Microeconomics

Session 16
Market failure
Externalities – when the price is not right

September 2016
 Session Objectives

Why the markets sometimes fail to provide the correct

price signals

Solutions to externalities

Private solution – the Coase theorem

Taxes and subsidies

Command and Control

Tradable allowance
Bank commercial – identify the externality
“I think you can make a better case for
regulating antibiotics than heroin: Misusing
antibiotics can endanger countless others, while
misusing heroin mostly endangers oneself.”

Glenn Reynolds
Distinguished Professor of Law at the University of Tennessee, and is best
known for his weblog, Instapundit
Recent findings about antibiotics

• Before the discovery of antibiotices – more deaths

because of infections rather than wounds

• But now the rise of the superbugs

• WHY?
– Antibiotics are overused

6
 External cost of antibiotic

• The bacteria not killed by antibiotic becomes more dominant –

E collie, for example

– Users get all the benefits but do not bear all the costs

– Each use of an antibiotic

• Creates an external cost
– Creates a small increase in bacterial resistance
– Pollutes the environment with more resistant and
stronger bacteria

• Antibiotic users ignore the costs created by this “pollution”

When the price is not right….

• Market failure

• Because social cost/social benefit differ from private

cost/private benefit

• So the market solution does not maximise social

surplus
Negative consumption externality
1. (SUVs)
• Environmental Externalities, wear and tear on roads
The contribution of driving to global warming is proportional to the
amount of fuel a vehicle requires to travel a mile.

• Safety Externalities:
A feeling of security to users, but the added insecurity imposed on other cars
on the road.

2. Traffic congestion
3. Talking on mobile while driving
4. Passive smoking
5. High-speed driving
6. Car alarms
 Positive consumption externality

When an individual's consumption increases the well-being of

others but the individual is not compensated by those others.

• Beautiful private garden that passers-by enjoy seeing

• Well-maintained houses increase real estate prices even for

neighbouring houses
 Negative production externality
• When a firm's production reduces the well-being of
others who are not compensated by the them.

– A steel plant that pollutes a river

– Acid rain – coal burning power plants – release sulfur

dioxide, nitric acid – kills fish, damage crops, trees
Positive Production Externality

When a firm's production increases the well-being of others but

the firm is not compensated by those others.

• R & D by a company – adds to a general knowledge about the

subject and helps in future inventions/innovations by others

• Employer subsidising employee higher education. More

education, in general

• Spillovers in the Silicon valley

 Types of externalities

Negative
Positive consumption Negative Production Positive Production
consumption
• Smoking – passive • Well maintained • Steel plant polluting • Company spending
smoking houses and impact a river, causing acid on R&D
• SUVs – safety of on house prices rain • Firms’ subsidy for
others in danger, • Private gardens • Other pollution education/training
road impact during any • Cluster spillovers
• Seat belts and High production process
speed driving
 Market does not maximise social surplus in the
presence of externalities

• A market maximises (consumer surplus +

producer surplus)

• When externalities are present –

Social surplus is CS +PS + bystander’s surplus

• So, when there are significant external cost or

benefits market does not maximise social
surplus
….. because Private cost ≠ Social Cost

• Private cost – the cost paid by the consumer or the

producer

• External cost – a cost paid by people other than the

consumer or the producer

• Social cost = the private cost + external cost

• Externalities = external costs or benefits that fall

on bystanders
15
A Market Maximizes Consumer + Producer Surplus

Price

Supply
(private costs)

13 Market equilibrium

Demand
(private value)
Quantity
210
But when there are external Costs

Price/costs

Efficient Deadweight
equilibrium loss Social cost

PEfficient External cost

Supply
(private costs)
PMarket
Private value

Overuse Demand
(private value)
QEfficient QMarket Quantity of
antibiotics
17
 External Benefits

• A benefit received by people other than the consumers or

producers trading in the market

• Vaccines create external benefits

– When one person gets a vaccine, the expected number of
people who can potentially get a disease falls even more.

• If people who get vaccinated did receive all of the benefits, the
demand curve would shift up by the amount of the external
benefit.

18
 External Benefits

Price/costs

Deadweight
loss Efficient
Social equilibrium
External benefit
value
Supply
PEfficient
(private costs)
PMarket
Social value
Demand
(private value)
QMarket QEfficient Quantity of
vaccine
Underuse
19
 Solutions to externalities

– Private market for externalities

• The Coase theorem

– Solutions involving the government

• Taxes (for external costs) and subsidies (for external
benefits)
• Command and Control
• Tradable Permits
 Internalising externality: The private solution
The payoff matrix
Smoke From BarBQ (units) 0 1 2 3

BarBQer’s Total Value $0 $30 $50 $60

Neighbour’s Total Value $35 $30 $20 $0

BarBQer + Neighbour Value $35 $60 $70 $60

The payoff matrix

Smoke From BarBQ (units) 0 1 2 3

BarBQer’s Total Value $0 $30 $50 $60

Neighbour’s Total Value $75 $30 $20 $0

BarBQer + Neighbour Value $75 $60 $70 $60

The Neighbor has the right, so we are moving from smoke=0 as
our starting point
A deal of the BarBQer giving the Neighbor $25 at smoke=2
would do this, leaving them with $25 and $45, respectively.

If the starting point for negotiation is smoke=3, the Neighbor will

reason that she can afford to compensate the BarBQer for a
reduction to Smoke=2.
An example would be a deal leaving the BarBQer with $65 and
herself with $5 of value (which is better than $0).
 Private Solutions to Externality

The Coase theorem

If transactions costs are

low and property rights are
clearly defined, private
bargains will ensure that
the market equilibrium is
efficient even if there are
externalities.
Ronald Coase, the Nobel prize in economics, 1991

23
In a market economy, today’s externalities are
tomorrow’s profit opportunities for
entrepreneurs, if a private solution can be found

Any examples?
 Private Solutions to Externalities

• Suppose that a railroad runs along a wheat field.

• Heat and smoke emititng from the train can burn the
neighboring crops.

• To avoid this danger, the wheat farmer does not plant

crops within two hundred feet of the railroad incurring
losses of Rs 3,000 per harvest.

• The railroad, thus, imposes an external cost on the

farmer.
• If the farmer has a right to grow crops without
them being burned, then the railroad must bear the
costs to the farmer.
– The railway could pay the farmer Rs 3,000 to cover the
losses each harvest and continue to use the rail line.

– Or, the railway could prevent the fires by installing spark

arresters that cost Rs 2,000 to maintain each harvest.

– In this situation all costs are now internalized, and the

railroad will install the spark arresters (the least costly
alternative).
• If the railway has a right to use the rail line, then
the farmer must bear the costs of the losses.

– The farmer would be willing to pay the railroad up to Rs

3,000 per harvest to cease using the rail line.

– Or, the farmer could purchase and maintain the spark

arresters for the railway at a cost of Rs 2,000 per harvest.

– In this situation all costs are now internalized, and the farmer
will install the spark arresters (the least costly alternative)
for the railroad.
• If the railroad and the farmer can negotiate
without incurring any additional costs, an
efficient outcome will arise.

• Note that regardless of who is initially assigned

the property right, the same solution occurs –
the spark arrester is installed.
 Private Solutions to Externality

• Government can play a role…

– Defining property rights.
– Reducing transaction costs.

31
Pollution and vaccinations - transaction costs are high and
property rights are unclear

• Pollution
– On whom exactly? And how much cost?
– Who owns the right?

• Vaccinations – who exactly gets the external benefit?

– Transaction costs are high
 Government Solutions to Externality

• Three types of solutions involving government

– Taxes and subsidies
– Command and control
– Tradable allowances

33
 External Costs - tax

– To maximize social surplus, output should be

reduced
– To decide the efficient level of output, who bears
the cost is irrelevant

• Solution: a Pigouvian tax – a tax on a good with

external costs

34
A Pigouvian Tax – internalise external cost

Price/costs

Efficient Social Cost =

equilibrium Private costs + Tax

PEfficient External cost = Tax

Supply
(private costs)
PMarket

Demand
(private value)
QEfficient QMarket Quantity of
antibiotics
35
 External Benefits

– To maximize social surplus, output should be

Increased.
– For determining the efficient level of output, who
gets the benefit is irrelevant.
– When other people receive some of the benefits,
fewer people receive flu shots.

• Solution: a Pigouvian subsidy – a subsidy on a good

with external benefits

36
 A Pigouvian Subsidy – internalises external
benefit
Price/costs

External benefit Efficient

equilibrium

Supply
PEfficient
(private costs)
PMarket
Social value =
private value + subsidy
Demand
(private value)
QMarket QEfficient Quantity of
vaccine
37
 Externalities: tax and subsidy

– External costs → market price is too low

• Solution: Pigouvian tax → PAfter-tax= PEfficient

– External benefits → market price is too high

• Solution: Pigouvian subsidy → PAfter-tax= Pefficient

38
 But, it is possible to tax or subsidies if
 Pollution can quantified, the price of pollution and the optimal
quantity of pollution are known.

 The optimal quantity of pollution? Zero?

 Pollution is a bad thing. Yet most pollution is a side effect of

activities that provide us with good things.

 So the optimal quantity of pollution isn’t zero.

So how much is the optimal quantity? What if government

overshoots and adds a tax that is too high? Will the equilibrium
quantity be higher or lower than the efficient equilibrium?
Command and Control
 Command and Control

• Example: To reduce external cost of pollution,

government orders firms to produce electrical
products which use less energy.

In 2007 the US Department of Energy mandated

that all washing machines had to use 21% less
electricity

The outcome?

42
 Command and Control

• Command and government control

– Affects quality and few people would choose to pay a lot
more for a washer that doesn’t clean well.
• Trade-off
• Alternatives
– Use less electricity where it is not required – least valuable
use of electricity
A tax on electricity – high prices lead people of
economise much – flexibility to find the lowest cost ways to
reduce the use of electricity
The goal is not to reduce electricity use but lower
pollution!
 Command and Control

• Command and control may be a good solution

when…

– Success requires very strong compliance, i.e., when

flexibility is not a good thing

– A good example is the eradication of smallpox.

44
 Tradable Allowances

– Government gives out licenses to emit limited quantities of

pollution.

– Tradable permits - These licenses can be bought or sold by

polluters.

– Initially, issued as per the pollution history, say 50% of pollution

licenses

– Firms whose cleanup costs are the highest will buy permits from
firms with low cleanup costs.

– The desired level of pollution is achieved but at lower cost.

45
The video - tradable permits
and solve a problem
Tradable Allowances In Practice

 Success of the Clean Air Act, 1990

• SO2 emissions have fallen

by 35%
• Electricity generation has
• Increased even though
pollution has been reduced

47
Tradable Allowances v/s Pigouvian Taxes

• Are equivalent if…

– The tax is set equal to the level of the external cost
– The number of allowances is equal to the efficient
quantity.

• Are different…
– If there is uncertainty.
– There are government preferences for one or the
other… WHY?
48
• These two companies
are a major source of air
pollution.

• The town wants to

reduce pollution to 200
units.

• The marginal cost is

constant.
• Suppose that Collegetown passes an environmental
standards law that limits each company to 100 units
of pollution. What would be the total cost to the two
companies of each reducing its pollution emissions to
100 units?
• College Cleaners – reduce pollution by 130 units,
costing it 130 ×$5 = $650.
• Big Green Cleaners - reduce its pollution level by 20
units, costing it 20 × $2 =$40.
• total cost of reducing pollution to a total of 200 units
would be $650 + $40 = $690
• Suppose instead Collegetown issues 100 pollution
vouchers to each company, each entitling the
company to one unit of pollution, and that these
vouchers can be traded. Who will sell vouchers and
who will buy them and within which price range?
• Equal to MC of reducing pollution.
• One pollution voucher is worth $5 to College
Cleaners and $2 to Big Green Cleaners. so Big Green
Cleaners will sell to College Cleaners (for a price
between $2 and $5)
• What is the total cost to the two companies of the pollution
controls under this voucher system?

• Big Green Cleaners will reduce its output of pollution to zero,

which will cost it 120 ×$2 =$240.
• College Cleaners will now have 200 vouchers and can emit
200 units of pollution, 30 fewer than before.
• This will cost College Cleaners 30 ×$5 =$150.
• So the total cost of pollution control under this system is $240
+$150 = $390.
• The prices paid by College Cleaners and received by Big
Green Cleaners in trading vouchers cancel each other out—
they are pure “transfers” between the two companies