Externalities

In the presence of externalities the market eq. is not pareto efficient

An externality is present whenever some economic agents welfare includes real
variables whose values are chosen by others without particular attention to the effect
upon the welfare of other agents they affect
Or whenever there is insufficient incentive for a potential market to be created for
some good

Simple Model

2 agents : A and B , 2 activities x and y

A : U = A(x) and B : V = B(y) S (x,y)
x has a harmful effect on Bs utility
For efficiency max A subject to the constraint that the U of B V0 :
Max : A(x) + ( B(y) S (x,y) - V0 ) and get the following FOCs:
Ax(xE )- Sx(xE,yE) = 0 and By( yE )- Sy(xE,yE) = 0
When under no-liability each agent max U w.r.t production and A plays his dominant
strategy and B reacts accordingly:
FOCs: Ax(xN) = 0 and By(yN) Sy(xN,yN) = 0
Therefore A overproduces and B underproduces in this situation
When under strict-liability A must pay for the full externality , and now B plays his
dominant strategy
FOCs: Ax(xL)- SX(xL,yL) = 0 and By ( yL ) = 0
Therefore A underproduces and B overproduces in this situation

Coase Theorem: Property Rights

B has property rights and therefore A has to pay B to pollute (p)

Note in eq. xs=xD=xE
Max Supply : A(x) - pxs
Max Demand : B(y) S(x,y) + pXD
FOCs: A: Ax ( xS) p = 0 ,
FOCs: B: By(y) Sy(xD,y) , B: -Sx (xD , y) + p
From these we get the following first best solution with property rights:
Ax(xE) = Sx(xE,yE) and By(yE) = Sy(xE,yE)
However , there is empirically a lack of such market solutions because of the
complexity of property rights and high transaction costs and asymmetric information ,
there is therefore a need for the govt to intervene

Pigovian Taxation

Govt levies a tax (t) on the polluting activity (x)

A:max A(x) tx , B:max B(y)-S(x,y)
FOCs: Ax(x) t = 0 and By(y) Sy(x,y) = 0

When the tax is equal to the marginal damage of As production the inefficiency is
solved and therefore the tax is Pigovian when : t = Sx(xE,yE)

2 polluters model

C produces z which enters as a negative externality for B

Max : A(x) + ( B(y) S (x,y,z) V0) + ( C(z) W0)
FOCS: Ax(xE) - Sx (xE,yE,zE) = 0
By(yE) - Sy(xE,yE,zE) = 0
Cz(zE) - Sz(xE,yE,zE) = 0
tA and tC are Sx (x,y,z) and Sz(x,y,z) respectively
If only the aggregate externality ( sum of x and z) matters Bs U fn is :
V=B(x) S(y, x+z)
Therefore Sx (y,x+z) = Sz(y,x+z) therefore tA = tC