UNIT 3: EXTERNALITY

EXTERNALITY
An externality is a link among economic agents that lies outside
price system of economy. An externality is present whenever
some economic agents’ welfare (utility or profit) is directly
affected by action of another economic agent in the economy. By
“directly” we exclude any effect that are mediated by price, it
means an externality is present if productivity of fishery firm is
affected by river pollution but there will be pecuniary externalities
when profit of fishery firm reduces due to increase in price of an
input. We must note that pecuniary externality will not create any
inefficiency. Therefore, it means that externality is a link among
economic agents that lies outside price system of economy.
Externalities can be production externality or consumption
externality. A production externality occurs when effect of
externality is on profit relationship, while in the case of
consumption externality utility level is affected. Using this
definition of externality, it is possible to incorporate them into
analysis of behaviour of household and firm.
Let consumption level of household are denoted by,
X = {X1, X2….XH}
And production plan of firm is denoted by,
Y = {Y1, Y2….YM}
It is assumed that consumption externality enters the utility
function and production externality enter into production
function. At the most general level this assumption imply that
utility function takes the form
Uh = Uh (X, Y) h = 1, 2,…..H
And production sets are described by
Yj = Yj (X, Y) j = 1, 2,……M
In this formulation the utility function and production sets are
potentially depended on entire consumption and production
level.

MARKET INEFFICIENCY

Due to presence of externality market outcome is not Pareto

efficient and therefore, it will maximise social welfare. Consider a
two consumer two good economy where consumers have utility
function
U1 = X1 + U1 (Z1) + V1 (Z2)
U2 = X2 + U2 (Z2) + V1 (Z1)
The externality is generated by consumption of good Z, so
externality will be positive if Vh(.) is increasing in consumption
level of another consumer and it will be negative if it is decreasing.

+Ve Externality Cost SMB (Vh > 0)

SMB > PMB & Benefit PMB
SMB
Under Production (Vh < 0)

-Ve Externality MC
SMB < PMB
Over Production

0 Z*** Z* Z**
In general, it can be concluded that if externality is positive then
more of good Z will be consumed at optimum then under market
outcome. The converse will hold for negative externality.
The market outcome is represented by equality between private
marginal benefit of good and marginal cost. The social marginal
benefit of good is sum of private marginal benefit and marginal
external effect when Vh is positive then SMB is above PMB and
when Vh is negative then SMB is below PMB. The pareto efficient
outcome equates SMB to MC, the market failure is characterised
by too much consumption of a good causing negative externality
and too little consumption of good generating positive externality.
The pareto efficient allocation is determined by maximising total
utility of consumer subject to production possibilities.
Max U1 + U2 = [X1 + U1 (Z1) + V1 (Z2)] + [X2 + U2 (Z2) + V1 (Z1)]
Subject to W1 + W2 – X1 – Z1 – X2 – Z2 ≥ 0

EXAMPLES
1. RIVER POLLUTION
Assume that two firms are located along the same river. The
upstream firm pollute river which reduces production of
downstream firm. Both firms produce same output which they sell
in market at a constant price of Rs.1 so that total revenue
coincides with production function.
Labour and water are used as inputs. Water is free but competitive
wage (W) is paid to each unit of labour. The production functions
are given by
FU(LU) Production function of Upstream firm
D D U
F (L ,L ) Production function of Downstream firm
𝑑𝐹𝐷
Where < 0, which reflect that pollution reduces output of
𝑑𝐿𝑈
downstream firm. Decreasing returns to scale are assumed with
respect to old labour input. Each firm act independently and they
maximise their profit.
 ΠU = FU(LU) – W.LU
ΠD = FD(LD,LU) – W.LD
Each firm maximises their profit at competitive market
equilibrium but it is not pareto efficient because reallocating
labour between firms increases total profit and reduces pollution.
This is because a small reduction in labour used by upstream firm
will shift production function of downstream firm upward. As a
result, aggregate profit increases for society and it also reduces
amount of pollution. Therefore, market equilibrium was not
pareto efficient.

2. TRAFFIC JAMS

Minutes
Commuting

Maximum Car Time = ( Time - Time ) x No. Of Cars

Time Saving Saved By Train By Car
40 Train

20

0 Efficient Market % of Car Users

Outcome Outcome
Let there be n number of commuters who have a choice of
commuting by train or by a car. Commuting by train always takes
40minutes regardless of number of travellers, but commuting
time by car increases as car users increases.
This congestion effect which increases commuting time is an
externality for travellers. Individual must each make decision to
minimize their own transportation time.
At equilibrium the number of car users will adjust until the travel
time by car is exactly equal to travel time by train. However, it is
not optimum because aggregate time saved will be zero. Social
optimum occurs when aggregate time saving is maximised and it
requires that a smaller number of cars should be on road. In this
example externality arises because each car driver takes into
account only their own travel time but not the fact that they will
increase travel time for all other drivers. As a result, too many
commuters choose to drive.

3. PECUNIARY EXTERNALITY
Consider a set of students each of whom must decide whether to
be an economist or a lawyer. If number of economists increases
significantly then they will eventually earn less then lawyers.
Suppose each person chooses the profession with best earning
prospect. While making decision each student ignores the
external effect on other students.
An important question is whether market equilibrium determines
correct allocation of students across different profession. The
equilibrium is determined by the point of intersection. To the right
of it lawyers earn more then economist and to the left of it,
economist earns more than lawyers. Due to this student will
continue to change their profession.
The free market outcome is efficient because the external effect
is a change is price. Since it is mediated by price so there is no
inefficiency.
Its policy implication is that any government policy that aims to
limit the access to some profession is not justified. Market forces
will correctly allocate the right number of people to each of the
different profession.

4. RAT RACE PROBLEM

The rat race problem is a contest for relative position as
highlighted by George Akerlof. It can help to explain why students
work to hard when final marking takes the form of a ranking. It can
also explain the intense competition for a prepromotion in
workplace when candidates compete with each other and only the
best is promoted.
Assume that performance is judged not in absolute term but in
relative terms, so that what matters is not how much is known but
how much is known compared to what other students know. In
this situation an advantage over other students can be gained only
by working harder than they do but since performance is judged
in relative terms so all extra efforts cancel out.
The result of which is inefficient rat race, in which each student
works too hard to no ultimate advantage. If all could agree to work
less hard then same ranking can be achieved with less work, but
such an agreement to work less hard cannot be self-supporting
because each student will have an incentive to work hard as it is
their dominant strategy.
In the game below both students have dominant strategy to apply
more effort but they are achieving same relative ranking.

B
Low High

Low

High

0<C<½

5. TRAGEDY OF COMMONS
The tragedy of commons arises from the common right of excess
to a resource. The inefficiency caused by tragedy of common
results from divergence between individual and social incentive
that characterised all externality problem.
Consider a lake that can be used by a fisherman from a village
located on it bank. The fisherman does not own a boat but he can
take it on rent for a daily use at a cost C. if B number of boats are
hired on a particular day, the number of fish caught by each boat
will be F(B) which is a decreasing function. A fisherman will hire a
boat if they can make a positive profit. Let opportunity cost of time
is wage rate W and price of fish is Rs. 1, so that total revenue
coincides with number of fish.
In such case the number of boats that will be rented by fisherman
will be determined by following equilibrium condition.
F(B*) -C = W Private Optimum
The optimal number for community must be that which maximises
total profit for the village, net of opportunity cost from fishing.
Max B [F(B) – C – W] Society Optimum
Since an increase in number of boats reduces quantity of fish
caught by each fisherman. So average revenue is declining and
therefore marginal revenue will be less then average revenue. So,
equilibrium number of boats will higher then optimal number.

C + W + tax

C+W

MR AR

0 Social Market No. Of

Optimum Optimum Boats (B)

The externality is at work because each fisherman is concerned

only with their own profit and they do not take account of the fact
that they will reduce quantity of fish for other fisherman. This
negative externality ensures that in equilibrium too many boats
are operating on lake.
NOTE: to achieve efficiency tax can be imposed which increases
cost for fisherman and thereby reduces number of boats.
6. BAND WAGON EFFECT
It studies the question of how standards are adopted and in
particular how it is possible for wrong standards to be adopted.
The standard application of this is choice of arrangement for the
keys on a keyboard. The current standard QWERTY was designed
in 1873 by Cristopher scholars, in order to deliberately slow down
the typist by maximising the distance between most used letters.
The motivation for this was reducing the key jamming problem. By
1904, the QWERTY keyboard was mass produced and became the
accepted standard. Th key jamming problem is now irrelevant an
da simplified alternative keyboard is DVORK keyboard. Simplified
alternative keyboard has been devised that reduces typing time
by 5-10%, but this alternative keyboard has not been adopted
because there is switching cost and all users are reluctant to
switch and bear the cost of switch and retaining and therefore
manufactures see no advantage in introducing the alternative.
Therefore, it has proved impossible to switch to better
technology. This problem is called band wagon effect and it is due
to network externalities.
1

Percentage p*
Of
QWERTY Users
At Time t+1

0 p* 1
Percentage Of QWERTY Users At Time t
SOLUTIONS OF EXTERNALITIES

1. PIGOUVIAN TAX

-Ve Externality +Ve Externality

The description of market inefficiency has shown that its basic

source is divergence between social and private benefit or
divergence between social and private cost. A natural way to
eliminate such divergence is to employee appropriate tax or
subsidy. By modifying the decision problem of firm and consumer
it is possible to move market to efficient position.
Due to negative consumption externality SMB < PMB. In the
absence of government intervention equilibrium is determined by
intersection of PMB and PMC but efficient level is determined by
intersection of SMB and PMC. The market outcome can be
improved by imposing tax and for that purpose Pigouvian tax is
imposed and its size is equal to MEB (Negative) at efficient level of
consumption.
Pigouvian tax has been proposed as a simple solution to
externality problem, the logic is that consumer or firm causing
externality should pay tax equal to marginal damage that
externality causes. In the case of positive externality there should
be Pigouvian subsidy.
There are certain issues involved in implementing Pigouvian tax.
Since consumer preference differs so efficient outcome can be
attained only when different tax rate for each externality
generating good is imposed for each consumer. It means achieving
efficiency requires that taxes to be differentiated across goods
and across consumers and It leads an unachievable degree of
differentiation.

2. INTERNALISATION
Externality problem can be solved by insisting that economic
agents such as firms should be merged. One way of avoiding
inefficiency is to internalise the external cost. It ensures that
private and social cost becomes same. It works for both
production and consumption and whether they are positive or
negative externality.
However, internalisation as solution is not free from its difficulties.
An important problem with merger is that it will lead to greater
degree of monopoly and that will lead to welfare loss. In addition,
economic agents involved may not agree for merger, this problem
is particularly insignificant when it is applied to consumption
externality.
3. COASE THEOREM (ASSIGNMENT OF PROPERTY RIGHTS)
Coase theorem suggests that economic agents may resolve
externality problem themselves without the need of government
intervention. According to this theorem if market is allowed to
function freely then it will achieve efficient allocation of resource.
In a competitive economy with complete information and zero
transaction cost the allocation of resource will be efficient
irrespective of assignment of property right. Once property right
gets assigned then there is no need for government intervention.
it does not matter whether polluter pays or pollute pays, once
rights get assigned and market is created then through exchange
efficiency can be attained.
Let C be the amount of compensation that firms require, on the
other hand cost of pollution to household is G. In that case if
G > C, then compensation takes place and there will be no
inefficiency. On the other hand, if C > G, then firms would continue
to create externality because household’s willingness to pay is
less. Same outcome can be attained when property right is given
to household. However, we must note that with different property
right there will be different distribution of income as a result there
could be change in demand. So, Coase theorem will hold only if
redistribution of income does not cause change in level of demand
which requires that there should be no income effect.
When property right is assigned then economic agents can
achieve pareto efficiency through bargaining also, but bargaining
will be possible only in a small group and only when willingness to
pay is greater than cost.