Monday, October 22 Lecture: Externalities and Efficiency

Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Monday, October 22 Lecture: Externalities and Efficiency Externalities Another Example of a Market Failure An externality exists whenever consumers or firms do not account fully for the ramifications of their actions. The effect that is not accounted for is called the external effect. Broadly speaking, two types of externalities exist: negative externalities: situations in which the external effect damages others; positive externalities: situations in which the external effect helps others. Negative Externalities: Not all the costs are accounted for One of the more obvious examples of an externality is the firm that pollutes the water or air when it produces its product. The firm that pollutes the water or air does not pay for the damage it is doing to the environment; consequently, the firm does not fully account for its actions. Consumers also can be part of negative externalities. When a commuter in Los Angeles drives an automobile to work, he/she does not account for the fact that by driving the atmosphere will be more polluted. The more polluted atmosphere imposes a cost on all Los Angeles residents. Positive externalities: Not all the benefits are accounted for Consider a friend, let us call him Joe, who is deciding whether or not to get a flu shot to protect himself against contracting the flu this winter. Joe will weigh the costs against the benefits. What are the costs Joe would incur by getting the shot? Joe may have to pay a fee for the shot; the shot may be painful; it takes time for Joe to go and get the shot. What are the benefits Joe would enjoy by getting the shot? Joe will be less likely to come down with the flu this season. In deciding whether or not to get the shot, Joe will weigh the costs against the benefits. If the benefits exceed the costs, he will get the shot. If the costs exceed the benefits he will not. A positive externality exists in this case because there is one benefit that Joe has not considered. Flu is a communicable disease; consequently, if Joe gets a flu shot not only is he less likely to get the flu, but he is less likely to pass it on to you. Joe typically does not consider this second benefit in deciding whether or not to get a flu shot. Externalities and Efficiency Efficiency Intuition: Are decisions based on correct or misleading information? Correct Misleading Efficiency Results Inefficiency Results

2 Exercise: Pollution and Efficiency A chemical firm and a farm are both located beside a lake. The chemical firm discharges waste water into the lake. Furthermore, assume that there is no way for the chemical firm to avoid polluting the lake in this manner. The farm must use the lake water to irrigate its fields. Before the farm can use the water pollutants must be removed, however. Farmer s Fields Chemical Firm Waste Water The costs of cleaning the water are: Clean-up Costs = C F where C = quantity of chemical produced F = quantity of food produced The farm's costs include not only the costs of the labor, fertilizer, seed, etc., but also the cost of cleaning the water. In this case, the chemical firm does not account for all the consequences of its actions. The chemical firm ignores the clean-up costs it imposes on the farmer. This situation is an externality. The owner of the chemical firm does not account for all the consequences of his/her actions. The owner does not account for the fact that when more chemicals are produced, the farmer s cleanup costs rise. This is a negative externality. To explain why an externality leads to inefficiency, first note that the specification of water clean-up costs are not unrealistic. If no chemicals were produced, the water would be pure and clean-up costs would equal 0. If no food were produced, no irrigation water would be needed and there would be no need to clean up any water. As more chemicals are produced and/or more food is produced, clean-up costs increase. Assume that both the chemical industry and the food industry are perfectly competitive. The price of chemicals is $1000 and the price food is $800. Chemical Firm Farm MC of Chemicals MC C = 200 + 2C MC of Food C = 400 C = 0 1,200 1,200 1,000 1,000 800 800 600 600 400 400 200 200 C 200 400 600 100 200 300 F Since the farmer s cost depends on the quantity of chemicals produced, the farmer has one marginal cost curve for each quantity of chemicals. As more chemicals are produced, the farmer s marginal cost curve shifts up reflecting the additional costs imposed on the farmer.

3 What is the profit maximizing quantity of output for the chemical firm? More specifically, do 399 units of chemicals maximize the chemical firm s profit? To answer this question, we shall compare the chemical firm s marginal revenue and marginal cost when chemical production, C, equals 399: Perfect Competition MC C = 200 + 2C = Price of Chemicals MC C = 200 + 2x399 = 200 + 798 = 1,000 MC C = 998 When the chemical firm produces 399 units, marginal revenue equals 1,000 and marginal cost 998. Consequently, the production of 1 additional unit of chemicals increases total revenue by 1000 and total cost by 998; profits increase by 2: C=399 TR up 1000 TC up 998 Profits up 2 C=400 400 units of chemicals are now being produced. Let us calculate marginal revenue and marginal cost again when chemical production, C, equals 400: Perfect Competition MC C = 200 + 2C = Price of Chemicals MC C = 200 + 2x400 = 200 + 800 = 1,000 MC C = 1,000 Since marginal revenue now equals marginal cost, the production of 400 units of chemicals maximizes the chemical firms profit. Now, consider the farmer. Since 400 units of chemicals are being produced, the marginal cost curve labeled as C=400 is relevant. Since the food industry is perfectly competitive, the farmer s marginal revenue equals 800. Consequently, the profit maximizing quantity of food is 100 units. Since 400 units of chemicals are produced and 100 units of food, clean up costs equal $40,000: C = 400 F = 100 Clean-up costs = C F = 400 100 = 40,000 We shall now argue that this state of affairs is inefficient by devising a special deal that would benefit both the owner of the chemical firm and the farmer. Suppose that the farmer agreed to pay the owner of the chemical firm a side payment of $50 on the condition that chemical production would decrease from 400 to 399 units. How would the owner of the chemical firm be affected? From above we know that when chemical production increases from 399 to 400 units, the chemical firm s profits rise by $2. Therefore, when chemical production decreases from 400 to 399 units, its profits must fall by $2. But do not forget about the side payment. The farmer is giving the owner of the chemical firm $50 to reduce chemical production by 1 unit. In net, the owner of the chemical firm is $48 ahead. The owner of the chemical firm is better off.

4 How would the farmer be affected? Since chemical production has decreased, the farmer s clean-up costs would fall: C = 400 F = 100 Clean-up costs = C F = 399 100 = 39,900 The farmer s clean up costs have decreased from $40,000 to $39,000, a fall of $100. But again, do not forget the side payment. The farmer is giving the owner of the chemical firm $50. In net, the farmer is $50 ahead. The farmer is better off. The owner of the chemical firm and the farmer can negotiate a special deal that will be mutually beneficial. The farmer could give the chemical firm owner $50 on the condition the he reduces chemical production by 1 unit. Both are made better off. Hence, the original state of affairs is inefficient. What is the intuition here? As a consequence of the externality, the owner of the chemical firm is basing his decisions on erroneous information; the owner of the chemical firm is not accounting for the fact that the production of chemicals imposes costs on the farmer. Consequently, too many chemicals and too much pollution because the owner of the chemical firm ignores some the costs associated with the production of chemicals. Alternatively, suppose that the chemical firm is ordered to close by the EPA thereby eliminating all pollution. Is this state of affairs efficient? First, consider the chemical firm. Since no chemicals are being produced, marginal revenue equals $1,000 and marginal cost $200: Perfect Competition MC C = 200 + 2C = Price of Chemicals MC C = 200 + 2x0 = 200 = 1,000 MC C = 200 Next, consider the farmer. Since no chemicals are being produced, the marginal cost curve labeled as C=0 is relevant. Since the food industry is perfectly competitive, the farmer s marginal revenue equals 800. Consequently, the profit maximizing quantity of food is 200 units. Clean up costs are 0: C = 0 F = 200 Clean-up costs = C F = 0 200 = 0 Is this state of affairs efficient? That is, can we devise a special deal that would benefit both the owner of the chemical firm and the owner of the farm? Suppose that the chemical firm produces 1 unit instead of none: C=0 TR up 1000 TC up 200 Profits up 800 C=1 The chemical firm s profits would rise by $800. The farmer's clean-up costs would rise from 0 to 200, however C = 1 F = 200 Clean-up costs = C F = 1 200 = 200 Suppose that the owner of the chemical firm would give the farmer a $400 side payment on the condition that the farmer would allow the chemical firm to produce

5 Summary 1 unit of chemicals. Both the farmer and the chemical firm are better off. The farmer would be $200 ahead and the owner of the chemical firm would be $400 ahead. Complete elimination of the externality leads to an inefficiently low level of chemical production. In other words, it is typically inefficient to have no pollution whatsoever. An externality is present whenever consumers or firms do not account for the full ramifications of their actions. In such a situation, the markets fail because decisions are based on erroneous information. A market failure occurs. More specifically when one party does not account for all the costs of its actions, a negative externality exists. In such a case, An unfettered market when each firm independently maximizes its own profits results in an inefficiently high level of production. On the other hand, complete elimination of the negative externality is typically inefficient also. (NB: it would be easy to deal with externalities if this second point were not true.) Efficiency calls for something in the middle. How can we get there?

6 The Coase Theorem Market Failure We have now found two causes of market failures: Monopoly Externalities We shall now discuss how the market failure problem can be remedied. Coase Approach Coase suggested a way to remedy market failures which relies on getting the affected parties together, bargaining, and striking deals. To understand the basic idea behind Coase's suggestion, we shall first consider when a deal be struck and when will it be impossible to strike a deal? Question: What must be true if two (or more) parties voluntarily agree to a deal? Answer: The deal must make at least one party better off. make no party worse off. The deal must make at least one party better off and make the other parties no worse off. If the deal made no parties better off, no one would have an incentive to pursue to the deal. If the deal made a party worse off, he/she would not voluntarily agree to the deal. Question: What must be true if it is impossible for two (or more) parties to agree to a deal? Answer: It must be impossible to find a way to make at least one party better off. make no party worse off. In this case, regardless of how long and hard the parties bargained they would never voluntarily agree to a deal. Next, let us review the efficiency criterion: Pareto s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No Is state of affairs getting the most Is state of affairs getting the most from the economy s resources? No from the economy s resources? Yes State of affairs is inefficient. State of affairs is efficient. Consequently, if parties get together and strike deals and continue to bargain until it is impossible for them to make any more deals, then it must be impossible to make someone better off without making anyone else worse off. That is, if parties get together and bargain repeated strike deals until they can voluntarily agree to no further deals, then we would end up with an efficient situation. For example, Coase would suggest that we sit the farmer an the owner of the chemical firm down at a table and have them bargain. Encourage them to strike deals. When we reached the situation in which they can no longer strike additional deals, we must have achieved efficiency. Now, let us state Coase s idea more formally:

7 Coase theorem: When bargaining costs are negligible: Bargaining leads to efficiency. Furthermore, the assignment of property rights does not affect the allocation of resources; the assignment does affect the distribution of income, however. An example helps us illustrate Coase's theorem. Consider two individual s: Mr. Smith and Ms. Jones. Mr. Smith, who suffers from asthma, is getting a new neighbor; Ms. Jones is building a house near Mr. Smith. Ms. Jones is deciding how to heat her house and has narrowed the options to two: electricity or wood. Electricity would cost her $5,000 per year and wood $2,000 a year. Ms. Jones does not suffer from any respiratory problems; consequently, the fact that wood burning will pollute the atmosphere does not concern her. Furthermore, she is not the least bit troubled by the inconvenience that wood heat might cause her. Scenairo #1: Ms. Jones has the right to pollute the air. In view of the relative costs of heating by electricity and wood, it is clear that Ms. Jones would choose wood, if the choice were hers alone; by doing so she would spend $2,000 per year rather than $5,000 on heat, a difference of $3,000. Mr. Smith hears that Ms. Jones will be using wood to heat her home, however. Since he has asthma, his lungs cannot not tolerate the pollution that accompanies wood burning stoves. If the air were polluted by Ms. Jones wood smoke, he would have to install a climate control system in his home which would filter the air. Such a system costs $2,500 per year. Obviously, Mr. Smith would like to persuade Ms. Jones to heat with electricity rather than wood. He could offer her a side payment on the condition that she agrees to heat with electricity: Mr. Smith s offer: If you, Ms. Jones, heat with electricity, I will pay you $x. Would they be able to strike a bargain? Answer: No. Mr. Smith would offer Ms. Jones at most $2,500 to switch fuels because the climate control system which he can purchase himself only costs $2,500. Since electricity is $3,000 more expensive for Ms. Smith, they will not be able to strike a deal. Mr. Smith will install the climate control system. Ms. Jones Mr. Smith Heats with wood Installs climate control system Spends $2,000 on heat Spends $2,500 on climate control Furthermore, note that this makes economic sense from the perspective of society as a whole. There are two ways to provide Jones with heat and Smith with clean air: Jones heats with electricity Jones heats with wood Smith installs climate control system Jones costs = $5,000 Jones costs = $2,000 Smith costs = $2,500 Total costs = $5,000 Total costs = $4,500 From the perspective of society as a whole, the cheaper way to provide Jones with heat and Smith with clean air is for Jones to heat with wood and Smith to install the climate control system. Outcome: Jones heats with wood and Smith installs climate control system. Scenairo #2: Mr. Smith has the right to clean air.

8 Mr. Smith now lobbies Town Hall. The town government passes an ordinance prohibiting Ms. Jones from heating with wood unless she receives Mr. Smith's approval. Ms. Jones could now offer Mr. Smith a side payment on the condition that he allow her to heat with wood: Ms. Jones offer: If you, Mr. Smith, let me to heat with wood, I will pay you $x. Will they agree to such a deal? Yes. Ms. Jones would pay Mr. Smith an amount between $2,500 and $3,000, say $2,700, to permit her to heat with wood. Mr. Smith would then buy the climate control system. Ms. Jones Mr. Smith Without deal: Heats with electricity No climate control system Spends $5,000 on heat Spends $0 on climate control With the deal: Heats with wood Installs climate control system Spends $2,000 on heat Spends $2,500 on climate control Side payment: $2,700 In net, spends $4,700 In net, receives $200 $300 better off $200 better off Outcome: Jones heats with wood and Smith installs climate control system. The two situation differ in how property rights are assigned. In the first instance, Ms. Jones has the right to pollute the air. In the second, Mr. Smith has the right to clean air. Note that the assignment of property rights does not ultimately affect how Ms. Jones heats her home and whether or not Mr. Smith installs the climate control system. The allocation of resources is unaffected: In both cases, the outcome is the same. Ms. Jones heats with wood; her heating expenses are $2,000. In both cases, Mr. Smith installs the climate control system which costs $2,500. The allocation of resources is unaffected by the assignment of property rights. In both cases, the efficient method is used to provide Ms. Jones with heat and Mr. Smith with clean air. How are their incomes (net of heating and climate control expenses) affected? The distribution of income is affected: When Jones has the right to pollute the air, Smith must pay for his $2,500 the climate control system himself. On the other hand, when Smith has the right to clean air, Jones in effect pays for Smith s climate control system. Limitation of Coase s solution: Bargaining costs Thus far, we have implicitly assumed that the costs of getting Mr. Smith and Ms. Jones together to bargain are negligible. When only two parties are involved we would not expect bargaining costs to be large, but as the number of involved parties increases bargaining costs would increase also. Consequently, we would expect Coase s solution to the externality problem to work well when the number of involved parties was small, but not work so well when the number was large.