Externalities and Public Goods

Contents
 Externalities
 Common property resources
 Public goods

 These provide numerous examples where the market

may not work. We try to see why not, and what
remedies may be available.
 Externalities
 Externalities exist when behavior of economic agents
has an effect on the utility or profit of another agent,
and the affected agent does not pay, or is not paid,
for the effects.
 The external effect does not pass via the price
mechanism (e.g. a new shop reduces profits of
existing shops, but via a drop in demand for the
latter). This is not an externality.
 Externalities may be beneficial (a tidy garden) or
detrimental (cigarette smoke)
 Externalities may be producer-producer, consumer-
consumer, producer-consumer or consumer-producer
 Steel mill and fishery example
 Externalities usually result in a Pareto-inefficient
outcome
 E.g. a steel mill pollutes a river in which there is a
fishery
 Define:
 x - quantity of pollution
 B(x) - benefit to the steel firm of polluting at level x
(cost reduction of not having to clean up its pollutant)
 D(x) - damage to fishery (loss of profits) due to
pollution of level x
 B’(x), D’(x) - marginal benefit and damage functions
 Basic externality diagram
B’(x) D’(x)
D’(x) B’(x) Marginal
damage
curve

Marginal benefit
curve

0 x* xs x
xF

Restrictive Permissive
Optimum
solution solution
 Optimal solution
 Neither the permissive nor restrictive regime is
Pareto efficient
 xS → x* yields gain of c + d to fishery, loss of c to
steel firm, overall gain d (potential Pareto
improvement)
 xF → x* yields gain of a + b to steel firm, loss of b to
fishery, overall gain a.

B’(x) D’(x)

a d

b c
0 xF x* xs x
 Optimal solution lies at x* where B’ = D’ and there are
no more gains to be made
 PPI means the gainers could potentially compensate
the losers. This may be difficult, e.g. if it is hard to
identify the polluters and sufferers.
 Political solution might differ - a single polluter may
be able to lobby the government/regulator more
effectively than than many individual sufferers
 The Coase theorem
 Because a PPI exists, both sides have an incentive to
trade
 Starting from xS, the fishery is willing to pay D’(xS) to
the steel firm to encourage it to reduce its pollution by
1 unit.
 The cost of this to the steel firm is B’(xS) < D’(xS)
 Hence both sides should voluntarily agree to this
 This opportunity persists as long as B’(x) < D’(x), i.e.
until x* is reached.
 A similar argument applies, starting from xF, except it
is the steel firm paying the fishery.
 The Coase theorem says that whatever the initial
situation regarding property rights, the same
equilibrium outcome occurs.
 What differs is the distribution of income. The steel
firm would be better off if the initial position were xS,
the fishery better off starting at xF.
 Property rights therefore are valuable.
 Starting from xS the fishery will pay an amount
between c and c+d (depending upon their negotiating
strengths). From xF the payment is between b and
a+b (from steel mill to fishery).
 The externality could be thought of as a problem of
non-existence of markets
 Caveats to Coase theorem
 Initial property rights may not be well defined (is there
a right to smoke in pubs?)
 It may be costly to establish those rights
 Negotiation may be costly (e.g. many participants)
 Compensation by steel firm may encourage more
‘pollutees’ to appear (i.e. people set up fisheries to
obtain compensation). Pollutees might exaggerate
their suffering. The free rider problem.
 Compensation by fishery may encourage initial
increase in pollution by steel firm, in order to be paid
more to reduce it! (Example of farmers increasing
cultivated land in order to get EU payments to stop.)
 Not incentive compatible
 Government intervention
 Standards, taxes or transferable allowances
 Set the Pigovian tax at a level t = B’(x*) = D’(x*) - this
assumes we know B’(x*)
 The private optimum for the steel firm moves from xS
to x*

B’(x) D’(x)
t

0 xF x* xs x
 However…
 The fishery can now bribe the steel mill away from
the Pareto optimum, to x’!
 Have to rule out post-tax negotiation

B’(x) D’(x)
t

0 xF x’ x* xs x
 Standards
 Alternative to the tax is to set a standard (maximum
pollution level) of x*
 Both tax and standard, B’(x) D’(x)
if set at the right levels
lead to the social
optimum, x*
 Firm prefers the
standard as it pays less 0
x F x* xs x
than under the tax.

standard
 Why firms prefer standards

B’(x) D’(x)
Tax
revenue
(tax regime
only)
0 xF x* xs x

Loss of benefit
(both tax and
standard)
 Firm may also prefer standards because:
 they have more influence over the level of the standard
(technical knowledge)
 standard may be better at keeping entrants out of the
market
 Governments ought to prefer taxes because they
bring in revenue, but often prefer standards because
they allow greater patronage and political influence.
 (Lawyers also prefer standards - it adds to job
opportunities...)
 Tradable allowances
 Government creates x* allowances and sells them (or
gives them) to firms.
 Market clearing price would be p = B’(x*)

B’(x) D’(x)

0 xF x* xs x
 Equivalence of methods
 Taxes, standards and tradable permits all achieve the
goal of arriving at the optimum x*
 The differences lie in the distributional outcomes
 However, this is in a world of certainty. Weitzman (R
Ec Studs, 1974) analysed the relative merits of price
vs quantity controls where there is uncertainty.
 Assume uncertainty over the clean up cost
(equivalent to B’(x), the cost avoided by the polluter)
 Case 1: standard preferred
D’(x)
S

T
t* Actual schedule
B’(x)+h
B’(x) Expected schedule
0 x* xt x

Agreed Revised Chosen level

standard optimum under tax t*

 S - welfare loss (relative to optimum) under standard

 T - welfare loss under tax
 T > S ⇒ standard preferred
 Case 2: tax preferred
D’(x)
S

T
t* Actual schedule
Expected schedule

0 x* x

Agreed Revised Chosen level

standard optimum under tax t*

 S - welfare loss (relative to optimum) under standard

 T - welfare loss under tax
 T < S ⇒ tax preferred
 Relative slopes matter
 More on taxes vs standards
 Standards do well when it is important to be near the
optimum (i.e. D’ is steep and punishes deviations)
 Taxes do well when D’ is shallow - having the ‘wrong’
tax rate does not matter too much
 ‘Stock’ pollutants (where it is the stock of pollutant that
matters not the annual flow) are likely to have shallow
D’ curves, hence a tax is preferred.
 Tax has other advantages - if there are several
polluters, the tax deals easily with all of them.
 Transferable permits are like standards, but with a
varying price (tax). The outcome would be like a
standard, but government tax revenue would vary.
TPs can also deal with differing abatement (clear-up)
costs. Those firms which can do it most cheaply do
so, then sell their permits to others with higher costs.
 Common property resources
 Another example of an externality and market failure
 Examples:
 fishing in a common pool
 two companies extracting oil from a common reservoir
 local authorities competing for grants from a fixed pool
 grazing of common land
 polluting the atmosphere
 A frequent result is over-use of the free common
property resource (the sea, the atmosphere, etc.)
 Lack of property rights is a fundamental problem
Common property resources (e.g. fishing)
Catch
Y = f(X)
f(Xe)

f(X*)
Slope = p, price
Cost
of X (in terms
of fish). (Think of
p as the price of a
fishing vessel.)
Profit

X* Xe fishing
Free entry effort, X
Maximum profit effort level
effort level (zero profits)
 Formal derivation
Y = f (X ) f ' > 0, f " < 0
x f (X )
yi = i Firm’s i’s output share
X
x f (X )
πi = i − pxi (Price of fish = 1)
X
 Assume free entry, hence π = 0
xi f ( X )
πi = − pxi = 0
X
f (X ) (NB. X varies to ensure this equality.
⇒ p=
X p is exogenous.)
 Price = average product (effort level = Xe)
 f’(Xe) < 0 possible
 Maximising joint profit (net social benefit)
π = f ( X ) − pX
dπ
= f '− p = 0 ⇒ p = f ' ( X ) (Effort level X*)
dX
 Factor price = marginal product
 Free entry equilibrium has greater effort and
(probably) catch than profit maximising effort and
catch
 This is due to an externality - a new entrant makes
profits but decreases the profits of all others by
entering the market
 NB A monopolist is the conservationist’s best friend!
 Alternative derivation of free entry equilibrium
xi f ( X )
πi = − pxi = 0
X
dπ i f ( X ) xi f ( X ) xi f ' ( X )
= − 2
+ − p=0
dxi X X X
 NB X = x1+ x2 +… etc. Have to assume Cournot
conjectures, i.e. dxj/dxi = 0.
 At the symmetric solution, xi/X = 1/N, hence
f (X ) 1  f (X ) 
−  − f ' ( X ) = p
X N X 
 As N → ∞ then p → f(X)/X. For finite N, f(X)/X > p so
positive profits are made
 N = 1 → p = f’(X). Monopoly ownership is efficient
 Implications
 X* is not a Nash equilibrium. If all other firms are
choosing xi*, the final firm should increase output
beyond x* (since average product > p)
 Free entry equilibrium might exhaust the stock
 Over-fishing is not the result of a rapacious search for
profits. In fact, it is more profitable to reduce fishing
 The lack of property rights is the problem. If we
assigned the right to fish to one firm (N = 1) we get
an efficient solution
 We ought to introduce intertemporal considerations
into this analysis - fish caught this period cannot be
caught next period (nor can they breed).
 Evolution of fish stocks
∆Z Maximum
sustainable
catch

Zu Z Stock, Z
s

Minimum Stable
threshold equilibrium
 Public goods
 Another aspect of the externality concept
 Public goods have certain characteristics:
 non-rival in consumption - one person’s consumption
does not diminish another’s (e.g. a lecture)
 (possibly non-optional too - you have to consume it,
e.g. national defence)
 non-excludable - you cannot prevent someone
consuming it (except perhaps at high cost)
 Non-rivalry implies it is optimal to allow anyone to
consume the good, once it is available.
 Non-excludability means you cannot charge for the
good, so the market fails
 Further aspects
 There are few ‘pure’ public goods (defence)
 It is better, perhaps, to think of the ‘degree of
publicness’ of the good, i.e. external effects
 It is possible, through advancing technology, to turn
public goods into private goods (or, reduce the
degree of publicness):
 Encrypted subscription TV (Sky)
 Cinemas overtaken by home DVD rentals
 Private security guards in gated communities
 Although these introduce market mechanisms to the
allocation of resources, you may not judge the
outcome to be a success
 Efficient allocation of public goods
 Public goods (non-optional) - all consume the same
quantity:
 q1 = q2 = … = qn
 Private goods
 x1 + x2 + … + xn ≤ x
 These are the material balance constraints
 Consumers (two only) have quasi-linear preferences:
 ui(xi, q) = Bi(q) + xi B’ > 0, B” < 0, i = 1,2
i
MRS xq = u qi u xi = Bi ' (q )

 gives the MRS for consumer i between public and

private goods.
 Efficiency condition
 Efficiency implies maximising the utility of person i,
given the utility of consumer j
x x available for person
PPF 1 given person 2’s utility

x*2 I2

q
x1
Max utility for 1, given
utility of person 2 (I2)

x*1
q* q
 Characteristics of the optimum
 All consume same quantity of q, different quantities of
x
 All have the same marginal valuation of x (its price),
but different marginal valuations of q
 Hence MRSqx differs between individuals.
 MRS1qx + MRS2qx = MRT
(for private goods MRS1xy = MRS2xy = MRT)
 Alternatively B1’(q) + B2’(q) = c

Marginal Marginal
benefit cost
 Note: assuming quasi-linear preferences…
 implies MRS independent of x, hence
 indifference curves are vertically parallel
 ensures q* is the optimum whatever the allocation of
consumption between 1 and 2.
 More generally, we have to agree on both the level of
the public good and the tax shares
 This leads on to the concept of a Lindahl equilibrium
 Lindahl equilibrium
 A tatonnement process for public goods
 Government announces a set of individualised tax
prices, ti
 Individual budget constraint becomes:
 u = Bi(q) + M - tiq (M is income)
 Taxes are such that
 Σti = c
 Individuals respond to tax prices by declaring their
desired levels of q, qi*
 If not all equal, revise tax prices: if qi* < q, lower ti and
vice versa.
 Leads to a Lindahl equilibrium
 Diagram of Lindahl equilibrium

ti
c

t2*
I2* q2* for tax price t2

I1* q1* for tax price t1

t1*

q* q
 Can we attain the Lindahl equilibrium?
 Necessary condition is that people are honest and
hence reveal their true preferences
 Free rider problem intervenes - people have an
incentive to under-bid, hoping others will pick up the
bill
 If all behave this way the Lindahl equilibrium might
not exist
 Preference revelation mechanisms are designed to
give people the incentive to reveal the truth
 Evidence
 Evidence suggests:
 only economists free ride
 most people have some altruistic elements to their
behaviour
 research on charitable giving (see old lecture notes)
suggests the evidence is not consistent with people
free riding. There may be sufficient private benefit
(warm glow) from giving that it over-rides the free rider
problem
 Conclusions
 Various forms of externality lead to market failure
 Some solutions exist in the form of taxes,quotas,
permits, etc
 Some solutions may not be incentive compatible, i.e.
people have an incentive to misrepresent their
preferences.