty-Two Externalities Externalities An externality is a cost or a benefit imposed upon someone by actions taken by others. The cost or benefit is thus generated externally to that somebody. An externally imposed benefit is a positive externality. An externally imposed cost is a negative externality. Examples of 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. Examples of Positive Externalities A well-maintained property next door that raises the market value of your property. A pleasant cologne or scent worn by the person seated next to you.  Improved driving habits that reduce accident risks. A scientific advance. Externalities and Efficiency Crucially, an externality impacts a third party; i.e. somebody who is not a participant in the activity that produces the external cost or benefit. Externalities and Efficiency Externalities cause Pareto inefficiency; typically – too much scarce resource is allocated to an activity which causes a negative externality – too little resource is allocated to an activity which causes a positive externality. 11/9/2015 2 Externalities and Property Rights An externality will 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). E.g. a broadcast television program. Inefficiency & Negative Externalities Consider two agents, A and B, and two commodities, money and smoke. Both smoke and money are goods for Agent A. Money is a good and smoke is a bad for Agent B. Smoke is a purely public commodity. Inefficiency & Negative Externalities Agent A is endowed with $yA. Agent B is endowed with $yB. Smoke intensity is measured on a scale from 0 (no smoke) to 1 (maximum concentration). Inefficiency & Negative Externalities OA 1 0 Smoke mAyA Money and smoke are both goods for Agent A. Inefficiency & Negative Externalities OA 1 0 Smoke mAyA Money and smoke are both goods for Agent A. Inefficiency & Negative Externalities OB 1 0 Smoke mByB Money is a good and smoke is a bad for Agent B. 11/9/2015 3 Inefficiency & Negative Externalities OB 1 0 Smoke mB yB Money is a good and smoke is a bad for Agent B. Inefficiency & Negative Externalities What are the efficient allocations of smoke and money? Inefficiency & Negative Externalities OA 1 0 Smoke mAyA OB 1 0 Smoke mB yB Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB 11/9/2015 4 Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations Inefficiency & Negative Externalities Suppose there is no means by which money can be exchanged for changes in smoke level. What then is Agent A’s most preferred allocation?  Is this allocation efficient? Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations A’s choices Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations A’s most preferred choice is inefficient Inefficiency & Negative Externalities Continue to suppose there is no means by which money can be exchanged for changes in smoke level. What is Agent B’s most preferred allocation?  Is this allocation efficient? 11/9/2015 5 Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations B’s choices Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations B’s most preferred choice Inefficiency & Negative Externalities OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Efficient allocations B’s most preferred choice is inefficient Inefficiency & Negative Externalities So if A and B cannot trade money for changes in smoke intensity, then the outcome is inefficient. Either there is too much smoke (A’s most preferred choice) or there is too little smoke (B’s choice). Externalities and Property Rights Ronald Coase’s insight is that 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. Externalities and Property Rights Causing a producer of an externality to bear the full external cost or to enjoy the full external benefit is called internalizing the externality. 11/9/2015 6 Externalities and Property Rights 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? Externalities and Property Rights Suppose Agent B is assigned ownership of the air in the room. Agent B can now sell “rights to smoke”. Will there be any smoking?  If so, how much smoking and what will be the price for this amount of smoke? Externalities and Property Rights Let p(sA) be the price paid by Agent A to Agent B in order to create a smoke intensity of sA. Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sA) sA 11/9/2015 7 Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sA) Both agents gain and there is a positive amount of smoking. sA Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sA) sA Establishing a market for trading rights to smoke causes an efficient allocation to be achieved. Externalities and Property Rights Suppose instead that Agent A is assigned the ownership of the air in the room. Agent B can now pay Agent A to reduce the smoke intensity. How much smoking will there be? How much money will Agent B pay to Agent A? Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB sB p(sB) 11/9/2015 8 Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sB) Both agents gain and there is a reduced amount of smoking. sB Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sB) Establishing a market for trading rights to reduce smoke causes an efficient allocation to be achieved. sB Externalities and Property Rights Notice that the –agent given the property right (asset) is better off than at her own most preferred allocation in the absence of the property right. –amount of smoking that occurs in equilibrium depends upon which agent is assigned the property right. Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sB)p(sA) sA sB sB sA Externalities and Property Rights  Is there a case in which the same amount of smoking occurs in equilibrium no matter which agent is assigned ownership of the air in the room? Externalities and Property Rights OA 1 0 Smoke mA OB 1 0 Smoke mB yA yB p(sB)p(sA) sA = sB 11/9/2015 9 Externalities and Property Rights OA 1 0 Smoke OB 1 0 Smoke yA yB p(sB)p(sA) sA = sB For both agents, the MRS is constant as money changes, for given smoke intensity. Externalities and Property Rights OA 1 0 Smoke OB 1 0 Smoke yA yB p(sB)p(sA) sA = sB So, for both agents, preferences must be quasilinear in money; U(m,s) = m + f(s). Coase’s Theorem Coase’s Theorem is: If all agents’ preferences are quasilinear in money, then the efficient level of the externality generating commodity is produced no matter which agent is assigned the property right. Production Externalities A steel mill produces jointly steel and pollution. The pollution adversely affects a nearby fishery. Both firms are price-takers. pS is the market price of steel. pF is the market price of fish. Production Externalities cS(s,x) is the steel firm’s cost of producing s units of steel jointly with x units of pollution.  If the steel firm does not face any of the external costs of its pollution production then its profit function is and the firm’s problem is to s s ss x p s c s x( , ) ( , )  Production Externalities max ( , ) ( , ). ,s x s s ss x p s c s x   The first-order profit-maximization conditions are 11/9/2015 10 Production Externalities max ( , ) ( , ). ,s x s s ss x p s c s x   The first-order profit-maximization conditions are p c s x ss s   ( , ) 0    c s x x s( , ) .and Production Externalities p c s x ss s   ( , ) states that the steel firm should produce the output level of steel for which price = marginal production cost. Production Externalities p c s x ss s   ( , ) states that the steel firm should produce the output level of steel for which price = marginal production cost.   c s x x s( , ) is the rate at which the firm’s internal production cost goes down as the pollution level rises Production Externalities p c s x ss s   ( , ) states that the steel firm should produce the output level of steel for which price = marginal production cost.   c s x x s( , ) is the rate at which the firm’s internal production cost goes down as the pollution level rises, so    c s x x s ( , ) is the marginal cost to the firm of pollution reduction. Production Externalities    c s x x s ( , ) is the marginal cost to the firm of pollution reduction. What is the marginal benefit to the steel firm from reducing pollution? Production Externalities    c s x x s ( , ) is the marginal cost to the firm of pollution reduction. What is the marginal benefit to the steel firm from reducing pollution? Zero, since the