Chapter 35

Externalities
 Externalities and Efficiency

We say that an economic situation

involves a consumption externality if one
consumer cares directly about another
agent’s production or consumption
Ex) my neighbor playing loud music
(negative), the pollution produced by
local automobiles, my neighbor’s flower
garden (positive).
 Externalities and Efficiency

Similarly a production externality

arises when the production
possibilities of one firm are
influenced by the choices of others.
Ex) an apple orchard located next to a
beekeeper (positive), a fishery cares
about the pollutants dumped by
others into a fishing area (negative).

3
 Externalities and Efficiency

 The crucial feature of externalities is

that there are goods people care
about that are not sold on markets.
EX) no market for loud music or a
neighbor who keeps a beautiful
flower garden.
 This lack of markets for externalities
causes efficiency problems.

4
 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.
Externalities and Property Rights
 An externality can happen when it
involves with 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
Smoke Money and smoke are
both goods for Agent A.
1

0
OA yA mA
Inefficiency & Negative Externalities
Smoke Money and smoke are
both goods for Agent A.
1

Be
0 tt
er
OA yA mA
Inefficiency & Negative Externalities
Smoke Money is a good and smoke
is a bad for Agent B.
1

er
tt
Be
0
OB yB mB
Inefficiency & Negative Externalities
Money is a good and smoke
Smoke
is a bad for Agent B.
1
Be
tte

0
r

mB yB OB
Inefficiency & Negative Externalities

 What are the efficient allocations of

smoke and money?
Inefficiency & Negative Externalities
Smoke Smoke

1 1

0 0
OA mB yA yB mA OB
Inefficiency & Negative Externalities
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
Smoke Smoke

1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
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
Smoke Smoke

1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
Smoke A’s choices Smoke

1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
A’s most
Smoke preferred choice Smoke
is inefficient
1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
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?
Inefficiency & Negative Externalities
Smoke B’s choices Smoke

1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
B’s most
Smoke preferred choice Smoke
1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
Inefficiency & Negative Externalities
B’s most
Smoke preferred choice Smoke
is inefficient
1 1
Efficient
allocations

0 0
OA yA yB OB
mA mB
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.
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 smok
e”.
 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
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke Smoke
p(sA)
1 1

sA

0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke Smoke
p(sA)
1 1
Both agents
gain and
there is a
positive
sA
amount of
smoking.
0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke Smoke
p(sA)
Establishing
1 1 a market for
trading rights
to smoke
causes an
sA efficient
allocation to
be achieved.
0 0
OA yA yB OB
mA mB
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
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke Smoke

1 1

0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke p(sB) Smoke

1 1

sB

0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke p(sB) Smoke

1 1
Both agents
gain and
sB there is a
reduced
amount of
smoking.
0 0
OA yA yB OB
mA mB
Externalities and Property Rights
Smoke p(sB) Smoke
Establishing
1 1 a market for
trading rights
sB to reduce
smoke
causes an
efficient
allocation to
0 0
OA yA yB OB be achieved.

mA mB
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
Smoke Smoke
p(sA) p(sB)
1 1

sB
sA sB
sA

0 0
OA yA yB OB
mA mB
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
Smoke Smoke
p(sA) p(sB)
1 1

sA = s B

0 0
OA yA yB OB
mA mB
 Externalities and Property Rights
Smoke Smoke
p(sA) p(sB)
1 1

sA = s B

0 0
OA yA yB OB
For both agents, the MRS is constant as
money changes, for given smoke intensity.
 Externalities and Property Rights
Smoke Smoke
p(sA) p(sB)
1 1

sA = s B

0 0
OA yA yB OB
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.

 (s,x)
 psc(s,x)
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

 m
a
x
 (
s
,s,x)
ssp
scs(s,x).
Production Externalities

The first-order profit-maximization

conditions are
 m
a
x

s
,p
c
(
s(
s
,
x
,
x
)
s0

s )
p

sss
c
(
s

s
c

,
x
)
.
(
s
,
x
s)
.
Production Externalities

The first-order profit-maximization

conditions are
and
 pc
(
s
,
x
)

s
s Production Externalities
states that the steel firm
should produce the output level of steel
for which price = marginal production cost.
 ps  c
(
s
,
x

s
cs(s,x)
 )
Production Externalities
states that the steel firm
should produce the output level of steel
for which price = marginal production cost.
≤0: the rate at which the firm’s
internal production cost decreases as the
pollution level rises(assumed over some range)
  p
s
c 
(css,(x
s c(
s
,
x
)
s
)s,x)
Production Externalities
states that the steel firm
should produce the output level of steel
for which price = marginal production cost.
≤0: the rate at which the firm’s
internal production cost decreases as the
pollution level rises(assumed over some range)
is the marginal benefit to the
firm of pollution production.
 c (
s
,x)
 s Production Externalities
is the marginal benefit to the
firm of pollution production.
What is the marginal cost to the steel
firm from producing pollution?
 c (
s
,x)
 s
c(
s
,

sx)0.
Production Externalities
is the marginal benefit to the
firm of pollution production.
What is the marginal cost to the steel
firm from producing pollution?
Zero, since the firm does not buy the
Pollution right. Hence the steel firm chooses
the pollutionlevel for which
 c (
s
,x)
 s
c(
s
,

sx)0.
Another interpretation
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 firm does not sell the
pollution right. Hence the steel firm chooses
the pollution level for which

60
 (2

s1s,sx)
12s0
pS = 12. Then
2()x2(4
 2
x4).
Production Externalities
E.g. suppose cS(s,x) = s2 + (x - 4)2 and

and the first-order profit-maximization

conditions are
and
 p12
s 2s,
Production Externalities
determines the profit-max.
output level of steel; s* = 6.
 p 1

s2 2
2
s
,

()x4
Production Externalities
determines the profit-max.
output level of steel; s* = 6.
is the marginal benefit to the firm
from pollution production. Since it gets
no marginal cost, it sets x* = 4.
 p 1

s2 2
()x
 4
(1
s$2
*
,s2s
,
x)
1
2s
*
 s
*
(
2
x
*
4
)
2

6
3.2()4

Production Externalities
determines the profit-max.
output level of steel; s* = 6.
is the marginal benefit to the firm
from pollution production. Since it gets
no marginal cost, it sets x* = 4.
The steel firm’s maximum profit level is
thus
 Production Externalities

 The cost to the fishery of catching f

units of fish when the steel mill emits
x units of pollution is cF(f,x). Given f,
cF(f,x) increases with x; i.e. the steel
firm inflicts a negative externality on
the fishery.
 (f;x)

F p
fcF(f;x)
F
Production Externalities

 The cost to the fishery of catching f units

of fish when the steel mill emits x units of
pollution is cF(f,x). Given f, cF(f,x)
increases with x; i.e. the steel firm inflicts
a negative externality on the fishery.
 The fishery’s profit function is

so the fishery’s problem is to

 m
a
x

F
f(
f
;
x
)p
f


Fc
(
f
;
x
)
.
F
Production Externalities

The first-order profit-maximization

condition is
 m
a
x
(
f
;
x
)

F
fp


Fp
f

F
c
(
f
;
Fc
(
f
;
x
F
x
)
.)
.
Production Externalities

The first-order profit-maximization

condition is
 m
a
x
(
f
;
x
)

F
fp


Fp
f

F
c
(
f
;
Fc
(
f
;
x
F
x
)
.)
.
Production Externalities

The first-order profit-maximization

condition is

Higher pollution raises the fishery’s

marginal production cost and lowers both
its output level and its profit. This is the
external cost of the pollution.
 (F
f;x
)
1
0
f2x
f
Production Externalities
E.g. suppose cF(f;x) = f2 + xf and pF = 10.
The external cost inflicted on the fishery
by the steel firm is xf. Since the fishery
has no control over x it must take the steel
firm’s choice of x as a given. The fishery’s
profit function is thus
 (f1

F ;0
x
)
1
0
f2x.
f2
x
f
Production Externalities

Given x, the first-order profit-maximization

condition is
 (ff1

F
condition is
;*
x
)0

 10
f
25f
xx..
2


2x
f
Production Externalities

Given x, the first-order profit-maximization

So, given a pollution level x inflicted upon

it, the fishery’s profit-maximizing output
level is
 (ff1

F
condition is
;*
x
)0

 10
f
25f
xx..
2


2x
f
Production Externalities

Given x, the first-order profit-maximization

So, given a pollution level x inflicted upon

it, the fishery’s profit-maximizing output
level is
Notice that the fishery produces less, and
earns less profit, as the steel firm’s
pollution level increases.
f*
5x
.
2

(
f1*
;F0
3x
)1
0f
*
f
*
4
 3
x
f
*
$
9
.

Production Externalities

2

2
The steel firm, ignoring its
external cost inflicted upon the fishery,
chooses x* = 4, so the fishery’s
profit-maximizing output level given the
steel firm’s choice of pollution level is
f* = 3, giving the fishery a maximum
profit level of

Notice that the external cost is $12.

 Production Externalities

 Are these choices by the two firms

efficient?
 When the steel firm ignores the
external costs of its choices, the sum
of the two firm’s profits is $36 + $9 =
$45.
 Is $45 the largest possible total profit
that can be achieved?
 Merger and Internalization

 Suppose the two firms merge to

become one. What is the highest
profit this new firm can achieve?
(s,fx)
m




12s
10fs().
22x4fxf
2
Merger and Internalization

Suppose the two firms merge to

become one. What is the highest
profit this new firm can achieve?

What choices of s, f and x maximize

the new firm’s profit?
(
m
 ssm
,mf
x
)120
1sf2
s
1 0
f0x
0.s22
().
x4fsm
f4xf
26
f
 2().
x 4 f x m2.
Merger and Internalization

m
x 
The first-order profit-maximization
conditions are
The solution is
(
s1
m
2,,)
f
m

6
$48.x
m
m
sfs
10
m
4
6
()
x
2
2
m4
fx
2
m

level is

2
m

4
f
Merger and Internalization
And the merged firm’s maximum profit

This exceeds $45, the sum of the non-

merged firms.
 Merger and Internalization
 Merger has improved efficiency.
 On its own, the steel firm produced x*
= 4 units of pollution.
 Within the merged firm, pollution
production is only xm = 2 units.
 So merger has caused both an
improvement in efficiency and less
pollution production. Why?
 s(s,x
 )
1
2
sM
C 2 ()x
2()x4
s(x) 4 2
Merger and Internalization
The steel firm’s profit function is

so the marginal cost of producing x units

of pollution is
When it does not have to face the
external costs of its pollution, the steel
firm increases pollution until this marginal
cost is zero; hence x* = 4.
(M
m
sC
,m
f(xx))
1(2x
s
1 0
f4)
s22
().
x4f2xf
Merger and Internalization
In the merged firm the profit function is

The marginal cost of pollution is thus

(M
m
sC
,m
f(xx))
1(2x
s
1 0
f4)
s
22().
x4
2()( fM
2
C
Merger and Internalization

x
fs).
In the merged firm the profit function is

The marginal cost of pollution is

(M
m
sC
,m
f(xx))
1(2x
s
1 0
f4)
s
22().
x4
2()( fM
2 x
fs).
C
Merger and Internalization
In the merged firm the profit function is

The marginal cost of pollution is

The merged firm’s marginal pollution cost

is larger because it faces the full cost of
its own pollution through increased costs
of production in the fishery, so less
pollution is produced by the merged firm.
 Merger and Internalization
 But why is the merged firm’s
pollution level of xm = 2 efficient?


M
C
Ef.
x
Merger and Internalization
But why is the merged firm’s
pollution level of xm = 2 efficient?
 The external cost inflicted on the
fishery is xf, so the marginal external
pollution cost is


M
C
Ef.
x
Merger and Internalization
But why is the merged firm’s
pollution level of xm = 2 efficient?
 The external cost inflicted on the
fishery is xf, so the marginal external
pollution cost is
 The steel firm’s benefit of producing
pollution is


M
C
Ef.
x
Merger and Internalization
But why is the merged firm’s
pollution level of xm = 2 efficient?
 The external cost inflicted on the
fishery is xf, so the marginal external
pollution cost is
 The steel firm’s benefit of producing
pollution is
 Efficiency requires

MC E
x
m
  MC (x )f   2(x  4).
 Merger and Internalization

 Merger therefore internalizes an

externality and induces economic
efficiency.
 How else might internalization be
caused so that efficiency can be
achieved?
Coase and Production Externalities

 Coase argues that the externality

exists because neither the steel firm
nor the fishery owns the water being
polluted.
 Suppose the property right to the
water is created and assigned to one
of the firms. Does this induce
efficiency?


(F
f,x
)
p
ff2x
f
p
x
.
x
Coase and Production Externalities
Suppose the fishery owns the water.
 Then it can sell pollution rights, in a


competitive market, at $px each.
The fishery’s profit function becomes
 (F
f,x
)
p
ff2x
f
p
x
.
x
Coase and Production Externalities



Suppose the fishery owns the water.
 Then it can sell pollution rights, in a
competitive market, at $px each.
The fishery’s profit function becomes

Given pf and px, how many fish and how

many rights does the fishery wish to
produce? (Notice that x is now a choice
variable for the fishery.)
(
f
,
x

F
p
f


f
x
F
)
p
f

2
f
x

p
xf
2


0
x
f
p

xx
.
Coase and Production Externalities

The profit-maximum conditions are

(

F
p
f

Ff
,
x
)

2
f

f
p
xx

xpf
f
2

x
0


fS
*
p
x
f
p
x

x.

x2
p
.
Coase and Production Externalities

fx
The profit-maximum conditions are

and these give (fish supply)

(pollution
right supply)

(s,x

S )
p
s(x
2 4
).p
2 x
x
Coase and Production Externalities
 The steel firm must buy one right for
every unit of pollution it emits so its
profit function becomes

Given pf and px, how much steel does

the steel firm want to produce and
how many rights does it wish to buy?
(
s
,
x

S
p
s


s
2
(
x

S
)
p
s

2
s


x
4
)2


0
p


x(
x
4
).

0p
x
2

x
Coase and Production Externalities

The profit-maximum conditions are

(
s
,

S
p
s


s
2

S
x
)
p
s

2
s


(
x
4
)
xx0
2


p

x(
x
4
).

0p
x
2

x
sD
*
2
s

4p
.
Coase and Production Externalities

2
x
The profit-maximum conditions are

and these give (steel supply)

(pollution
right demand)
 x
*
4


Dp
p
2
x

2
p
x

fx
S*
.
Coase and Production Externalities
In a competitive market for pollution rights
the price px must adjust to clear the market
so, at equilibrium,
 x
*
4


Dp
p
2
x


2
p
3
f

x2
p
x

fx
S
8*
.
Coase and Production Externalities
In a competitive market for pollution rights
the price px must adjust to clear the market
so, at equilibrium,

The market-clearing price for pollution

rights is thus
 x
*
4


D
x
*
D
p
p
2
x

f

x
x
*2
p


fx
2
p8
3
1
6
p
S3


fx
*
.
S
.
Coase and Production Externalities
In a competitive market for pollution rights
the price px must adjust to clear the market
so, at equilibrium,

The market-clearing price for pollution

rights is thus

and the equilibrium quantity of rights

traded is
 p
sp
*
;
f
*
2
s

8
x3

fp
;
x
.x
*

D1
6
x
*
3


Sp
;
f
Coase and Production Externalities
sp
*
xp
;
2
s

f
s*
6
f
*

8
.
3
p
;
x
;fx
*
 x
*
x
*

D
S
42
;D
*
x
*

S
1
6
3

p;
f
;.p

x4
Coase and Production Externalities

So if ps = 12 and pf = 10 then

This is the efficient outcome.

Coase and Production Externalities
 Q: Would it matter if the property right to
the water had instead been assigned to
the steel firm?
 A: The optimal pattern of production is
independent of the assignment of property
rights since the same first order
conditions are satisfied (check textbook).
Of course, the distribution of profits
depends on the assignment.
 The Tragedy of the Commons
 Consider a grazing area owned “in
common” by all members of a village.
 Villagers graze cows on the common.
 When c cows are grazed, total milk
production is f(c), where f’>0 and f”<0.
 How should the villagers graze their
cows so as to maximize their overall
income?
 The Tragedy of the Commons
Milk
f(c)

c


(mc
)c
f

(
c
)
p
c
a0xc.
The Tragedy of the Commons

Make the price of milk $1 and let the

relative cost of grazing a cow be $p c.
Then the profit function for the entire
village is

and the village’s problem is to

 m
a
x
(c
c
)0f(c
f)
(p
cc)pc.
The Tragedy of the Commons

The income-maximizing number of cows

to graze, c*, satisfies

i.e. the marginal income gain from the

last cow grazed must equal the marginal
cost of grazing it.
 The Tragedy of the Commons
Milk pcc
f(c)
slope =
f’(c*)

slope
= pc

c* c
 The Tragedy of the Commons
Milk pcc
f(c)
slope =
f’(c*)
f(c*)
Maximal income
slope
= pc

c* c


(c*)
 f(c*)pc*
grazed is
f(c*)p0
c
The Tragedy of the Commons

For c = c*, the average gain per cow

because f’ > 0 and f” < 0.

f(c*)
slope =
f’(c*)

c*
f(c*)
p
c
The Tragedy of the Commons
Milk pcc
f(c)

c


(c*)
 f(c*)pc*
f(c*)p0
c
The Tragedy of the Commons
For c = c*, the average gain per cow
grazed is

because f’ > 0 and f” < 0. So the

economic profit from introducing one
more cow is positive.
 Since nobody owns the common, entry
is not restricted.


(c)
 f(c)pc
f(c)p0.
c
The Tragedy of the Commons

Entry continues until the economic

profit of grazing another cow is zero;
that is, until
 Milk

f(c*)
slope =
f’(c*)

c*
fc
(c)
f(c)

c
p
c
The Tragedy of the Commons
pcc
 Milk

f(c*)
slope =
f’(c*)

c*
fc
(c)
c
p
c
The Tragedy of the Commons
pcc
f(c)

The commons are over-grazed, tragically.

 The Tragedy of the Commons

 The reason for the tragedy is that

when a villager enters with one more
cow, his income rises (as long as
positive f(c)/c - pc) but every other
villager’s income falls.
 The villager who adds the extra cow
takes no account of the cost inflicted
upon the rest of the village.
 The Tragedy of the Commons

 Modern-day “tragedies of the

commons” include
– over-fishing the high seas
– over-logging forests on public lands
– over-intensive use of public parks;
e.g. Yellowstone.
– urban traffic congestion.