An Externality Is an Unintended Consequence of a Choice That Falls on Someone Other Than the Decision-Maker

Home , Factors of production, Marginal cost, Social cost

Externalities may be positive or negative Externalities may arise in consumption or production

Production externalities drive a wedge between the marginal private cost (MC) that is borne by the producer, and the marginal social cost (MSC) that is the total cost to society.

MSC = MC + marginal external cost

The marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

Production and Pollution: How Much? In the market for a good with an externality that is unregulated, the amount of pollution created depends on the equilibrium quantity of the good produced.

Figure 16.2 shows the equilibrium in an unregulated market with an external cost. The quantity produced is where marginal private cost equals marginal social benefit.

At the market equilibrium, MSB is less than MSC, so the market produces an inefficient quantity. At the efficient quantity, marginal social cost equals marginal social benefit. With no regulation, the market overproduces and creates a deadweight loss.

Consumption externalities drive a wedge between the marginal private benefit (MB) that is borne by the producer, and the marginal social benefit (MSB) that is the total cost to society.

MSB = MB + marginal external benefit

The marginal external benefit is the benefit from consuming one more unit of a good or service that falls on people other than the consumer.

A private market will underproduce an item that generates an external benefit and creates a deadweight loss.

Property Rights Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.

One way to look at the market failure that arises in the presence of externalities is that it comes about because of the absence of property rights.

The Coase Theorem The Coase theorem is a proposition that if property rights exist, only a small number of parties are involved, and transactions costs (defined below) are low, then private transactions are efficient. There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights.

To see this, take the example of “the barking dog”.

D owns a dog that barks J is bothered by the dog barking

What is the efficient allocation?

Depends on value of benefit to D of keeping dog compared to cost to J of barking.

© 2010 Pearson Education Canada Benefit to D from owning dog: $500 Cost to J of barking dog: -$800 Total surplus if D keeps dog : -$300 Total surplus if D gets rid of the dog : $ 0 Efficient outcome: J pays D to get rid of the dog

Scenario 1 Suppose D owns the “property right” to let the dog bark. J can offer to pay him to get rid of the dog. She will offer P<$800; he will accept P>500. So he gets rid of the dog - outcome is efficient. Scenario 2 Suppose J owns the “property right” to quiet. D can offer to pay her not to complain about the dog. D will offer P<500; J will accept P>500. No deal. She complains, the dog is removed. The outcome is efficient.

© 2010 Pearson Education Canada This example illustrates the Coase theorem: (1) if property rights exist, only a small number of parties are involved, and transactions costs (defined below) are low, then private transactions are efficient; and (2) the outcome is independent of who has the property rights.

Easy to see (2) in our example. In both scenarios, the dog is not allowed to bark. Does not depend on who has property right. However, the distribution of surplus depends on the property right. When D has the property right, J gets less surplus and D gets more surplus (J pays D to get rid of dog).

What about the first proposition?

© 2010 Pearson Education Canada The Coase solution works only if transaction costs are low. Transactions costs are the cost of conducting a transaction. In our example, the transactions cost would involve negotiating a price between J and D. When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality.

Government Actions in the Face of External Costs There are three main methods that the government uses to cope with external costs:

 Taxes

 Emission charges

 Marketable permits

Taxes The government can set a tax equal to marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost, MC + tax = MSC. This tax is called Pigovian tax, in honor of the British economist Arthur Pigou, who first proposed dealing with externalities in this fashion.

A pollution tax equal to the marginal external cost can achieve an efficient outcome because MSC = MSB. The government collects a tax revenue.

Marketable Permits Each firm is assigned a permitted amount of pollution per period and firms trade permits. The market price of a permit confronts polluters with the marginal social cost of their actions and leads to an efficient outcome.

Government Action in the Face of External Benefits Four devices that the government can use to achieve a more efficient allocation of resources in the presence of external benefits are

 Public provision

 Private subsidies

 Vouchers

 Patents and copyrights

Public Provision Under public provision, a public authority that receives payment from the government produces the good or service. Figure 16.7(a) shows how public provision can achieve an efficient outcome.

Private Subsidies A subsidy is a payment by the government to private producers. If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced is efficient.

Figure 16.7(b) shows how a subsidy can achieve an efficient outcome.

Vouchers A voucher is a token that the government provides to households, which they can use to buy specified goods or services. Figure 16.8 shows how vouchers can achieve a more efficient outcome.

Patents and Copyrights Intellectual property rights give the creator of knowledge the property right to the use of that knowledge. The legal device for establishing an intellectual property right is the patent or a copyright. A patent or copyright is a government-sanctioned exclusive right given to an inventor of a good, service or productive process to use to produce, use and sell the invention for a given number of years.

What is the essential difference between:

 A city police department and Brinks security

 Fish in the Atlantic Ocean and fish in a fish farm

 A live concert and a concert on television These and all goods and services can be classified according to whether they are excludable or nonexcludable and rival or nonrival.

Excludable A good is excludable if only the people who pay for it are able to enjoy its benefits. Brinks’s security services, Cooke Aquaculture’s fish, and a U2 concert are examples. Nonexcludable A good is nonexcludable if everyone can benefit from it regardless of whether they pay for it. The services of the Calgary police, fish in the Atlantic Ocean, and a concert on network television are examples.

Rival

A good is rival if one person’s use of it decreases the quantity available for someone else.

A Brinks’s truck can’t deliver cash to two banks at the same time. A fish can be consumed only once.

Nonrival

A good is nonrival if one person’s use of it does not decrease the quantity available for someone else.

The services of the Calgary police and a concert on network television are nonrival.

A Four-Fold Classification Private Goods A private good is both rival and excludable. A can of Coke and a fish on Cooke’s Aquaculture farm are examples of private goods. Public goods A public good is both nonrival and nonexcludable. A public good can be consumed simultaneously by everyone, and no one can be excluded from its benefits. National defence is the best example of a public good.

Common Resources A common resource is rival and nonexcludable. A unit of a common resource can be used only once, but no one can be prevented from using what is available. Ocean fish are a common resource. They are rival because a fish taken by one person isn’t available for anyone else. They are nonexcludable because it is difficult to prevent people from catching them.

Natural Monopolies (don’t focus on this) In a natural monopoly, economies of scale exist over the entire range of output for which there is a demand. A special case of natural monopoly arises when the good or service can be produced at zero marginal cost. Such a good is nonrival. If it is also excludable, it is produced by a natural monopoly. The Internet and cable television are examples.

Figure 17.1 shows this four- fold classification of goods and services.

The Free-Rider Problem A free rider enjoys the benefits of a good or service without paying for it.

Because no one can be excluded from the benefits is a public good, everyone has an incentive to free ride.

Public goods create a free-rider problem—the absence of an incentive for people to pay for what they consume.

The value of a private good is the maximum amount that a person is willing to pay for one more unit of it. The value of a public good is the maximum amount that all the people are willing to pay for one more unit of it. To calculate the value placed on a public good, we use the concepts of total benefit and marginal benefit.

Marginal Social Benefit of a Public Good Total benefit is the dollar value that a person places on a given quantity of a good. The greater the quantity of a good, the larger is a person’s total benefit. Marginal benefit is the increase in total benefit that results from a one-unit increase in the quantity of a good. The marginal benefit of a public good diminishes with the quantity of the good provided.

Figure 17.2 shows that the marginal social benefit of a public good is the sum of marginal benefits of everyone at each quantity of the good provided. Part (a) shows Lisa’s marginal benefit. Part (b) shows Max’s marginal benefit.

The economy’s marginal social benefit of a public good is the sum of the marginal benefits of all individuals at each quantity of the good provided. The economy’s marginal social benefit curve for a public good is the vertical sum of all individual marginal benefit curves.

The marginal social benefit curve for a public good contrasts with the demand curve for a private good, which is the horizontal sum of the individual demand curves at each price.

The Marginal Social Cost of a Public Good The marginal social cost of a public good is determined in the same way as that of a private good. The Efficient Quantity of a Public Good The efficient quantity of a public good is the quantity that at which marginal social benefit equals marginal social cost.

Figure 17.3 illustrates the efficient quantity of a public good. With fewer than 2 satellites, MSB exceeds MSC. Resources a can be used more efficiently by increasing the quantity.

With more than 2 satellites, MSC exceeds MSB. Resources can be used more efficiently if fewer satellites are provided. So the quantity at which MSB = MSC, resources are used efficiently. Private production would produce 0 satellites.

Efficient Public Provision Because the government can tax all the consumers of the public good and force everyone to pay for its provision, public provision overcomes the free-rider problem. If two political parties compete, each is driven to propose the efficient quantity of a public good. A party that proposes either too much or too little can be beaten by one that proposes the efficient amount because more people vote for an increase in net benefit.

The Tragedy of the Commons The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. Examples include the Atlantic Ocean cod stocks, South Pacific whales, and the quality of the earth’s atmosphere. The traditional example from which the term derives is the common grazing land surrounding middle-age villages.

Sustainable Production Sustainable production is the rate of production that can be maintained indefinitely. This production rate depends on the existing stock of fish and the number of boats that go fishing. For a given fish stock, as more boats go fishing, the quantity of fish caught increases. But with too many boats fishing, the quantity of fish caught decreases.

Table 17.1 illustrates the number of boats and the quantity if fish caught. As the number of fishing boats increases, the quantity of fish caught increases to some maximum. Overfishing occurs when the maximum sustainable catch decreases.

Table 17.1 also shows the average and marginal catch depends on the number of boats that go fishing. As the number of fishing boats increases:  The average quantity of fish caught decreases.  The marginal catch decreases.

Figure 17.6 illustrates the sustainable production of fish. As the number of fishing boats increases, the quantity of fish caught increases to some maximum. Overfishing occurs when the maximum sustainable catch decreases.

An Overfishing Equilibrium Figure 17.7 shows why overfishing occurs. Marginal private benefit, MB, is the average catch per boat. Marginal private benefit decreases as the number of boats increases. The marginal cost per boat is MC (assumed constant).

The Efficient Use of the Commons The quantity of fish caught by each boat decreases as the number of boats increases. But no one has an incentive to take this fact into account when deciding whether to fish. The efficient use of a common resource requires marginal social cost to equal marginal social benefit.

Marginal Social Benefit Marginal social benefit is the increase in the total fish catch that results from an additional boat. Marginal social benefit equals the marginal catch of a boat, not the average catch per boat.

Efficient Use Figure 17.8 shows the marginal private benefit curve, MB, and the marginal social benefit curve, MSB. With no external costs, the marginal social cost MSC equals marginal cost MC. Resources are used efficiently when MSB equals MSC.

Achieving an Efficient Outcome It is harder to achieve an efficient use of a common resource than to define the conditions under which it occurs. Three methods that might be used are

 Property rights

 Production quotas

 Individual transferable quotas (ITQs)

Property Rights By assigning property rights, common property becomes private property. When someone owns a resource, the owner is confronted with the full consequences of her/his actions in using that resources. The social benefits become the private benefits. But assigning property rights is not always feasible.

Production Quotas By setting a production quota at the efficient quantity, a common resource might remain in common use but be used efficiently. Figure 17.9 shows this situation. It is hard to make a production quota work.

Individual Transferable Quotas An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer (sell) the quota to someone else. A market in ITQs emerges. If the efficient quantity of ITQs is assigned, the market price of an ITQ confronts resource users with a marginal cost of MC + price of ITQ. With MC + price of ITQ equal to MSB, the quantity produced is efficient.

Figure 17.10 shows the situation with an efficient number of ITQs. The market price of an ITQ increases the marginal cost to

MC0 + price of ITQ. Users of the resource make MB equal

MC0 + price of ITQ, and the outcome is efficient.

Public Choice and Political Equilibrium It is easy for economists to agree that ITQs make it possible to achieve an efficient use of a common resource. It is difficult to get the political marketplace to deliver that outcome. In 1996, Congress killed an attempt to use ITQs in the Gulf of Mexico and the Northern Pacific Ocean. Self-interest and capture of the political process sometimes beats the social interest.