Externality Problem: Harvey Rosen Ch.

5
Pecuniary Externality : When the effects of the actions of one economic entity on the other are transmitted through changes in the market price there is pecuniary externality.
Example: Rural-urban migration increases the rents of urban houses. This affects house owners positively and negatively affects those people who were living in rented house previously .

Real Externalities: A real externality occurs when the actions of one economic entity directly affects the other economic entity. In this case effects are not transmitted through the market. An externality is a consequence of the failure to establish property rights. Owned resources are used efficiently however common property resources are misused. Externalities can be produced by consumers as well as firms. Externalities are reciprocal in nature. Public good is a special case of externality.

Externality Problem
Rs.

Bart (Factory) and Lisa (Fishery)

MPC+MD = MSC

1. In the case of negative externality market does not bring socially efficient production level. 2. If output is reduced from Qs to Qe Bart looses some profit shown by triangle egh. 3. For each unit of output reduced Lisa gains an amount equal to her marginal damage (MD). 4. Her total gains are measured by area efgh. 5. Hence there are net gains to society shown by triangle efg.

MB
MPC g h c b f e MD

a
QUANTITY

QS Qe
Socially efficient output

Actual Output

Externality Problem: The Coase Theorem

Rs.

Bart (Factory) and Lisa (Fishery)

MB

Socially efficient output

Bargaining and Coase theorem: 1. When property rights are assigned people respond to the externality by MPC+MD = MSC bargaining. It is possible after the bargaining that the output reach at socially efficient level Qs. 2. Bart would agree to reduce his MPC output so long he gets a payment exceeding (MB-MPC). 3. Lisa would be paying to Bart for MD output reduction so long her payments are less then MD for each unit. 4. Output reduction will go on so long MD > (MB-MPC). QS Qe Quantity 5. The amounts paid and received per year depend on their relative bargaining strength however the final output Actual level will be at Qs Output

Externality Problem: The Coase Theorem

Even if the property rights are in favour of Lisa final outcome of bargain would be at socially efficient level. The difference now is that Bart will have to pay a price to Lisa to produce.

Two necessary assumptions: 1. The cost of bargaining to the parties are low 2. The owners of the resources can identify the source of damage to their property and legally prevent damage.
Under these assumptions the efficient outcome is achieved independently of who is assigned the property rights. This is known as the Coase Theorem.

Pigouvian Tax
Rs. Pigouvian Tax Revenues

MPC+MD = MSC
MB MPC+ cd MPC d a b c MD

A Pigouvian tax is a tax levied on each unit of polluters output in an amount just equal to the marginal damage it inflicts at the efficient level of output. Barts effective marginal cost increases after the tax (MPC to MPC + cd). For profit maximization MPC + cd = MPC which occurs at Q* output. Total tax revenues are cd OQ* = area abcd Should Lisa be compensated now? No, because that would lead to overfishing.

Q*

Q per year Problem: How to calculate MD so how to find correct rate of tax? How to know who is polluting and in what quantity?

Pigouvian Subsidy
Rs. MPC+MD = MSC MB MPC+ cd

Assuming fixed number of firms, Pollution can be regulated by paying some money as subsidy to the polluter for not polluting or for not producing beyond the efficient level. The Pigouvian subsidy increases to effective production cost of the polluters.

MPC
d a b f
g

c h

A subsidy, at a uniform rate equal to the MD at efficient level of output (cd), for MD not producing should be given. After subsidy Barts production cost increases so that his perceived marginal cost schedule becomes ( MPC + cd ).
Q per year

QS Qe

Hence Bart will choose to produce at Qs and receive a subsidy equal to dfhc.

Pigouvian Subsidy
Problems with the subsidy scheme:

How to calculate MD so how to find correct rate of subsidy?

How to know who is polluting and in what quantity?

The subsidy will increase the profitability of the polluting firm. Hence there is an incentive for other firms to locate on the river bank. As a result there will be so many firms that the actual amount of pollution will increase.
Subsidies to polluters may be called unethical. It may be noted here that efficient outcomes may be associated with different income distributions. (analogous to infinite number of efficient allocations in the Edgeworth Box.

Market For Clean Water & Air etc.

Rs. per year Creating market for certain resources for which market do not exist (missing market). SL Govt. may choose optimal amount of pollution (Z* associated with output level Qs) and then sell pollution permits to the firms in open market. Market supply of permits is therefore vertical.

P* DL Z*
Right to produce sulfur oxide (Parts per 100 million per year)

Price P* shows the value of one permit to producers to pollute.

The pollution rights Z* may alternatively be assigned to a various firms that can then sell them in open market on bidding basis. Efficiency remains the same but distributional effects change. In the first scheme the sale proceeds goes to the govt. while in the second one it goes to those firms who were assigned property rights.

Which scheme is better: tax, subsidy or permit? a) Given the difficult associated with the tax and subsidy schemes the policy of devising pollution permit has an advantage over them. b) With the permit scheme the uncertainty about the ultimate level of pollution is less. c) Under the permit scheme if the polluting firms are profit maximizers they will have an incentive to adopt cost minimizing technology. d) In case of inflation the price of the pollution permits would be automatically adjusted. However changing the tax rate require a lengthy administrative procedure.

e) Since MPC, MB and MD schedules are not known to govt. with uncertainty there will remain an element of arbitrariness in determining the tax or subsidy rate.
f) If the pollution standards are to be chosen arbitrarily it would be better to choose the permit scheme.

g) However there may occur a problem even with the pollution permit scheme. The incumbent firms might be able to buy pollution rights in excess of their cost minimizing requirements to deter the other firms to enter the market.

REGULATING POLLUTERS
Under regulation each polluting firm is simply ordered to reduce the level of pollution up to a certain level otherwise face legal sanctions. Rs.

(MPC1+ d) = (MPC2 + d)
d MPC1 = MPC2

This policy would become inefficient when there are multiple firms different from each other. An example is sighted in the diagram here.
In the absence of the regulation both the firms are producing same output (X1 = Z1). The regulation in place require them to produce where their respective MB intersects (MPC+d). Where it is known that MD at efficient level of O/P is d. Hence their efficient outputs are X* and Z*. The cut in outputs of X and Z are different. If firms are ordered to decrease emissions by equal amounts, some firms produce too much and others too little.

MB2 MB1 o
Z* X* X1 = Z1 QUANTITY PER YEAR

Positive Externality
Rs.

MSB = MPB + MEB MC a b a' MPB MEB

RESEARCH PER YEAR

When an individual or firm produces positive externality the market will under provide the activity or good. An appropriate subsidy can solve the problem.
A subsidy is appropriate only when the producers of positive externality are unable to capture full marginal return. The subsidy should be provided judiciously because it has distributional implications. The income redistributions takes place from the taxpayers to the recipients of the subsidies.

b'
o R1 R*

For examples of +ve ext. please see the texts by Rosen and Cullis & Jones.

Look at the desirability of the distributional implications from subsidy on the basis of the value judgments embodied in the SWF.