Externalities

& Common Property

Externalities
Externality: cost/benefit imposed upon someone by actions taken by others
o Cost/benefit generated externally to the someone
o Positive externality: externally provided benefit
Ex. well-maintained property next door that raises market value of your property
Pleasant cologne worn by the person seated next to you
Vaccinations against contagious diseases
Scientific advance
o Negative externality: externality imposed cost
Ex. air / water pollution, loud parties next door, traffic congestion, 2 nd hand smoke
Externalities and Efficiency
Externality impacts a third party
o Someone who is not a participant in activity that produces the external cost/benefit
o Someone EXTERNAL to the activity
Externalities:
o Occurs whenever the activities of on economic agent affects the activities of another agent in
ways which are NOT taken into account by operation of market
Many activities have effects that would NOT be considered externalities
If I buy a large amount of wheat in market price of wheat could rise (cause
excess demand) ; affecting activities of other agents
MARKET effect price rise
Externalities and Efficiency
Externalities cause Pareto inefficiency;
o Too much scarce resource allocated to an activity causes ve externality
o Too little resource is allocated to an activity cause +ve externality
When externalities are harmful to 3rd parties -ve externalities
(ex. pollution , costs are borne by outsiders
o competitive market w/ -ve externally free market produces too much of the good
cost of supplying good that is not borne by suppliers private cost used in output
decisions is too small
true MC to all agents in society includes costs borne by those external to the
market for the good
when externalities are beneficial to third parties +ve externalities
(ex. vaccinations, fewer carriers of disease)
o competitive market w/ +ve externality free market produces too little of the good
when there is a benefit to those others than primary consumers (buyers)
Marginal Social Benefit > Marginal Private Benefit

*Externalities
externality: consequence of improper specification of property rights
o farmer chooses to let his land produce whatever plants naturally occur (doesnt plow, fertilize,
maintain it) will end up with crops of weeds = low/0 value
o entirely within farmers right as long as the property right is helped by the farmer
o if farmer chooses to apply chemical fertilizer (leaches into body of water) causing damage
to neighbors land
Externality occurs because the property right to the body of water is NOT FULLY
SPECIFIED
Externalities are mostly due to improper specification of property rights
Positive Externalities

Apples and Bees Example

o 2 farmers side by side
A: apple tree and sells apples
B: bee0kepper and sells honey
o can be done using reciprocal +ve externalities
bees provide pollination services to A simplify w/1-way +ve externality:
nectar from apple-blossoms are an input to production of honey
A expects 10 baskets of apples from each tree
o total revenue depends n # of apple trees (linear function more trees more apples)
o cost of maintaining (non-linear of # of trees)
o profit function:
T = # of trees
PA = market price of basket of apples
B profit depends on # of bee-hives he keeps + # of trees kept by A
o LOGIC:
More trees more apple blossoms more nectar more honey
o Profit:

B = # of bee-hives maintained
T = # of trees next-door
PH = price of bee-hives production of honey
controls B, # of bees/hives maintained
depends on # of apple trees, not controlled by B
depends on # of bees CONDITIONAL on # of trees
A determines # of trees to maintain by getting marginal benefit of another tree (marginal revenue
product) with MC of another tree
o slope of profit = 0

o optimal # of trees for A alone = linear for price of apples

B determines # bee-hives to maintain by equating MB with MC of another bee-hive
o MR depends on # of trees next door

Outputs arent socially optimal (not pareto-optimal)

o A ignore external benefit of apple blossoms for honey production b/c HE HAS NO PROPERTY
RIGHTS TO NECTAR
o pareto-efficient determined farmers merging
change in either will reduce profit
differentiate combined profit w.r.t T
and set = 0
socially optimal # trees:

differentiate w.r.t B

optimal Q from social perspective of apple trees is LARGER

than private

Coase Theorem
possible solution to externalities

suggest no need for govt intervention dont need third party involvement as long as 2 conditions
satisfied:
1st:
o property right must be well-defined
ex. who owns apples, who owns nectar produced by apple blossoms
2nd:
o no significant costs to transacting/bargaining
if both conditions satisfies externality can be internalized through side payments (bribes)
is transaction = costly Coase solution cant be implemented appeal to outside agency
analysis of economics of contract law begins with Coase
o ex. prices of apples, honey can compute side payment made to compensate A for
maintaining more trees than would be consistent with maximizing apples profit alone
Pa ($ of basket of apples) = $6
Ph ($ of hives worth of honey) = $10
Sub apple $ into expression for optimal # of trees
o T*private = 5 x Pa = 5 x 6 = 30
o B*private = 0.05 x Ph x T*private = 0.05 x 10 x 30 = 15

Separate Profits
Compute stand-alone/ private profits of each of 2 farmers:

Merged Profits

Side Payment
bee-keepers
o revenue increases from $450 to $800 ($350)
o cost increases from $225 to $400 ($175)
o profit rises $175
apple-grower (privately) worse off:
o revenue from apples increased from $1800 to $2400 (600)
o cost increases from $900 to $1600 (700)
o profit falls by $100
2 farmers separately will not reach optimal (surplus-max) activity levels
Externalities and Property Rights
externality viewed as a purely public commodity only if:
o consumed by everyone (nonexcludability)
o everybody consumer the entire amount of commodity (nonrivalry in consumption)
o ex. broadcast television program
Inefficiency and Negative Externalities
two agents A & B ; 2 commodities money & smoke
smoke and money good for agent A
money is good and smoke is bad for B
smoke = purely public commodity

agent A = endowed with $yA

agent B = endowed with $yB
Smoke intensity is measured on scale from 0 to 1(max
concentration)

What are the efficient allocations of smoke and money?

Suppose there is no means by which money can be exchanged for changes in smoke level
o What is As most preferred allocation?
o Is this allocation efficient?

o
o

Bs most preferred allocation?

Allocation efficient?

If A and B cannot trade money for changes in smoke intensity outcome = inefficient
o Either too much smoke (As most preferred choice)
o Too little smoke (Bs choice)

Externalities and Property Rights

Coases insight is that most externality problems are due to an inadequate specification of property
rights &
an absence of markets in which trade can be used to internalize external
costs/benefits
Internalizing the externality: causing producer of externality to bear full external cost/ enjoy full
external benefit
Neither A nor B owns air in their room
o What happens if this property right is created and is assigned to one of them?
Suppose B assigned ownership of air in room can now sell rights to smoke
Will there be smoked? How much? And what price for this amount of smoke?
p(sA) = price paid to agent A to agent B in order to create a smoke intensity of s A

suppose A assigned ownership of air

o B can now pay A to reduce
smoke intensity
How much smoking will
there me? How much $
will B pay A?

Agent given property right better off than at her own most preferred allocation in absence of
property right
Amount of smoking that occurs in equilibrium depends upon which agent is assigned the property
right

Other Utility Functions and Their Indifference Curves

linear in just x2 quasi-linear
ex.
MRS for Quasi-Linear Utility Functions

A quasi-linear utility function is of the form

MRS = -f(x1) does not depend upon x2 so the slope of indifference

curves for a quasi-linear utility function = constant along any line for
which x1 is constant
What does that make indifference map for quasi-linear utility function
look like?

Externalities and Property Rights

is there a case in which the same amount of smoking occurs in
equilibrium no matter which agent is assigned ownership of the air in the room?
o Yes if the MRS is independent of each agents money
Ex. If each agent is willing to pay an identical amount of money to (smoke/reduce
smoking) irrespective of that agents wealth
Both agents: MRS = constant as $ changes, for given smoke intensity/ preferences must be quasi-linear in $

Coases Theorem
If all agents preferences are quasilinear in money, then efficient level of externality generating
commodity is produced no matter which agent is assigned the property right
Coase & Pigou
Coase: showed that IF:
o All affected partied could be identified
o Property rights well-specified
o Bargaining is costless
Then externality could be internalized through side payments
Pigou:
o All affect parties cannot bet identified
o If right not perfectly specified
o Transacting is costly
Central rep (govt) can as at:
Payer of side payments (subsidize +ve externality)
Recipient of side payments (impose tax on activity causing ve externality)
Pigou
Example 1 Proposal of Carbon Tax on CO2 emissions
o Carbon emissions impose costs on outsiders; a tax per unit emitted (Assuming the
monitoring problem can be solved) forces polluters to internalize these costs
Example 2 City of Waterloo subsidy of rain barrels for homeowners
o Use of water from municipal system for gardens imposes costs on al Waterloo users
o use of rain barrels reduces demand n water system, can save $ (volume charge or fixed
charge through property tax) --- subsidy to users of rain barrels encourages their use
Coase, Pigou, and Negative Externalities
ex of negative externality
o river on the banks there are 2 firms Upstream & Downstream
o profit of upstream firm, as a function of its activity level (output):
profit harmed by Upstream firm
o ex. upstream firm discharges some substance into the river water which must be removed,
through a costly kind of treatment, by downstream firm before the water can be used in the
downstream firms production process
no upstream water would not have to be treated treatment cost borne by downstream is direct
result of the activity of upstream firm
downstream firms profit function:
o depends on both its own activities,
which it controls
level of activity (output) of the upstream (downstream has no control)
optimal(profit-max) output of UPSTREAM
o considers ONLY its own production cost MR = MC (slope of profit function =0)

optimal output of DOWNSTREAM

o
o
o

MR = MC (slope of profit function = 0)

Qu disappears from differentiation
Downstream doesnt choose upstream firms output cost of cleanup is not in their control

Surplus-max (pareto-efficient, socially optimal)

o Assume that the 2 firms merge and max a joint profit function of 2 outputs

can separate Qu, Qd

partial derivatives of profit function = derivatives of 2 component functions:
o
o

Socially optimal level of downstream output is unchanged at 25:

Socially optimal level of upstream output falls from 30 to 20:

WHEN MERGED PROFITS = MAXIMIZED

o Upstream takes account of ALL costs of production (including downstream cost of cleaning)
Profits maximized in isolated (not merged)
o Cost considered by upstream = private (ignores cleanup costs)
Example external cost
o When external cost is ignored upstream produces TOO MUCH output

Negative Externalities

private marginal cost output is 2*Qu

social marginal cost of upstream firms
private marginal cost (2Qu) & marginal cost
of damage imposed on downstream firm
(Qu) Social marginal cost of upstream
output (3Qu)
which firms has property right to river?
o Coase-type world of 0 transactions
cost
Doesnt matter who owns it

To see:
o Give property right to downstream firm
Can charge upstream firm for using water
Downstream owns river and can sell its services for whatever $ it chooses
What price? (goal is surplus max)

Marginal private cost = 2*Qu

MC at Qu = 20 (socially optimal) = $40
Marginal social csot = 3*Qu
MC at Qu = 20 (socially optimal) = $60
At socially optimal output the MCext = $20 marginal cost that firm ignores
o If downstream firm charges $20 for every unit of discharge emitted by upstream firm
upstream firm will have incentive to produce socially optimal output
* giving ownership to downstream firm CAN solve externality problem
and induce upstream firm to produce socially optimal output

Alternate Ownership
Upstream owns river
Downstream could pay upstream to reduce its production
Marginal (external) damage on downstream firm $20/unit of output
o Downstream pay upstream license fee that allows downstream to operate river
o Pays license fee of $600, fee reduced by $20 for every unit of upstream output produced
Upstream profit function
o Receives revenue from 2 sources selling output that it produces and fee income from
downstream firm
o Collects $600 less $20 for every unit or produces

Upstream optimal private output MR = MC (slope of profit

function = 0
Optimal output again = 20 pareto-efficient
Doesnt matter which firm owns river
o SOMEBODY has property right not who