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     When the activity of one agent
unintentionally imposes costs on, or brings
        benefits to, another agent.
A Negative Externality: Pollution
1. production
  1. to production
  2. to individual welfare
2. consumption
  1. to production
  2. to individual welfare
        Positive Externalities
1. Bees and fruit trees
2. Neighbor’s garden
3. Vaccination, etc
        Analysis of Pollution
• Private cost of production: A cost that is
  borne by the producer.
  – hired labor
  – rental of machines and buildings
  – material inputs
• Marginal private cost (MC): Cost of
  producing an additional unit that is borne
  by the producer.
• Marginal external Cost (MEC): The cost of
  producing an additional unit that falls on
  other agents than the producer. (i.e. Not
  borne by the producer.)
• Marginal social cost (MSC): Marginal cost
  of production imposed on whole society.
             MSC = MC + MEC
To add them up, costs must be expressed in
                 same units.
• Convenient to use $.
• MC: Represents a true social cost in a well
  functioning market.
  – In LDCs, land, labor, and credit markets often
    do not function well. (distortions)
  – opportunity cost: value of the inputs in their
    best alternative use.
 Expressing MEC in $ assumes that external
        costs have equivalent $ value.
• Easy in the case of production
  – lost fish due to river pollution
  – lost agricultural output due to Global Warming
  – lower value of houses due to polluted river
  More complicated in the case of health
       effects (scandalous to some)
• But we do it all the time!
  – Organic food: too costly for most families
  – Safety features in cars: value of life?
  – No. of supervisors in kindergarten
  – Choice of location within city.
  – Doctors decide whether to prolong life or
  – Costs of medicines
  – Building a school instead of a hospital.
             Back to
          MSC = MC + MEC

• NB Graphic assumes that MC and MEC
  increase with output.
• Unfettered market outcome:
• D measures marginal benefit of coffee
  consumption (chap 6)
• External costs are not accounted for.
• Market yields inefficient outcome. Why?
• Social cost of production exceeds MB.
• Calculate deadweight loss.
• …
Some solutions to externalities
             Property rights:

Legally established titles to the ownership,
 use, and disposal of factors of production
      and goods and services that are
         enforceable in the courts.
       The property rights solution
              Example 1
• River with 500 houses and polluting mill upstream.
• Loss of rent: 1000$/house
• Assume: Riverside residents « own » rights to a clean
• Mill must ask for permission to pollute river.
• House owners ask for at least 500000$/m. in
  compensation. (Each owner would not accept less than
• Mill pays to pollute only if benefits from pollution exceed
                      Efficiency restored
     The property rights solution
            Example 2
• Jane and Tarzan share office
• Jane’s benefit from smoking: 500$
  – i.e. indifferent…
• Tarzan’s loss: 1000$
  – i.e. indifferent…
• Nego: Tarzan offers 800$ to Jane for her to stop
  smoking in office.
• gains from trade:
  – Surplus Jane: 300$
  – Surplus Tarzan: 200$
               Efficient outcome
• Final allocation : no smoke.
• Q. Are the actual amounts paid relevant to
  determine if outcome is efficient or not?
• Q. Why is Tarzan the one to pay?
• Try allocating the right to Tarzan…
         The Coase Theorem
 If transaction costs are negligible, resource
     allocations will be efficient, regardless of
     who owns the property rights. The initial
        allocation of PR will, however, affect
                 wealth distribution.
• Right to jane implies +800$ for Jane and -
   800$ for tarzan, compared to right to
   Tarzan. In both cases, there is no
            Reconsider ex 1
• What if mill can pollute at will?
       Important implications
• If people can negotiate freely, direct gvt
  intervention is not necessary to achieve
  efficiency. All that is required is clear
  definition of PR.
  – Chicago school (in parts)
  – Minimal state?
  – laissez-faire economy?
• Q. Have you ever seen someone offer
  money to a smoker in a resto?
• …
          Transaction costs
• Can block gains from trade.
  – lawyer fees
  – negotiation failures
  – large no of asymmetric parties
  – costly enforcement
 Sometimes, gvt must intervene to achieve
  M & A as solution to externalities
1. Mill buys out houses along river.
2. Bees and apple trees
         Fundamentals of theory of firms:
             contracts vs acquisition
• Why don’t we have one large firm that
   produces everything?
  –   Problems of control: Incentives to be efficient,
      improve quality, etc.
  –   Firm size represents a tradeoff between both
  Internalization of externalities
• When previous externalities are now
  accounted for, either through contract
  nego (market creation), M&A, or other,
  more direct, gvt intervention.
• NB M&A will not work in the ex of Tarzan
  and Jane. Why? Should they get married?
          Direct gvt interventions
•    4 types to consider here:
    1.   Command and control
    2.   taxes
    3.   Effluent charges
    4.   marketable permits
      Command and Control
• forbid certain activities
• determine max amount of emissions
• Problems:
  – No incentives to cut back further. No R&D.
  – Restrictions may be too harsh.
            Regulator needs a lot of info.
• t = tax per extra unit of output
• Set t = MEC at efficient output level.
• graphic…
         Emissions charges
• tax/unit of emissions
• Roughly similar to output taxes:
  – Higher incentives to adopt cleaner techno.
  – Gvt raises revenues while increasing
    efficiency. (win-win)
• Economists usually prefer taxes to C&C.
    Taxes are generally more efficient to
      achieve same pollution objective.
   Emissions charges vs C&C
• 2 firms
• Each 500 t/y of emissions
• Regulator’s objective: reduce total
  emissions to 600t/y
• 300 t/y allowed each
            Emissions Taxes
• 50000$/t of emissions
  – firm A abates to 200t/y
  – firm B abates to 400 t/y
  – total still at 600 t/y
  – NB Firms have different abatement costs
• Firm A abates more because it can do so
  at lower cost.
 With taxes, less info is required to achieve
     same pollution objective at lower cost.
• Which is more fair?
          Marketable Permits
• Problem with taxes: may be difficult to find
  right tax level to achieve objective (trial
  and error process)
• Marketable permits: Instead of setting a
  limit to each individual firm, set global limit,
  distribute corresponding permits, and let
  firms exchange them.
         Marketable Permits
• Give 300t/y of permits to each firm.
• B would save 1m$/y if it could emit 400t/y
• It would cost 0.5m$/y to A to reduce from
  300t/y to 200t/y.
• B offers 0.75m$ to A to buy 100t/y of
  emissions permits.
• Total pollution unchanged but total cost of
  abatement is 0.5m$/y lower.
         Marketable Permits
• Advantage over taxes is that there is no
  need to know the right tax level to achieve
  objective. No trial and error. The market
  will determine the price of pollution by
• Efficient allocation is attained regardless of
  initial distribution of pollution rights. (Does
  this remind you of something?)
• private benefit: A benefit that the consumer of a good
• marginal private benefit (MB): The benefit from an
  additional unit of a good or service that the consumer of
  that good or service receives.
• external benefit: The benefit from a good or service that
  somebody other than the consumer receives.
• marginal external benefit (MEB): The benefit from an
  additional unit of a good or service that people other than
  the consumer enjoy.
                      MSB = MB + MEB
        Positive externality:
     knowledge from education
• MB:
  – better salaries
  – more interesting job
  – satisfied curiosity
    knowledge from education
• External benefits:
  – better choice of elected gvt
  – more effective communication between
  – more tolerance towards each other
  – better citizens (environmental degradation,
    crime rates, vandalism, etc)
  – more support for higher quality TV, radio,
  – transfer of knowledge to others (LDCs…)
    knowledge from education
1. add MSB curve to graphic
2. add private supply curve
    Free market outcome is inefficient.
     knowledge from education
• NB Calculation of deadweight loss is
  independent of who pays for education. Given
  quantity at 150, amount paid affects wealth
  distribution but not relevant for efficiency.
• With positive externalities, free markets will
  generally provide too little of the good or service.
  Opposite of neg. ext.
• Market failures call for gvt intervention (as long
  as it does not make things worse, which may be
  the case (Chicago school)).
           Positive externalities:
•   invention of wheel
•   discovery of medicine (penicillin)
•   trigonometry
•   rock music
•   electricity
•   light bulb
     People often copy ideas of other without
                   paying for it.
•    Social benefit > private benefit
•    Free market supplies much too few ideas.

                What can the gvt do?
1.   public provision
2.   private subsidies
3.   vouchers
4.   patents
         Positive externalities:
             gvt solutions
• Public provision: The good or service is
  provided by a public authority (state-
  owned enterprise)
• NB Contrary to book, I’m not sure if it is
  relevant to mention which part of revenue
  comes from where.
         Positive externalities:
             gvt solutions
• Private subsidy: A payment by gvt to firms
  per unit of output.
Public provision vs Private subsidy
•   Both efficient as per your model.
•   Additional issues concerning education:
    1. monitoring of school performance
    2. incentives to provide quality education
    3. fairness
        Positive externalities:
            gvt solutions
• Vouchers: A token that gvt gives to
  households, which can be used to buy a
  specific good or service.
• Reduces problems of fairness and
• Our university system?
          Positive externalities:
              gvt solutions
• Patents and copyrights: A gvt-sanctioned
  exclusive right granted to the inventor of a good,
  service, or productive process to produce, use,
  and sell the invention for a number of years.
• Creation of PR over ideas (Intellectual PR)
• Once PR are defined, owner can exchange with
  rest of society and reap total social benefits (or
  part of external benefit). Coase theorem.
• Provides incentives to create valuable ideas
• Very important to understand prosperity in
  last 200 years.
• Technological progress
• Comparatively small role played by natural
  resources and colonization for
  industrialized countries. (Though effects of
  those may be important to explain poverty
  in Africa. See my Intro à l’éco. du dével.)
• An institution that creates PR where none existed before.
• Institution: Rules of the game. (laws, social norms,
  culture, religion) Requires definition and enforcement
• For markets to function properly, PR must be well
  defined and enforced over valuable goods. Gvt
  intervenes in
   – theft
   – contract violations
   – land and house eviction
• In this respect, PR over ideas is really no different from
  PR over other goods and services
• IPR is a market-based mechanism. (State could
  also supply ideas through state research
  institutes. Does it for fundamental research
  because not directly profitable in market.)
• PR over ideas differ from PR on goods and
  services in one important respect: They give a
  monopoly to its owner. (chap 14)
• With monopoly, prices are too high. That’s why
  IPR are limited in time. It’s a tradeoff.
• Problem in LDCs for medicines.
• PR can also take the form of common
  property. (next chapter)

   Institutions are crucial to understand
      difference between rich and poor