CHAPTER 35
Externalities
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Externalities
An externality is a cost or a benefit imposed upon someone by actions taken
by others.
The cost or benefit is generated externally to that somebody.
An externally imposed benefit is a positive externality.
An externally imposed cost is a negative externality.
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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
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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
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Externalities & Efficiency – 1
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.
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Externalities & Efficiency – 2
Externalities cause Pareto inefficiency; typically either:
• too much scarce resource is allocated to an activity which causes a
negative externality, or
• too little resource is allocated to an activity which causes a positive
externality.
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Externalities & Property Rights – 1
An externality will be 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).
For example, a broadcast television program.
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Inefficiency & Negative Externalities – 1
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.
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Inefficiency & Negative Externalities – 2
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).
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Inefficiency & Negative Externalities – 3
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Inefficiency & Negative Externalities – 4
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Inefficiency & Negative Externalities – 5
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Inefficiency & Negative Externalities – 6
What are the efficient allocations of smoke and money?
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Inefficiency & Negative Externalities – 7
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Inefficiency & Negative Externalities – 8
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Inefficiency & Negative Externalities – 9
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?
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Inefficiency & Negative Externalities – 10
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Inefficiency & Negative Externalities – 11
mA mB
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Inefficiency & Negative Externalities – 12
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?
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Inefficiency & Negative Externalities – 13
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Inefficiency & Negative Externalities – 14
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Inefficiency & Negative Externalities – 15
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).
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Externalities & Property Rights – 2
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.
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Externalities & Property Rights – 3
Causing a producer of an externality to bear the full external cost or to enjoy
the full external benefit is called internalizing the externality.
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Externalities & Property Rights – 4
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?
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Externalities & Property Rights – 5
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?
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Externalities & Property Rights – 6
Let p(sA) be the price paid by agent A to agent B in order to create a smoke
intensity of sA.
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Externalities & Property Rights – 7
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Externalities & Property Rights – 8
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Externalities & Property Rights – 9
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Externalities & Property Rights – 10
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Externalities & Property Rights – 11
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?
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Externalities & Property Rights – 12
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Externalities & Property Rights – 13
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Externalities & Property Rights – 14
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Externalities & Property Rights – 15
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Externalities & Property Rights – 16
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.
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Externalities & Property Rights – 17
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Coase Theorem
Coase Theorem:
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.
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Merger & Internalization – 3
And the merged firm’s maximum profit level is
This exceeds $45, the sum of the non-merged firms.
Merger has improved efficiency. On its own, the steel firm produced
x* = 4 units of pollution. Within the merged firm, pollution production is only x*
= 2 units.
So, merger has caused both an improvement in efficiency and less pollution
production.
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The Tragedy of the Commons – 1
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?
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The Tragedy of the Commons – 2
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The Tragedy of the Commons – 3
Make the price of milk $1 and let the relative cost of grazing a cow be $pc . Then the profit function for the entire village is
and the village’s problem is to
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The Tragedy of the Commons – 4
The income-maximizing number of cows to graze, c*, satisfies
In other words, the marginal income gained from the last cow grazed
must equal the marginal cost of grazing it.
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The Tragedy of the Commons – 5
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The Tragedy of the Commons – 6
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. Entry continues
until the economic profit of grazing another cow is zero.
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The Tragedy of the Commons – 7
The commons are overgrazed, tragically.
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The Tragedy of the Commons – 8
The reason for the tragedy is that when a villager adds one more cow his
income rises (by 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.
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The Tragedy of the Commons – 9
Modern-day “tragedies of the commons” include
• overfishing the high seas
• over-logging forests on public lands
• over-intensive use of public parks; e.g. Yellowstone.
• urban traffic congestion.
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CHAPTER 37
Public Goods
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Public Goods – Definition
A good is purely public if it is both nonexcludable and non-rival in
consumption.
• Nonexcludable—all consumers can consume the good.
• non-rival—each consumer can consume all of the good.
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Public Goods: Examples
• broadcast radio and TV programs
• national defense
• public highways
• reductions in air pollution
• national parks
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Credits
This concludes the Lecture PowerPoint presentation for Chapter 35 of Intermediate Microeconomics, 9e.
For more resources, please visit http://digital.wwnorton.com/intermicro9media.
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