What is Externalities and Resource Allocation?

Externality is an external cost or benefit of an activity that affects people who are not directly involved in the activity. Individuals or firms that consider only their own cost and benefits will tend to engage too much in activities that generate external cost and too little in activities that generate external benefits.

In general:

• For a good that produces external benefits, market equilibrium quantity is LESS than socially optimal quantity
• For a good that produces external costs, market equilibrium quantity is MORE than socially optimal quantity

E.g. consider an energy company using coal-burning generators, where each ton of output has a pollution cost of $1000. Show how this situation is not socially optimal

 For the company, equilibrium price is $1300 at 12000 tonnes a year. The $1000 pollution cost is an external cost since it doesn’t affect the company itself. Thus, the social marginal cost is $1000 more than the company’s marginal cost. In this case, last tonne of output brings $1300 benefit but at a cost of $2300 to society. This gives rise to deadweight loss and society can benefit from reducing production.

Socially optimal level is at 8000 tonnes a year.           

Irrelevant External Effects

• Pecuniary externality: an effect on the welfare of other people that occurs through changes in relative prices. It is an application of the invisible hand that allocates resources, i.e. some people are better off, some are worse off but market is not more or less efficient
• Inframarginal externalities: the magnitude of the eternal cost or benefits of activities that does not depend on small changes in the level of activity in the market

Coase Theorem

The Coase theorem states that if people can negotiate, at no cost, the purchase and sale of the right to perform activities that cause externalities, they will arrive at efficient solutions to the problems caused by the externalities.                 

E.g. Consider Ruth whose factory dumps toxic waste into the river which harms fisherman Hugh. Ruth can install a filter at a cost to remove this harm, how should Hugh negotiate?

Hugh should offer $40 to Ruth for the filter, this way both are $10 better off for a net gain of $20

Legal Remedies for Externalities

Legal remedies such as laws help people to reach efficient solutions where negotiation is difficult. These laws generally require the adjustments to be made by the party that can do it with the lowest cost. E.g. restrictions on loud music are often on late weekend nights, because the cost of loud music to other people is less on weekend than weekdays.

Market-Based Instruments (MBIs)

MBIs are policies that positively influence the behaviour of people in markets to achieve targeted outcomes, i.e. to lower production of goods that generate negative externalities.

Ø  Price Based MBIs

Price based MBIs include:

• Subsidies to encourage activities with positive externalities
• Taxes to discourage activities with negative externalities

Both tax and subsidy should be equal to the external cost/benefit in order to achieve socially optimal levels. They make the economy more efficient by making produces take account of relevant social cost that they ignore as a profit maximising firm

Ø  Quantity Based MBIs

The best known quantity based MBI is the marketable permit system, it creates a market to facilitate the trade of environmental goods, such as pollutant. It involves:

• Set a quantity cap that limits allowable emissions
• Define entitlements and distribute these among users
• Create a market to enable the trade of entitlements

E.g. consider firm X and Y that can use 5 production processes with different amounts of pollution. To half emissions, government can either enforce a law to cut emissions or impose a tax.

Without regulations, both will use process A and produce 8 tonnes of pollution

• Legal Remedy – law that requires produces to cut emissions by half

This law forces both to use process C, adding cost of $500 to X and $80 to Y, for a total of $580

• Price Based MBI – Tax of $101 per tonne

Firm X will now use B, since producing another tonne of pollution cost $101 but only saves $100 on production cost. Firm Y now use process D, since the saving on production cost for ever extra tonne is $100, $60 and $20, all less than the tax of $101. Total cost is $100 + $180 = $280.

Advantage of tax is that it concentrates pollution reduction on firms that can do it with the least cost. Laws requiring every producer to cut the same amount ignore the fact that some producers can cut pollution much cheaper than others.

• Quantity Based MBI – Government auctions 4 permits at $101 each

Without permits, X and Y must use process E at cost of $2300 and $700. If 4 permits are sold at

$101 each, firm X will demand 3, since moving from E to D, C and B saves more than $101 each time. Firm Y will demand 1, since moving from E to D saves $280, more than the permit.

Advantage of permits is that it does not force firms to commit to costly investments. It also allows the public to determine where emissions levels should be, e.g. people who want higher reduction targets can buy permits in order to prevent companies from emitting more.