PPA 723: Managerial Economics Lecture 18: Externalities The Maxwell School, Syracuse University...

PPA 723: Managerial Economics

Lecture 18:

Externalities

The Maxwell School, Syracuse UniversityProfessor John Yinger

Managerial Economics, Lecture 18: Externalities

Outline

What Are Externalities?

Externalities Lead to Inefficient Outcomes

Externalities and Monopoly

Externalities and Property Rights


Externalities An externality exists if

Someone's consumption or production activities inadvertently affect others.

The well-being of a consumer or the production capability of a firm is affected directly by actions of other consumers or firms, rather than indirectly through changes in prices.


Positive & Negative ExternalitiesExternalities may help or harm others

An externality that harms someone is a negative externality.Pollution and congestion are examples.

A positive externality benefits other.Example: Painting your house (called the

neighborhood effect).


More ExamplesA firm whose production process lets off

fumes or particles that harm its neighbors is creating an externality.

A firm is not causing an externality when it harms a rival by selling extra output that lowers market price.

An individual is not causing an externality by stealing.


Inefficiency of Competition with Externalities

Competitive firms and consumers do not have to pay for harms of their negative externalities (and do not receive compensation for their positive externalities).

So they do too much of the activities that cause negative externalities (and too little of those with positive externalities).


Private vs. Social Costs

Private cost is cost to firm of production only, not including externalities:Direct costs of labor, energy, and wood pulp. But not indirect costs of harm from pollution

associated with production.

Social cost equals private cost plus the cost of harms from externalities.


Supply-and-Demand Analysis A competitive market produces excessive

production (and excessive pollution) because firms' private costs are less than social costs

A market sets supply (= private marginal cost) equal to demand (= marginal benefit).

The social optimum sets social marginal costs equal to marginal benefit.

These are different, so a competitive market with externalities has deadweight loss.


Paper Mill: Assumptions Competitive paper market. Firms produce paper and a by-product, gunk,

which causes air and water pollution that harms people who live near paper mills.

Each ton of paper produced increases the amount of gunk by 1 unit.

The only way to decrease volume of gunk is to reduce the amount of paper manufactured.

Paper firms do not have to pay for harm from pollution they cause.


Figure 18.01 Welfare Effects of Pollution in a Competitive Market

Demand

MC pMC g = Social Cost of Pollution

MC g

MC s = MC p + MC g

450

ps = 282

pc = 240

30

84

198

Qc = 105Qs = 84 2250

ec

es

A

B

F

C D

E

H

G

Q, Tons of paper per day

MC p

Price of paper, p,$ per ton

, Units of gunk per dayG

Deadweight Loss


Analysis of Pollution ReductionAnother way to think about pollution is

to consider the benefits and costs of reducing it.

In the simple case just considered, the cost is lost output, the benefit is lower health costs from pollution.


Figure 18.03 Cost-Benefit

Analysis of Pollution(Reduction)

Cost: less paper

Benefit: less gunk

Maximumnetbenefit

84 631050

84105

G, Units of gunk per day


G, Units of gunk per day


(a) Cost and Benefit

(b) Marginal Cost and Marginal Benefit

4,000

2,000

105

84

0

MC

MB

Ben

efit,

Cos

t, $

Mar

gina

l ben

efit,

Mar

gina

l cos

t, $


Analysis of Pollution Reduction, 2

In the more general case, marginal benefits may decline more rapidly: Health impacts may only appear at high concentrations, so

there are not large benefits from continual reduction.

Marginal costs may increase more rapidly: It is easy to eliminate the worst pollution, but often

technologically difficult to get rid of it all—or getting rid of it all requires not producing things people value highly.

So it often is inefficient to eliminate all pollution of a given type.


Optimal Pollution Reduction

$

Pollution Reduction

100%

MC

MB

Optimal0%


Monopoly and Externalities

Monopoly output may be less than the social optimum even with an externality.

Competition is not necessarily better than a monopoly with an externality.


Figure 18.04 Monopoly, Competition, and Social Optimum with Pollution


DemandMR

MC p

MC g

MC s = MC p + MC g

450

330310

282

240

30

84 105 22570600

em

ec

es

et

A B CDP

rice

of p

aper

, p,

$ p

er t

on


Allocating Property RightsA property right is an exclusive

privilege to use an asset.The Coase Theorem: if property rights

are clearly defined, optimal levels of pollution and output result from bargaining between a polluter and its victims.

Parties generally won’t negotiate unless property rights are clearly assigned.


Coase Theorem ResultsIf there are no impediments to bargaining,

assigning property rights results in an efficient outcome: joint surplus is maximized.

Efficiency is achieved regardless of who is assigned the property rights.

Who gets the property rights affects the income distribution (property rights are valuable).


Alternative Property Rights

The right to be free from pollutionA firm cannot pollute unless it compensates its

victims to their satisfaction.

The right to polluteFirms will pollute unless compensated by victims for

the profits it loses from stopping pollution.


Problems with Coase Approach

The Coase approach works only if: Property rights are clearly defined.Parties can bargain successfully.

3 common causes of bargaining failure:Transaction costs are very high.Firms engage in strategic bargaining behavior.Either side lacks information about costs or

benefits.

PPA 723: Managerial Economics Lecture 18: Externalities The Maxwell School, Syracuse University...

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