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Managerial Economics
Sisir Debnath
Session 7

Indian School of Business

May 18, 2015

Sisir Debnath, Managerial Economics, Indian School of Business

Deadliest Killer?
Suppose you want to offer a mosquito abatement
program to your community.
The cost of the program is 5 lack Rs.
The total benefit of the program is more than 5 lack.
There are 100,000 households which will benefit.
Can you charge Rs. 5 to each household and break
even?

Sisir Debnath, Managerial Economics, Indian School of Business

Sisir Debnath, Managerial Economics, Indian School of Business

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BP Oil Spill
BP drills a well in the depths of the Gulf of
Mexico, hoping that the marginal benefits from
large oil deposits exceed the marginal costs of
drilling
The explosion of Deepwater Horizon creates an
oil spill that threatens the livelihoods of Louisiana
fishermen
The fishermen were not party to the decision to
drill
Drilling creates a social problem that is not
addressed through unrestricted markets
Sisir Debnath, Managerial Economics, Indian School of Business

Public Goods
Transactions in free markets with price systems
always make market participants better off
If all participants were not better off, the
transaction would not take place
But what about non-participants? They might
either benefit or suffer from transactions between
market participants
The objective of today's class is to analyze the
provision of goods and services that impact both
market participants and non-participants
Sisir Debnath, Managerial Economics, Indian School of Business

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Public Goods and Externalities
Public Goods
Externalities
Optimal provision of Public goods
Coasian bargaining
Pigouvian taxes
Cap and trade

Sisir Debnath, Managerial Economics, Indian School of Business

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Public Goods
Apart from usual goods and services, we consume
many public services everyday
The military protects us even without a conscious
choice to consume their services
Roads, railways and telecommunications enable us to
access different goods and services
Health and education services increase our ability to
appreciate different goods and services
Imagine life without public goods and services
Libertarian paradise?
Sisir Debnath, Managerial Economics, Indian School of Business

Public Goods
Public goods are goods and services that are nonrivaled and non-excludable in consumption.
National defense is a pure public good.
Non-rivaled: marginal cost of protection given the
level of defence is zero.
Non-excluded: One person cannot exclude another
from protection.

Radio broadcasts are a pure public good.

Non-rivaled: Cost for a marginal listener is negligible.
Non-excluded: One listener cannot exclude another
tuning in.
Sisir Debnath, Managerial Economics, Indian School of Business

Other Types of Public Goods

Marketable public goods are non-rivaled but
excludable
Also called club goods
Examples?
Highways with low traffic, satellite television

Common property goods are rivaled and

nonexcludable
Suffer from congestion problems
Examples?
Fish stock, Grazing in common area

Private goods are both rivaled and excludable

Most goods and services
Examples?
Sisir Debnath, Managerial Economics, Indian School of Business

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Voluntary Contributions to Public

Goods
Your group is allocated Rs. 50
You can contribute any amount (x, including 0 and
50) towards a public good
Public good provision is sum of x from all groups
Total public good xi
i
Your group's earnings

4 ( 50- xi ) Total public good

Actual payment to one randomly chosen group

Sisir Debnath, Managerial Economics, Indian School of Business

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Features of Public Goods

Even when everyone consumes equal quantities of a
public good, not everyone has same value of
consumption
Classification of public good is not absolute
Depends on market conditions and state of
technology
Example: Broadcast, Cable and Satellite TV
Private sector does not need to supply only private
goods
Yet difficult for the private sector to provide nonexcludable goods and make a profit
Example: Basic research
Not necessary that public goods are produced only by
public sector
Sisir Debnath, Managerial Economics, Indian School of Business

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Aggregate Demand for Public Goods

For private goods aggregate demand is obtained by
summing up individual demand at each price
How to obtain aggregate demand for public good?
Recall that the same amount of public good many be
consumed by many at the same time.

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Voluntary Contributions to Public

Goods
What is the optimal provision of public good?
Under voluntary provision, are public goods under or
over supplied?

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Externalities
Think about the following examples:
Introducing a knowledgeable worker to a team of
employees increases the team's productivity
Vaccination against communicable diseases
protects not only vaccine receivers, but reduces the
probability others around them get the disease
Literacy not only improves a person's job
prospects, but also allows society to use written
contracts and forms of communication

Sisir Debnath, Managerial Economics, Indian School of Business

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Externalities
An externality is the effect of a decision by one set of
parties on others who were not participants in that
decision.
Externalities are not always beneficial
Air pollution from a factory or a car's tailpipe has a
negative impact on asthma sufferers who live or work
close by
A business that underfunds the pension fund pushes
the cost of providing retirement income on society
Corruption by bureaucrats has a negative impact on
users of public services
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Externalities & Managerial Decision

Making
In what context do managers deal with externalities?
Externalities that involve the government and the
public
Professional education
Pollution
Consumer safety

Externalities within the firm

Employees who are particularly helpful or disruptive
Knowledge sharing

Externalities between a firm and other firms

Intellectual property generated through research
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A Negative Externality Example

If there are no externalities,
P0Q0 is the equilibrium

Cost, P
S1 = Marginal
Social Cost

S0 = Marginal
Private Cost

Cost of externality

P1
P0

D = Marginal

If there are negative

externalities, the marginal
social cost differs from the
marginal private cost, and
P0 is too low and Q0 is too
high to maximize social
welfare

Social

Benefit

Q1 Q0

Sisir Debnath, Managerial Economics, Indian School of Business

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A Positive Externality Example

If there are no externalities,
P0Q0 is the equilibrium

Cost, P

S = Marginal
Private Cost

P1

Benefit of
externality

P0

D1 = Marginal

Social

Benefit

D0 = Marginal
Private Benefit

Q0

Q1

If there are positive

externalities, the marginal
social benefit differs from
the marginal private benefit,
and both P0 and Q0 are too
low to maximize social
welfare
Government intervention
may be necessary to
increase consumption

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Externality Solution
Goods and services with negative externalities are
over-supplied by private markets
Goods and services with positive externalities are
under-supplied by private markets
If externalities have a significant negative (positive)
impact, how does one mitigate (encourage) their
incidence?
Internalize the externality
Alter incentives so that individuals take account of
externality in their own actions

Sisir Debnath, Managerial Economics, Indian School of Business

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Externality Solutions
Private solutions
Moral codes
Private charities
Bargaining (Coase theorem)
Public (government) solutions
Regulation mandating maximum (negative
externality) or minimum (positive externality)
provision
Pigouvian taxes (for negative externalities) and
subsidies (for positive externalities)
Cap and trade
Privately developed public solutions
Social institutions
Sisir Debnath, Managerial Economics, Indian School of Business

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Mandated Maximum Provision

If there are no externalities,
P0Q0 is the equilibrium

Cost, P
S1 = Marginal
Social Cost

S0 = Marginal
Private Cost

Cost of externality

P1
P0

D = Marginal
Benefit

Q1 Q0

Social

If there are externalities, the

marginal social cost differs
from the marginal private
cost, and P0 is too low and
Q0 is too high to maximize
social welfare
Government intervention
may be necessary to reduce
production

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Coase Bargaining
Example:
A perfume factory is downstream to a paper mill.
Gunk from the paper mill impose a negative
externality on the operations of the perfume
factory.
The paper mill could reduce effluents by installing
filters.
The perfume factory could eliminate the impact of
the gunk by treating water before use.

Sisir Debnath, Managerial Economics, Indian School of Business

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Coase Bargaining
Definition: A property right is a legal rule that
describes what economic agents can do with an object
or idea.
Example:
Deed to parcel of land
Patent on an idea

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Coase Bargaining
Example: Case 1: No explicit rights allocation.
Both the paper mill and the perfume factory can
do whatever they wish.
Perfume Factory

Paper Mill

No Treatment

Treatment

No Filter

(500,100)

(500,200)

Filter

(300,500)

(300,300)

The paper mill will not install a filter

The perfume factory will install a treatment plant
Joint payoff will be 700 Can they do better?
Sisir Debnath, Managerial Economics, Indian School of Business

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Coase Bargaining
Example: Case 2: The perfume factory has the right
to clean water and sets a fee of Rs. 500 for receiving
gunk.
Perfume Factory
No Treatment
Paper Mill

Treatment

No Filter

(0,600)

(0,700)

Filter

(300,500)

(300,300)

The paper mill will install a filter

The perfume factory will not install a treatment plant
Joint payoff will be 800 The best they can do
Sisir Debnath, Managerial Economics, Indian School of Business

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Coase Bargaining
Example: Case 3: The mill has a right to pollute and
sells fresh water for Rs. 250.
Perfume Factory

Paper Mill

No Treatment

Treatment

No Filter

(500,100)

(500,200)

Filter

(550,250)

(550,50)

The paper mill will install a filter

The perfume factory will not install a treatment plant
Joint payoff will be 800 The best they can do
Sisir Debnath, Managerial Economics, Indian School of Business

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Coase Bargaining
Summary of the main results
Ownership of property rights affects income
distribution
Party with property rights is compensated by other
party
Property rights are valuable
With no impediments to bargaining, assigning
property rights results in efficient outcome
Joint profits are maximized at this outcome
Efficiency is achieved regardless of who receives the
property rights!
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Challenges to Coase Bargaining

Why doesn't Coase bargaining solve every
negative externality?
High transaction costs
Ex: In Bhopal Gas case, defendants are far away

Large numbers of injured parties

Ex: In Erin Brockovich's suit, 1 defendant but 634
plaintiffs

Incomplete or asymmetric information

Ex: In carbon emission case, exact marginal
abatement costs for each emitter are not known

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Pigouvian Taxes and Subsidies

Definition: A Pigouvian tax or subsidy is a tax
(subsidy) levied on a market activity that generates
negative (positive) externalities.
A Pigouvian tax is not intended to raise funds, or
to tax sinful activities.
Examples of Pigouvian Subsidies and Taxes
Subsidies for higher education
Free vaccines
Taxes on high sugar sodas and snacks to combat
obesity (fat tax)
Carbon taxes to combat global warming
Sisir Debnath, Managerial Economics, Indian School of Business

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Pigouvian Taxes and Subsidies

Firm has to either abate pollution or pay a tax
Marginal
Abatement
Costs (MAC)

Pigouvian
Tax

MAC > Tax

Firm prefers to pay tax

MAC < Tax

Firm prefers to abate emissions
Sisir Debnath, Managerial Economics, Indian School of Business

Abatement
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Pigouvian Taxes and Subsidies

Rs./ton

Shift in supply curve when firm internalizes costs

Social Cost

Supply

PC
Pigouvian Tax

PS

Demand

QO

QM

Quantity of Aluminium

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Cap and Trade

How does cap and trade work?
Cap or limit on total quantity of production (across
the industry)
Producers need a permit for every unit of production
Cap is equal to total number of permits in market
Permits are tradable => Market price for permits
Leads to known quantity, unknown price

Sisir Debnath, Managerial Economics, Indian School of Business

Rs./ton

Cap and Trade

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Rs./ton

Same production but different abatement cost

MAC2

Trade 1 unit
of right to
pollute
MAC1

Firm 1 0
Firm 2 10

5
5
Sisir Debnath, Managerial Economics, Indian School of Business

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0
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Cap and Trade

Each firm must either abate pollution, or pollute with a
permit.
Initially, each firm is allocated five permits (to pollute 5
units).
Total pollution is 10 units (the cap).
Both Firm 1 and Firm 2 can pollute first 5 units and must
buy the permit to pollute beyond 5 units.
But Firm 1 can sell its permit to Firm 2 (the trade).
Firm 2 will be happy to buy, since using the permit lowers
TAC2 (Total Abatement Cost).
Increase in TAC1 is less than reduction in TAC2 for Firm 2.
Price of permits is net cost savings for Firm 2.
Keep trading till MAC1 = MAC2.
No additional gains from trading for either firm.
Sisir Debnath, Managerial Economics, Indian School of Business

Rs./ton

Cap and Trade

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Rs./ton

Each firm can do better if Firm 1 sells its permits to Firm 2

MAC2

MAC1
Net Cost
Savings

Firm 1 0

5
5

Firm 2 10

10
0

Sisir Debnath, Managerial Economics, Indian School of Business

Rs./ton

Cap and Trade

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Rs./ton

Keep trading till there are no more gains from trade

MAC2

Keep trading till

MACs are
equalized
MAC1
Net Cost
Savings

Firm 1 0
Firm 2 10

5
5
Sisir Debnath, Managerial Economics, Indian School of Business

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0
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Carbon tax vs. Cap-and-Trade

Revenue
Direct tax revenues from carbon taxes
Government can redistribute carbon tax revenues as
transfers to individuals or firms
Revenues from cap-and-trade only if permits are
auctioned
Free permits are a hidden transfer to emitters

Allocation

Who should receive permits initially?

Distribution to current emitters?
Distribution by auction?
Distribution to affected parties?

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Takeaways from Today's Class

Public goods are non-rivaled and non-excludable in
consumption
Voluntary provision tends to undersupply public goods
and oversupply public bads
Remedy through government action
Externalities are impact of market transactions on nonparticipants
Public policy should encourage positive externalities
and discourage negative ones
If property rights are well-designed and transaction
costs are low, bargaining will remedy externalities
(Coase Theorem)
But bargaining cannot fix every situation, so role for
government through mandates, pigouvian taxes and
subsidies, cap and trade etc.
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Readings for Next Session

Oligopoly (Course pack page 171-199)

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