CHAPTER 5

Externalities: Problems and Solutions

Externalities
An externality exists if there are costs incurred or benefits received by those outside the market transaction External costs = Negative Externality External benefits = Positive Externality
Note about pecuniary externalities

Market Inefficiencies with Externalities

Market transactions result in PMB = PMC Negative Externalities: SMC = PMC + MEC; SMB = PMB SMC > PMC; implies SMC > SMB Positive Externalities: SMB = PMB + MEB; SMC = PMC SMB > PMB; implies SMB > SMC Markets do not max. Social Welfare in these cases Note: MEC = MD; MEB = MB

Coase Theorem
Markets will provide efficient outcomes in the case of externalities if: Property rights are clearly defined Bargaining costs are low Damages to property rights can be identified at the source

Potential problems with Coase Thm.

Assignment problem exists if damages cannot be

clearly identified at their source Holdout problems can arise if there are multiple agents suffering damages the last to negotiate can holdout for a better deal market power Free rider problems exist if it is difficult to enforce bargaining solutions among multiple agents Bargaining costs may be high with multiple agents Some property rights are difficult to assign

Strategic Mergers
With firm-on-firm externalities: The externality becomes internalized if the two firms merge

Coase theorem and strategic mergers provide two examples where externalities can be corrected without the need for direct government intervention

Government Actions
Direct Regulation Mandating restrictions to address negative externalities Mandating consumption to address positive externality
Advantage: potentially fast policy response

Disadvantage: tends to be inefficient

Government Actions
Pigouvian taxes to act as a proxy for MEC SMB = SMC SMB = PMC + MEC Optimal tax = MEC SMB = PMC + t = SMC Problems Slow phase-in to find optimal tax Tax on output does not encourage greener tech. Tax on pollution would be preferred if feasible

Government Actions
Pigouvian subsidies to act as a proxy for MEB SMB = SMC PMB + MEB = SMC Optimal subsidy = MEB SMB = PMB + s = SMC Problems Slow phase-in to find optimal subsidy

Government Actions
Cap-and-Trade; Tradable Permits Define the target level of pollution Issue/Sell pollution permits equal to target Allow trading of permits; trade results in efficient allocation; faster response than pig. taxes. Problems May be impractical with large # of polluters May be impractical with consumption externalities May result in hot-spots