An externality is the direct effect of the actions of one person or firm on the welfare of another person or firm, in a way that is not transmitted by market prices.
18.1 Externalities and Efficiency
If the market for a commodity is missing, we cannot rely on market forces to provide it efficiently. The “missing market” interpretation of an externality is important because it allows us to focus on the reason why externalities can lead to inefficiencies. No one owns the air, and therefore people can use it for free. If someone owned clean air and could charge a price for its use, then a market for it would emerge and there would be no efficiency problem.
These are four characteristics of externalities:
1. They can be produced by individuals as well as firms.
2. There is an important reciprocal aspect to externalities. (Person 1 feels it is their “right” to smoke indoors, while Person 2 feels they have a “right” to smoke-free air.)
3. Externalities can be positive or negative. You may plant a flower garden that is a positive externality for others.
4. Zero pollution is not, as a general rule, socially desirable.
Private Cost versus Social Cost
The social marginal cost is the incremental cost of production which includes the opportunity cost of scare resources, whether priced or not.
In the absence of any intervention, the output is at the intersection of the demand and supply curves. However, because the externality leads to marginal damages, the social marginal cost is greater than the private marginal cost (which is embodied in the supply curve). Efficiency requires that a lower amount be produced at a higher price (equal to where the social marginal cost curve crosses demand).
18.2 Responses to Externalities
One way to solve the problems posed by an externality is to “internalize” it by combining the involved parties. If two firms causing externalities on each other worked together, than the overall benefits would be higher – when the decisions are brought under one firm, these benefits can be gained.
School children are taught that littering is not “nice.” People are taught the golden rule – “do unto others as you would have others do unto you.” These moral precepts help to internalize externalities that individual behavior may create.
Bargaining and the Coase Theorem
As long as the amount that Firm A is willing to pay Firm B (marginal damages – MD) exceeds the cost to Firm B of not producing (marginal revenue minus private marginal cost), then the opportunity for a bargain exists.
The Coase Theorem states that assuming there are no bargaining costs, once ownership rights to a resource are established, individuals with bargain their way to an efficient use of the resource.
Reasons for Failure of Negotiations
Costs of Bargaining: When many people are the victims of pollution, there may be a problem of free-riders when a negotiation would take place. We can use the tools of game theory to explore this phenomenon. Each person can decide to either negotiate or not – if person 1 does not negotiate, but person 2 does, then person 1 gets all of the benefits of negotiation with none of the costs (free-riding). The dominant solution for any individual is not to participate in negotiations.
Difficulty in Identifying Sources of Damages: It can be hard to identify the source of the damages to property and to legally prevent damages.
Asymmetric Information: When everyone’s preferences and opportunities are common knowledge, negotiations can lead to an efficient solution. If this is not the case, bargaining may be expensive, take a long time, and ultimately be unsuccessful.
Government Responses to Externalities
If individuals’ marginal benefit schedules differ, then a regulation requiring that everyone cut back by the same amount is inefficient.
A Pigouvian tax is a tax levied upon each unit of pollution in an amount just equal to the marginal damage it inflicts upon society at the efficient level of output.
A Pigouvian tax forces firms to take into account the costs of the externality that they generate, and hence induces them to produce efficiently. However, it requires the answers to several potentially difficult questions: Which activities produce pollutants? Which pollutants do harm? What is the value of the damage done?
Creating a Market
An effluent fee is the price paid for permission to pollute. When the government auctions off pollution rights, the supply curve is perfectly inelastic. Firms that are not willing to buy permission to pollute at this price must either cut output or change their technology.
18.3 Public Goods
A public good is a commodity that is non-rival in consumption. The fact that one household partakes in the good does not diminish the benefits received by other households. (e.g. National defense)
Efficient Provision of Public Goods
Group willingness to pay for a public good is found by vertical summation of demand curves. At the efficient level of the public good, the sum of the marginal rates of substitution equals the marginal rate of transformation.
Because everybody must consume the same amount of the public good, its efficient provision requires that the total valuation they place on the last unit provided – the sum of the MRSs – equal the increment cost of society producing it – the MRT.
Impure Public Goods
An impure public good is a commodity that is somewhat nonrival in consumption. (Reading room of a library, highways that get congested.)
Market Provision of Public Goods
A nonexcludable good is a good for which preventing consumption is prohibitively expensive. A nonexcludable public good is simply a kind of positive externality. Because of the opportunity to free-ride, there is a good chance that the market will fall short of providing the efficient amount of the public good.
Even if a public good is excludable, private provision is likely to lead to efficiency problems. This is because full discrimination is not possible – therefore the same price has to be charged to everyone. Some people with low, but positive values on the good will not be able to buy it.
Responses to the Public-Good Problem
People do not always act as free riders. People donate money to many different causes.
Simply because a commodity is provided by the public sector, does not mean it meets the definition of a “public good.” There are many cases of publicly provided private goods – rival commodities that are provided by governments. Examples are housing and medical services.