Externalities :

During the production and consumption of some commodities, harmful or beneficial side effects arise that are borne by firms and people not directly involved in production or consumption of the commodities. These side effects are called externalities . They are felt by economic units (individuals and firms) which are not directly involved with the economic unit generating the side effects. --Ex.Air pollution External diseconomies of Production: Uncompenstated costs imposed on others by the expansion of output by a firm. Ex-discharge of waste by a factory External diseconomies of consumption : Uncompenstated costs imposed on others by the consumption expenditure of some other individual. Exdischarge of waste by a factory. External economies of Production: Uncompenstated benefits conferred on others by the expansion of output by a firm.Training of more workers

External economies of consumption : Uncompensated benefits conferred on others by the consumption expenditure of some other individual. Increased expenditure for lawn maintenance increases the benefits of neighbour Externalities rise because of the mismatch of the marginal private cost and ,marginal social cost. Taxes can be used to bridge this difference

Externalities and property rights

Ex. A owner of a car has clear property right. Anybody who damages the car have to compensate him. y A factory polluting the air. y Nobody owns the air. So cant claim compensation y But that affects an individuals health etc. y Air is a common property. Because of ill defined property rights externality arises. Coase Theorem: When property rights are clearly defined, perfect competition results in the internalization of externalities, regardless of how property rights are assigned among the parties(individuals or firms) Ex: Upstream paper mill pollutes the stream and affects and agricultural farmer
y

Agricultural farmer: Rs. 1000 to clean water, paper mill Rs. 400 for not polluting the stream water. The party who has the property rights will internalize the externality. y If the paper mill has the property right to the stream, the farmers will pay Rs. 400 for not to pollute the stream and get clean stream water for irrigation. y If farmer has the property right for clean water of the stream, the paper mill will go for cleaner ways to dispose its waste without polluting the stream y Thus externaities can be avoided under perfect competition if the property rights are well defined
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Nature of public goods

If consumption of a commodity does not reduce the amount available for others the commodity is a public good. Once the good is provided for somebody others can also consume it without incurring any extra cost.: Non-rivial consumption y Non-exclusion :It is impossible or prohibitively expensive to confine the benefits of consumption of the good to selected people and (such as to those who are paying for it). y National defense.
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y y

The optimal amount of public good is the amount at which the sum of the marginal benefits of all the individuals consuming the good equals its marginal cost. Where aggregate demand for the good equals to the aggregate supply.

But less than optimal amount of the good is likely to be supplied because of y 1) free rider problem 2) Individual has no incentive to actually reveal his preferece for a public good

Benefit Cost analysis

A tool which is adopted in order to decide which project to implement and which not? y If the Net present value is greater than one the government should undertake that project. y i.e, if the present value of the social benefits>present value of the social costs y But there are a few difficulties 1) The benefits and costs are spread over the years and it is difficult to estimate so far into the future 2) The current or projected prices may not reflect the true scarcity of the resources
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Some benefits may not be quantifiable y Choice of Discount rate may be a problem
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Pollution

Government control and regulation of environmental pollution: Air pollution Water pollution Pollution from thermal power plants Waste disposal In order to control pollution what would be the effect of that pollution has to be known. Some amount of pollution always has to be tollerated. Ideally it should be zero, but cant be so since production process will entail some pollution. The optimal level of pollution from societys point of view is not zero, but given by the level at which marginal cost of pollution is equal to the marginal benefit from pollution.

y y y y y 1) 2)

There are two devices for pollution control: Direct regulation: legalize that the industry limit pollution to the optimal level Install a pollution abatement device Effluent fees: tax that a firm must pay to the government for discharging wastes or polluting. Effluent fees are more preferred than direct regulation, They require less information Minimize the cost of optimal pollution control