Externalities Flashcards
What is an externality?
An externality occurs when a person’s well-being or a firm’s profits are directly affected by the actions of other consumers or firms rather than indirectly through changes in prices
In the presence of externalities, the perfectly competitive market outcome _____?
In the presence of externalities, the perfectly competitive market outcome can be inefficient
Why are externalities inefficient?
Negative externalities: competitive firms and consumers do not pay for the harms of their negative externalities & so create excessive amounts
Positive externalities: producers are not compensated for the benefits of a positive externality& so too little is produced
What is the problem with externalities?
Problem is that private cost and benefits are not equal to the social cost and benefits
Response to externalities?
Externalities in markets can be addressed through private responses or government intervention
What are the private responses to externalities?
Possible private responses: mergers and bargaining
How can mergers internalise an externality?
Mergers can help internalize externalities by bringing together companies involved in a transaction. This can lead to cost savings, better coordination, and shared goals, making it easier to address and manage external costs or benefits.
–A paper mill’s pollution reduces the profit of a hotel
–If less paper was produced overall profits would be higher
–A merger between the two firms could achieve this outcome
–Also works for positive externalities (e.g., R&D co-operation agreements)
When can you use bargaining?
If property rights are clearly assigned, bargaining between the affected parties can achieve efficiency.
What is bargaining?
negotiations between parties to address and resolve the impact of an external cost or benefit associated with a transaction.
–Consider the paper mill and the hotel affected by the mill’s pollution
–The paper mill could reduce output to increase the hotel’s profit
–Consider two cases: hotel has right to be free of pollution, mill has right to pollute (Table 1)
What is the Coase theorem?
Coase Theorem: If ownership rights to a resource can be clearly assigned, the affected parties can bargain and externalities do not create efficiency problems
Why does the Coase theorem not solve most real world externality problems?
Cost of bargaining may be too high
Difficult for resource owner to identify sources of damage
Affected parties often have asymmetric information which can lead to the breakdown of negotiations
Why does the Coase theorem does not solve most real-world externality problems?
Cost of bargaining may be too high!!
–Difficult for resource owner to identify sources of damage
–Affected parties often have asymmetric information which can lead to the breakdown of negotiations
Response to externalities? (Intervention)
Most of the time, externalities require some form of government intervention
–Quantity restrictions (e.g., emission standards for cars)
–Fees to internalise external costs (e.g., emission fees, effluent charges)
–Taxes on output
–Creation of markets (e.g., EU Emissions Trading System)
MAIN response to externalities?
Output taxes
Setting the correct standard or tax requires perfect information about costs and benefits, those are?
- Which activities produce externalities?
- What is the value of damage done
- Some techniques available but far from perfect
What is the uncertainty about correct standard or tax?
Welfare will not be maximised
Output taxes, emission fees, emission standards can yield different results
Polluting firms get?
Pollution permits - they create property rights and allow firms to trade with eachother.
Government sets overall pollution level and firms find best way to achieve that level by trading permits.
Properties of private goods?
Rivalry and exclusion
What is rivalry?
Only one person can consume good
What is exclusion?
Can prevent others from consuming the good
Quasi public goods (lack rivalry or exckusion)
Open access common properties lack exclusion
Club goods: lack ricalry
Public goods are?
Non rivalrous and non exclusive
Lack of rivalry and/or exclusion can…
Can lead to market failures
Lack of rivalry or exclusion in a market can lead to market failure because it disrupts the competitive forces that typically drive efficient resource allocation.
Producers might lack incentives to improve quality or reduce costs, leading to suboptimal outcomes. This is often associated with public goods or natural monopolies, where traditional market mechanisms struggle to achieve efficiency.
Ocean fishery example
Ocean fishery is an open access common property. Non exclusive but rival.
- All fishers have access but catching a fish reduces the availability of fish for others
Negative externality! Social costs are Private costs + Cost from reduced fish populations due to overfishing.
Problem arises because property rights are not clearly defined: you don’t own a fish before it is caught.
Compare to a situation where each fisher owns a lake
Club goods are an example of?
Non rival but exclusive goods
What is a club good example?
Cable television, streaming services, computer software
Market provision of club goods ____
Inefficient.
The MC of providing an additional unit is 0.
Charging positive price means P>MC so there is welfare loss.
Why is government intervention difficult in club goods?
Initial investment often required so no entry if P = MC = 0.
What does non rival mean in terms of MC?
Marginal cost of additional person using the good is 0
What is the socially optimal provision of public goods?
Until SOCIAL MARGINAL COST = SOCIAL MARGINAL BENEFIT
Will competitive markets achieve the socially optimal provision of public goods?
No.
In a competitive market, there is often a free-rider problem where individuals can benefit from the public good without paying for it.
This leads to under-provision of public goods as private firms may not find it profitable to produce them when they can’t exclude non-payers.
Consequently, government intervention or alternative mechanisms are often required to address this market failure and ensure the socially optimal level of public goods provision.
What is the MSB?
Sum of individual benefits
What do individual demand curves reflect?
Private marginal valuation
What is TOTAL Marginal Benefit?
Vertical sum of demand curves
What is the free rider problem?
The free rider problem occurs when individuals benefit from a public good or service without directly paying for it. It’s like enjoying the benefits of a shared resource or service without contributing, taking advantage of others who do pay. This can lead to underfunding of public goods since people have an incentive to let others pay while still enjoying the benefits.
Problems from free riding and positive externalities can sometimes be solved through private initiatives like?
1: social pressure. Convince each firm to “voluntarily” contribute.
2: mergers. If two firms merge, joint valuation = social valuation and optimum is reached
But mostly what is needed to solve market failure from externalities?
Government intervention.
What’s the problem of using private solutions to solve market failure?
Private solutions only work for small groups
Externalities arise when..
There is an impact on a 3rd party not involved in the transaction
Private provision of public goods leads to?
Under provision of public goods due to free rider provlem
