Lecture 3: Externalities Flashcards
Assumption behind Market Efficiency
The welfare of each consumer depends solely on their own consumption decision
The production of each firm depends only on its own input and output choices
In reality these conditions may not be met. A consumer or a firm may be directly affected by the actions of other agents in the economy – EXTERNAL EFFECTS from the actions of other consumers or firms
Externality
An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism
Types of externalities
Positive and consumption: Art, Culture
Negative and Consumption: Cigarette smoke
Negative and production: Pollution
Positive and Production: R&D
The nature of Externalities
Can be produced by consumers and firms
Can be positive or negative
In the presence of externalities the market is unlikely to reach a pareto efficient allocation
Negative externality: Market leads to an overproduction of the good with social optimum
Positive externality: Market leads to an under-production of the good with social optimum
The tragedy of the commons
Each fisherman is only concerned with his own profit
They do not take into account the negative externality they impose on each other: Each additional fisherman who hires a boat will reduce the amount of fish caught by the other fishermen
In equilibrium too many boats will be hired with respect to the social equilibrium
How to deal with externalities
Public intervention: Price-based solution: Tax levied on each unit of a polluter’s output in an amount equal to the marginal damage it inflicts at the efficient level of output (Pigouvian tax)
Private solutions: Let the market solve the issue of externalities via private transactions (Coase Theorem)
The Coase Theorem
Given: No transactions costs, clear assignment of property rights (An efficient solution to an externality problem can be achieved)
Assumptions necessary for Coase theorem to work:
The costs to the parties of bargaining are zero (or lower)
The owner of resources can identify the source of damages to their property and legally prevent damages
Other Private Solutions
Mergers: Way to internalize the externality – The externality transmitter and recipient become one company
Social conventions/morals: Eg littering is wrong
Public intervention: Pigouvian Subsidy
Pigouvian subsidy: The government gives the producer a subsidy for each unit that she decides not to produce
Equivalent for the tax: For each unit the producer gives up a unit of subsidy
Cap and Trade vs. Emissions Fee in the presence of uncertainty
When MSB is inelastic, a change in cost has little effect on the optimal amount of pollution reduction
Therefore a cap and trade system (which fixes the amount of allowable pollution) does not deviate much from the effiency level
Viceversa, when the marginal social benefits are elastic, a change in cost has a big effect on the optimal amount of pollution reduction
Hence, a cap and trade will deviate substantially from new efficient level
