Externalities

Externalities

• An externality
• Present whenever the well-being of a consumer or the
production possibilities of a firm are directly affected by
the actions of another agent in the economy
• Occurs whenever the activities of one economic agent
affect the activities of another economic agent in ways
that are not reflected in market transactions.
• Toxic chemical discharges
• Noise from airplanes
• Litter

2
Externalities

• Interfirm externalities
• One producing good x and the other producing good y
• The production of x will have an external effect on the
production of y
• If the output of y depends not only on the level of inputs
chosen by the firm but on the level at which x is produced

y = f(k,l;x)
Externalities

• The output of firm x could have a negative marginal

physical productivity
𝜕𝑦
<0
𝜕𝑥
• Increases in x output would cause less y to be produced.
• The relationship between the two firms can be beneficial
• Two firms, one producing honey and the other producing
apples
y
0
x
Externalities

• Externalities can also occur if the activities of an economic

agent directly affect an individual’s utility
• Externalities can decrease or increase utility
• Someone’s utility dependent on the utility of another

utility = US(x1,…,xn;UJ)
𝜕𝑈𝑆
• can be negative or positive
𝜕𝑈𝐽
Externality

• Public goods externalities

• Once they are produced, they provide benefit to the
entire group
• It is impossible to restrict these benefits to the specific
group of individuals who pay them.
Example of production externality

• Suppose we have two firms, firm 1 produces x (sell in

competitive market), which imposes a cost e(x) on firm 2.
• Suppose the technology is such that x units of output can
only be produced by generating x units of pollution.
Example of production externality

• Let p be the price of output, the profits of the two firms are
𝜋1 = max 𝑝𝑥 − 𝑐(𝑥)
𝜋2 = −𝑒(𝑥)
• Firm 1 chooses x at p = c’(x)
• c’(x) is private marginal costs
Example of production externality

• To determine the efficient output, we ask what would

happen if the two firms merged so as to internalize the
externality.
• Merged firms would maximize
𝜋 = max 𝑝𝑥 − 𝑐 𝑥 − 𝑒(𝑥)
• Firm chooses x at p = c’(xe) + e’(xe)
• c’(xe) + e’(xe) is social marginal costs
Externalities and Resource Allocations

• Externalities lead to inefficient allocations of resources

• Market prices do not accurately reflect the additional
costs or benefits to third parties
• The First Welfare Theorem does not hold in the
presence of externalities.
• Because there are things that people care about that are
not priced.
Traditional Solutions to the Externality Problem

• Quotas and taxes

• Fostering bargaining over externalities: enforceable property
rights
• Creating the market for externality
Quota and taxes

• Quota: The most direct sort of government intervention is

the direct control of the externality-generating activity it self.
• Mandate that the amount cannot exceed the optimal level.
Quota and taxes

• Taxes: Impose a tax on externality-generating activity. The

idea is that firm faces the wrong price for its action, and a
corrective tax can be imposed that will lead to efficient
resource allocation.
• Known as Pigouvian taxation.
Quota and taxes
Quota and taxes

• Suppose firm faced a tax on its output in amount t.

• 𝜋 = max 𝑝𝑥 − 𝑐 𝑥 − 𝑡𝑥
• Profit maximization: p = c’(x) + t. Therefore, can set t = e’(xe)
to achieve optimal output.
Quota and taxes

• Note that the optimality-restoring tax is exactly equal to the

marginal externality at the optimal solution.
• Optimality can be achieved either by taxing the externality
of by subsidizing its reduction.
• It is essential to tax the externality-producing activity
directly.
• Government must have a great deal of information about
the benefits and costs of the externality for the parties
involved to set the optimal levels of either the quota or the
tax.
Fostering bargaining

• Pollution rights equilibrium

• The rights are well-defined
• And tradable with zero transactions costs
• The initial assignment of rights is irrelevant
• Subsequent trading will always achieve the same, efficient
equilibrium
• This solution to the externality problem has a significant
advantage over the tax and quota schemes in terms of
the level of knowledge required of the government.
Creating the market

• Problem: firm 2 cares about pollution generated by firm

1 but has no way to influence it.
• Adding a market for firm 2 to express its demand for
pollution will provide mechanism for efficient
allocation.
• Firm x must purchase from firm y the rights to pollute the
river they share
• x’s choice to purchase these rights is identical to its
output choice
• Net revenue per unit: p – r
• Where r is the payment the firm must make to firm y for
each unit of x it produces
Creating the market

• In our example, x units of pollution are unavoidably

produced for every x units of output produced. If the market
price for pollution is r, then firm 1 can decide how much
pollution it want to sell, x1 and firm 2 can decide how much
pollution it wants to buy, x2.

𝜋1 = max 𝑝𝑥1 + 𝑟𝑥1 − 𝑐 𝑥1

𝜋2 = max −𝑟𝑥2 − 𝑒 𝑥2
Creating the market

• FOCs are
p + r = c’(x1)
-r = e’(x2)
• When supply equals demand we have x1=x2, leads to
p = c’(x) + e’(x) … socially optimum.
• If a competitive market exists for the externality, the
optimality results. Thus, externalities can be seen as being
inherently tied to the absence of certain competitive
markets.