15 Externalities

An externality is an uncompensated impact of one economically active unit’s (person or firm) actions on the well-being of a bystander. It arises when a person engages in an activity that affects the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

When the impact on the bystander is adverse, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality. Externalities cause markets to be inefficient and thus fail to maximize total surplus. Buyers/consumers and sellers/producers neglect the external effects of their actions. (Otherwise, the effects wouldn’t be considered to be external.)

15.1 Positive and negative externalities

Watch the video shown in Figure 15.1.

Figure 15.1: Intro to externalities

Source: Youtube

Example: Aluminum industry

Background: Aluminum factories emit pollution (a negative externality). For each unit of aluminum produced, a certain amount of smoke enters the atmosphere. The smoke poses a health risk for innocent bystanders who breathe the air.

How does a negative externality affect the efficiency of the market outcome?

The cost to society of producing aluminum is larger than the cost to the aluminum producers.
The social cost includes the private costs of the aluminum producers plus the costs of the bystanders impacted by the pollution.
The social-cost curve is above the supply curve (because it adds the external costs of aluminum production).
The socially optimal equilibrium (intersection of social-cost curve and demand curve) is different from the actual equilibrium (where externalities are not considered).

One solution: Policymakers can tax aluminum producers for each ton of aluminum sold. The tax shifts the supply curve upward by the size of the tax. The tax should reflect the external cost of pollutants released into the atmosphere (in order to match the social-cost curve). The new market equilibrium would result in the socially optimal quantity of aluminum.

Another solution: Internalizing the externality: Altering incentives so that people and firms account for the external effects of their actions.

Alternatives: If property rights were clearly defined, we would have a (theoretical) chance of a market solution. However, the transaction costs are probably simply too high, as all people are harmed, necessitating that all people bargain with the polluting firms.

Exercise 15.1 Give examples of positive and negative externalities. Distinguish whether the externalities stem from consumption or production. Discuss the visualization shown in Figure 15.2.

15.2 Production externalities

Production externalities refer to a side effect from an industrial operation, such as a paper mill producing waste that is dumped into a river. They are usually unintended, and their impacts are typically unrelated to and unsolicited by anyone. They can have economic, social, or environmental side effects. Production externalities can be measured in terms of the difference between the actual cost of production of the good and the real cost of this production to society at large. The impact of production externalities can be positive or negative or a combination of both.

Examples of production externalities:

(+) The construction and operation of an airport will benefit local businesses because of increased accessibility.
(+) An industrial company providing first aid classes for employees to increase workplace safety. This may also save lives outside the factory.
(+) A foreign firm that demonstrates up-to-date technologies to local firms and improves their productivity.
(+) Many sectors participate in technological innovation that happens in one sector (technological spillovers).
(-) Noise pollution produced by a productive unit.
(-) Increased usage of antibiotics propagates increased antibiotic-resistant infections.
(-) The development of ill health, notably early-onset Type II diabetes and metabolic syndrome, as a result of companies over-processing foods including the addition of (too much) sugar.

Formally

Production externalities happen because the output of one productive unit (unit 1) is a function of the amount of output of another productive unit (unit 2).

\[\begin{align} y_1 = f_1(L_1, K_1, y_2) \\ y_2 = f_2(L_2, K_2). \end{align}\]

If $\frac{\partial y_1}{y_2} < 0$, it indicates a negative external effect; if $\frac{\partial y_1}{y_2} > 0$, it indicates a positive external effect.

In the case of positive (negative) external effects, the welfare optimum would require more (less) production of productive unit 2.

15.3 Consumption externalities

Examples of consumption externalities:

(+) Going to university. Your education benefits the rest of society (you can teach others).
(+) Taking medicine or a vaccine which prevents the spread of infectious disease.
(-) Consuming fireworks causes damage to the environment and to the health of other people.
(-) Driving a car pollutes the environment and injures people.
(-) Smoking and eating unhealthily may cause costs for other people.

Formally

Consumption externalities occur because the utility of one individual is determined by the consumption of good $z_1 $ but also by the amount another individual is consuming from good $z_2 $:

\[\begin{align} u_1 = f_1(z_1, z_2) \\ u_2 = f_2(z_2). \end{align}\]

If $\frac{\partial u_1}{z_2} < 0$, it indicates a negative external effect; if $\frac{\partial u_1}{z_2} > 0$, it indicates a positive external effect.

Alternatively, the utility of an individual can be determined by the utility level of another individual:

\[ u_1 = f_1(z_1, u_2) \\ u_2 = f_2(z_2). \]

If $\frac{\partial u_1}{u_2} < 0$, it indicates a negative external effect; if $\frac{\partial u_1}{u_2} > 0$, it indicates a positive external effect.

In the case of positive (negative) external effects, the welfare optimum would require more (less) of the consumption of good $z_2 $.

15.4 Government interventions

Governments can manage externalities in two ways:

Command-and-control policies which regulate behavior directly. Regulations that require or forbid certain behaviors or subsidize good behavior. Example: Making it a crime to dump hazardous chemicals into the water supply.
Market-based policies which provide incentives so that firms can determine the best way to solve a problem.
- Corrective tax: A tax designed to induce private decision-makers to take into account the social costs that arise from a negative externality.
- Tradable permits (aka “Cap and Trade”): For example, voluntary transfer of the right to pollute from one firm to another. The government, in effect, creates a scarce resource (“pollution permits”). The result is the creation of a market governed by supply and demand. Permits end up in the hands of firms that value them most highly. Tradable green certificates of the EU are financial assets issued to producers of certified green electricity and can be regarded as a market-based environmental subsidy.

15.5 Private solutions to externalities

In some cases, government intervention is not necessarily needed to address externalities and to coordinate the behavior of market participants. For instance, if your neighbor plays loud music, you can talk to him and bargain for a good solution that leaves both parties better off.

Some types of private solutions include: - Moral codes and social sanctions. - Charitable and private organizations that aim to help and bring people together.

15.6 The Coase theorem

The Coase Theorem is named after Ronald Coase, a Nobel laureate of 1991 (see Figure 15.3). It states that if property rights exist and transaction costs are low, private transactions are efficient. In other words, with property rights and low transaction costs, there are no externalities. All costs and benefits are taken into account by the transacting parties. Thus, it doesn’t matter how the property rights are assigned as long as they are assigned. The theorem posits that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. However, the theorem only works when the relevant parties can come to an agreement and are able to enforce that agreement. This is often not the case.

Transaction costs, in this respect, refer to the costs that parties incur during the process of agreeing to and following through on a bargain. Efficient bargaining becomes increasingly difficult when the number of interested parties is large. Coordinating more people is costly, and the more individuals involved, the less likely it is that private transactions yield a successful, efficient market outcome.

Figure 15.3: Ronald H. Coase (1910-2013)

15.7 Imperfect information

In previous sections, we assumed that households and firms have perfect information on products and inputs. For example, to make good choices among goods and services available in the market, consumers must have full information on product quality, availability, and price. To make sound judgments about what inputs to use, producers must have full information on input availability, quality, and price. If this information is not available, consumers and producers are likely to make mistakes.

15.8 Moral hazard

An information problem that arises in insurance markets is moral hazard. Often, people enter into contracts in which the outcome of the contract depends on one of the parties’ future behavior. A moral hazard problem arises when one party to a contract passes the cost of his or her behavior onto the other party to the contract. In other words, moral hazard is a situation in which one party engages in risky behavior or fails to act in good faith because it knows the other party bears the economic consequences of their behavior.

15.9 Information asymmetry

When participants in an economic transaction have different information about the transaction, information is spread asymmetrically. This often causes inefficient markets. For example, in the healthcare market, there is a significant amount of information asymmetry, as doctors and suppliers of medical products and services possess much more knowledge on the topic and may use that informational advantage to offer overpriced and possibly unnecessary products and treatments.

15.10 Adverse selection

This sort of imperfect information occurs when a buyer or seller enters into an exchange with another party who has more information. For example, suppose there are two types of workers: lazy workers and hard workers. Each worker knows which they are, but employers cannot tell. If there is only one wage rate, lazy workers will be overpaid and hard workers will be underpaid relative to their productivity.

Another example is the secondhand car market. Suppose buyers cannot distinguish between a high-quality car (a cherry) and a low-quality car (a lemon), but sellers know the quality of their cars. Buyers would be willing to pay €6000 for a good car and €2000 for a bad car. If half of the cars for sale are good and half are bad, the market price of a car would be €4000.

Moreover, the asymmetric information yields a so-called adverse selection problem. That is, used car sellers know they are getting far more than their cars are worth by selling at €4000, while owners of good cars know they are getting far less than their cars are really worth. Thus, more lemon owners are attracted into selling their cars than are cherry owners. This sort of market is known as a market for lemons, named after the article The Market for Lemons: Quality Uncertainty and the Market Mechanism by George Akerlof (1970) (see Figure 15.4), the Nobel laureate of 2001.

Akerlof, G. (1970). The market for lemons: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500.

Exercise 15.2 Market failure review

What is an external effect? Explain in detail and define the terms external benefit and external cost.
What does it mean to internalize an external effect?
What is a public good? Define briefly.
What is the free-rider problem and how does government help to overcome it?
Why is it so important to have a monopoly control commission?
What do property rights have to do with externalities? What are the conditions that must hold so that private market transactions can eliminate external effects?
What are good reasons for the government to tax people and restrict civil rights and liberties?

Solution

An externality is a cost or benefit of a production or consumption activity that spills over to affect people other than those who decide the scale of the activity.
An external cost is the cost of producing a good or service that is not borne by its consumers or producers but by other people.
An external benefit is the benefit of consuming a good or service that does not accrue to its consumers or producers but to other people.
In order to eliminate market failures caused by externalities, it is necessary to intervene in the market in a way to encourage consumers and producers to change their rational choices so that they produce or purchase quantities that are closer to the social optimum, correcting efficiency deviations of externalities. This correction process is called internalization of externalities. In other words, when a person considers the consequences of his market transactions on individuals that are not part of the market transaction itself, we say he has internalized the external effects of his actions.
A public good is a good or service that can be consumed simultaneously by everyone and from which no one can be excluded. Public goods are non-rival in consumption, meaning one person’s consumption of the good does not affect the quantity available for anyone else. Public goods are non-excludable if it is impossible to prevent someone from benefiting from a good without having paid for it.
Public goods create a free-rider problem. A free-rider is a person who consumes a good without paying for it. Markets fail to supply a public good because no one has an incentive to pay for it. The government can provide the public good and finance the costs with taxes and other duties. The challenge here is to find the optimal level of provision for public goods.
The rent-seeking behavior of a monopolist prevents the allocation of resources from being efficient. Markets fail when monopoly power exists, as a monopolist increases profit by restricting output and increasing price. A major activity of government is to regulate monopolies and enforce laws that prevent cartels and other restrictions on competition.
If property rights are assigned, externalities can be eliminated by private parties bargaining for a jointly optimal solution. This holds only if there are no transaction costs or other market imperfections, like imperfect information, and if enforcement is possible.
Any sort of market failure can act as a legitimate reason for the government to intervene in the market. Economists, however, have different viewpoints regarding whether or not (and how) government should intervene. An often-mentioned criterion is the Pareto criterion: If an intervention yields a Pareto improvement, meaning a change that harms no one and helps at least one person, most economists would support the policy intervention. However, it is hard to think of any real-world market intervention that actually does not harm anybody. Thus, it is often – to some extent – a normative judgment whether to support a market intervention or not. The main argument for market interventions in the case of market failure is that the intervention can improve overall welfare; hence it is just a matter of redistributing endowments and output, respectively. In other words, when the overall output increases due to government action, those who were harmed by the intervention can be compensated so that nobody is worse off due to the government action, while at least some are better off. While this may be theoretically clear and true, it may be practically hard to implement because it is challenging to identify losers and to calculate their loss. Thus, any market intervention and government activity should be discussed transparently (especially with respect to normative views), with an open mind and by protecting minorities that may be the losers of a government action.

Exercise 15.3 Externalities examples

For each of the examples below, the following questions will be answered:

Does an externality exist? If so, classify the externality as positive/negative (or both).
If an externality exists, determine whether the Coase theorem applies (i.e., is it possible or reasonably feasible to assign property rights and solve the problem?).
If an externality exists and the Coase Theorem does not apply, argue which of the government’s tools are best suited to address the issue: quantity regulation, taxes/subsidies, tradable permits, or something else.

Examples:

British Petroleum drills for oil in the Gulf Coast

Solution

1. Yes. You can either think of there being a negative externality (accidents on oil rigs cause spills, which negatively affect other inhabitants of the Gulf states) or a positive externality (identifying where oil is allows other companies to drill for oil more effectively because they know where it is).
1. If oil spills only damage property, and these property owners can costlessly recoup costs in the legal system, then the drillers will internalize the impact of their drilling on the social cost of the oil spill. However, if it is hard to determine the true costs from an oil spill (e.g., it may be hard to figure out whether someone lost their job because of an oil spill or some other reason), then the Coase Theorem may not apply. In the positive externality case, it may be difficult to assign property rights to an oil field after it is identified, so the Coase Theorem may not apply.
1. Quantity regulation on the amount of safety/advanced drilling technology investments seems feasible. One could also argue for subsidies for safer drilling technologies (or taxes on less safe technologies). Tradable permits seem difficult to implement here.

Carbon emissions from vehicles

Solution

1. Yes. I drive my car which emits gases that harm others, whose harm I do not pay for.
1. The Coase Theorem is difficult to apply since it would require assigning property rights to those who are harmed. Since many of the harmed are dispersed (e.g., driving in Charlotte theoretically harms everyone in the world a small amount) and in some cases involves the “unborn” (future generations facing global warming), the feasibility of negotiated private contracts is highly questionable.
1. If we believe that the social marginal benefit curve is flat (horizontal), we would want to price the carbon using a tax. Quantity regulation would require different quantities for each producer of carbon, but each individual has different marginal costs, making this difficult. Perhaps we can also do quantity regulation with tradable permits to address the issue of not knowing the costs.

Your upstairs neighbors throwing an awesome but loud party

Solution

1. Yes, an externality exists, but it may be positive or negative depending on your tastes and preferences.
1. The Coase Theorem would require the neighbors to own rights to holding the party. Then the neighbors would pay other neighbors to have (or not have) the party. This could work (so an answer of “yes” is fine). However, in reality, there are likely many different people affected by the party (e.g., multiple neighbors hate the noise). Bargaining with all parties may allow one party to “hold-up” the others, rendering the Coase theorem inapplicable.
1. The best solution may be a community agreement or regulation regarding noise levels during certain hours.

Buying a car with added safety features that prevent drivers/passengers’ deaths in the event of an accident

Solution

1. It depends. If people drive more recklessly as a result of having a safer car, then buying the safety feature imposes a negative externality on other drivers. If having a safety feature does not change the likelihood of an accident or the impact on other cars, then there is no externality.
1. The Coase Theorem does not apply: it would be incredibly difficult to write a contract with those with whom you may eventually be engaged in a car accident.
1. Quantity regulation (e.g., regulating the safety feature, or preventing it) or taxation would potentially correct the externality. It seems strange, but theoretically we would want to tax the safety feature if it leads to more reckless driving.

Bringing crying babies on a plane

Solution

1. Yes, obviously negative.
1. The Coase Theorem does not apply.
1. One solution could be to tax parents who bring babies on the plane and redistribute that tax to those who are exposed to the crying around the baby on the plane. Airlines could also potentially intervene and lower the ticket price for everyone seated nearby who has to listen to the baby crying (or serve free drinks/snacks when a baby starts crying).

Exercise 15.4 Tax a market failure

The private marginal benefit (PMB) associated with a product’s consumption is given by:

\[ PMB = 360 - 4Q \]

The private marginal cost (PMC) associated with its production is:

\[ PMC = 6Q \]

Furthermore, the marginal (external) damage (MD) associated with this good’s production is:

\[ MD = 2Q \]

Questions:

Calculate how much private production and hence consumption is in a free market.
Calculate the social optimal quantity consumed.
As there is an external effect, the government decides to intervene and correct the externality by imposing a tax of $T$ per unit consumed. What tax should it set to achieve the social optimum?
Can you think of other ways for the government to intervene?

Solution

Private production and consumption in a free market:

To find the quantity produced and consumed in a free market, set PMB equal to PMC:

\[ PMB = PMC \]

\[ 360 - 4Q = 6Q \]

Solving this equation:

\[ 360 = 10Q \]

\[ Q_F^* = 36 \]

Answer: In a free market, 36 units are produced and consumed.
Social optimal quantity consumed:

To determine the socially optimal quantity, we must account for the marginal external damage (MD) by adding it to PMC. The equation becomes:

\[ MD + PMC = PMB \]

\[ 2Q + 6Q = 360 - 4Q \]

Simplifying this gives:

\[ 8Q = 360 - 4Q \]

Solving for (Q_S^*):

\[ 12Q = 360 \]

\[ Q_S^* = 30 \]

Answer: The social optimum quantity of consumption would be 30 units.
Tax to achieve the social optimum:

To determine the required tax (T), set PMB equal to PMC plus tax:

\[ PMB = PMC + T \]

Substituting (Q = 30):

\[ 360 - 4Q = 6Q + T \]

Plugging in (Q = 30):

\[ 360 - 4 \cdot 30 = 6 \cdot 30 + T \]

\[ 360 - 120 = 180 + T \]

\[ T = 60 \]

Answer: A tax of 60 per unit of consumption would ensure that the social optimum quantity of 30 is consumed.
Other regulations:

Other government interventions could include:
- Imposing a direct restriction on the quantity produced or consumed.
- Implementing subsidies for more environmentally friendly production methods.
- Establishing tradeable permits for emissions related to the production of this good.
- Promoting public awareness campaigns about the negative externalities involved.

16 Public goods (PRELIMINARY)

There are many goods that have no market price. These goods include things like nature (e.g., rivers, mountains, beaches, lakes) or government amenities and events (playgrounds, parks, parades). These goods face a different set of economic problems since the normal market forces that provide efficient allocation are absent.

Economic goods can be grouped according to the following characteristics:

Is the good excludable? Excludability: The property of a good whereby a person can be prevented from using it.
Is the good rival in consumption? Rivalry in consumption: The property of a good whereby one person’s use diminishes other people’s use.

Using the above characteristics, it is possible to categorize goods into four categories:

Private goods: Goods that are both excludable and rival in consumption.
- Example: An ice cream cone. It is excludable because you can prevent someone from eating one. It is rival in consumption because if someone eats an ice cream cone, another person cannot eat the same cone.
Public goods: Goods that are neither excludable nor rival in consumption.
- Example: A tornado siren in a small town. It is not excludable because it is impossible to prevent any single person from hearing it when the siren sounds. It is not rival in consumption because when one person benefits from the warning, it does not reduce the benefit to others. Other important public goods are national defense, basic research, and fighting poverty.
Common resources: Goods that are rival in consumption but not excludable.
- Example: Fish in the ocean. It is rival in consumption because when one person catches a fish, there are fewer fish for the next person to catch. It is not excludable because it is difficult to stop fishermen from catching fish from a large ocean.
Club goods: Goods that are excludable but not rival in consumption.
- Example: Fire protection in a small town. It is excludable because the fire department can decide not to save a building from a fire. It is not rival in consumption because once paid for, the additional cost of protecting one more house is small.

Figure 16.1: Matrix of economic goods with examples

Whether governments should provide public goods or not must be the result of a cost-benefit analysis that compares the costs and benefits to society of providing a public good.

Common resources

Common resources are not excludable (like public goods). Unlike public goods, common resources are rival in consumption: one person’s use degrades the resource for others.
Tragedy of the Commons: A parable that illustrates why common resources are used more than is desirable from the standpoint of society as a whole.
- Social and private incentives differ.
- Government can solve the problem through regulation or taxes to reduce consumption.
- Government can also solve the problem by turning the common resource into a private good.
Some important common resources:
- Clean air and water.
- Congested roads.
- Fish, whales, and other wildlife.

Switching between public and private goods

Some goods switch between public and private goods depending on circumstances.
- Example: A fireworks display performed in a town can be a public good. A fireworks display at a private amusement park (e.g., Disneyland) is a private good.
- Example: A lighthouse operated by the government is a public good. A privately owned lighthouse that charges adjacent ports for operation is a private good.

The boundaries between goods are not always clear

The characteristics of being excludable and rival in consumption can be a matter of degree.
Example: Fish in an ocean may not be excludable because of practical challenges in managing ocean stocks. However, government restrictions and a large coast guard can make fish partially excludable.
Public goods and common resources are closely related to externalities; both these goods and externalities result from something valuable having no associated price.
- Example: If an individual builds and operates a tornado siren in a town, the neighbors will benefit from the siren without paying for it (positive externality).
- Example: If an individual uses a common resource such as fish in the ocean, others are worse off because there are fewer fish to catch (negative externality).
Private decisions about consumption and production can lead to an inefficient allocation of resources, and government intervention can potentially raise economic well-being.

16.1 The free-rider problem

Example: A fireworks display. This good is not excludable (you cannot prevent someone from seeing fireworks) and it is not rival in consumption (because one person’s enjoyment does not reduce another’s enjoyment).
Free rider: A person who receives the benefit of a good but avoids paying for it.
The free-rider problem prevents the private market from supplying public goods.
Government is one solution to this problem. If the total benefit exceeds the costs, a government can finance a public good with tax revenue.

16.2 The importance of property rights

There are some goods that the market does not adequately address or provide for (clean air, for example).
Governments are relied on to provide necessary common goods.
Markets cannot allocate resources efficiently without property rights.
Goods that do not have well-established owners lack similar incentives for firms and individual actors.
Well-planned and necessary policies can make the allocation of resources more efficient and raise economic well-being.