Externalities Externalities

Negative Production Externalities Positive Production Externalities

• Occurs when production of a good reduces the well-being of parties that are not involved in the production processes. • Occurs when the production process increases the well-being of other parties but the party involved in the production
Also, they are not compensated for the losses. process is not compensated.
• Higher marginal costs ( PMC to SMC ) results in over production and hence the deadweight loss. • Higher marginal benefits (MPB to MSB) results in under production and thus creates loss of welfare.
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Externalities Externalities
Externalities arise when the parties involved neither bear the costs nor receive the benefits for their actions. Negative Consumption Externalities
• Occurs when the consumption of a commodity reduces the well-being of others and are not compensated for the same.
• Private Marginal Cost (PMC) : Cost incurred by the producer for producing an extra unit of a good • Lower marginal benefits (MPB to MSB) results in over consumption of the commodity and hence, the loss of welfare
• Social Marginal Cost (SMC) : Private marginal cost plus any external cost imposed by the production occurs.
• Private Marginal Benefit (PMB) : Benefits accrued to the consumer by consuming an additional unit of a good
• Social Marginal Benefit (SMB) : Private marginal benefit minus any cost incurred to any party during the consumption
of the good.
Externalities
• Negative production externalities
• Negative consumption externalities
• Positive production externalities
• Positive consumption externalities
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 Solutions to Negative Externalities
Why is the market unable to compensate the affected parties in case of negative externalities?
Due to the absence of property rights which might have helped the contributing/affected parties to claim for
compensation.
Coase Theorem
• Given, well-defined property rights and costless bargaining, the negotiations between the parties creating the
externality and the parties affected by externalities will result in a socially optimum level of market quantity.
• The efficient solution does not depend on which party is assigned the property rights, as long as either of the party is
assigned the rights.
Once the property rights are clearly defined, it is easy to internalise the externality. Internalisation of the externality
happens when the private negotiations (or the govt. mandate) causes the market price to fully reflect the costs/benefits of
the party’s actions. This paves way for the proper estimation of the marginal social cost/benefit curves which can yield
socially optimum levels of consumption or production.
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Externalities
Positive Consumption Externalities
• Occurs when the consumption of a commodity increases the well-being of others but the party consuming the
commodity is not compensated for the same.
• Lower marginal costs ( MPC to MSC) results in under consumption and hence the welfare loss.
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Solutions to Negative Externalities
Public sector solutions to externalities:
• Corrective taxation : Just like the Coasian solution, a corrective tax shall internalise the externality and result in
socially efficient level of production (in the case of a negative production externality).
• Subsidies : Subsidies paid by the govt. to an individual or firm lowers their cost of consumption or production
respectively.
• Regulation : Mandate by the govt. to bring the production to the socially optimal level. This method is
straightforward; but the govt. must know the exact quantity that is socially desired.
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Solutions to Negative Externalities
Problems associated with Coasian solutions:
• Assigning the cost/benefit accruing to a party and the accurate estimation of the damage or advantage is difficult. It
results in over-statement of the damage or under-statement of the benefits.
• Shared ownership of the property might give each owner, power over the others. This materialises when the party
involved goes for negotiation in the final round.
• There is a possibility of free rider problem when the investment has a personal cost but a common benefit and thus, the
individuals will under-invest. This happens because the party gets the benefit even if he does not pay for it, as the
benefits are common.
• Transaction costs and negotiation problems can be huge depending on the scale of the problem. In reality, all these
processes might consume lot of time and yet result in no solutions.
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 Solutions to Negative Externalities Solutions to Negative Externalities
Multiple Plants Case: What happens if the government is uncertain while imposing quantity restrictions?
Suppose there are two firms such that the cost of firm 1 and firm 2 adds up to the total marginal cost of pollution The government estimates regarding the cost curves of the firms may not be right always. Suppose if the govt.
reduction. Optimal quantity of pollution abatement is when the total marginal cost of abatement intersects the social underestimates the cost curves of the firms and impose quantity regulation/taxes in pollution abatement, then there will be
marginal benefit (150 units). How should the units be divided among the firms for abatement? loss of welfare, depending upon the slope of the social marginal benefit curve for different externalities.
In case of a flatter marginal damage curve or marginal benefit curve, the loss of welfare due to taxation will be lesser than
the loss of welfare resulting from quantity regulation (if the costs are under-estimated). If the marginal damage curve is
steeper, the effect would be the opposite.
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Price and Quantity Approaches Solutions to Negative Externalities
Price Approach : Taxation Multiple Plants Case:
Quantity Approach : Regulation
• Abating the pollution in equal units will not be efficient as both firms have different marginal costs (Let us assume that
• The baseline model shows the socially optimum level of pollution abatement to be at 𝑄∗ (where SMB = SMC). On the the difference in marginal cost is due to the superior technology employed by firm 1in pollution treatment, which
x-axis, towards the origin “o”, we measure the level of pollution as well. reduces the cost incurred by firm 1).
• Ideally, each firm should abate as many units as indicated by the point of intersection between its MC curve and the
total MB curve. In this case, firm 1 should abate 100 units and firm 2 should abate 50 units. By doing so, at the
optimum level of pollution abatement, the marginal cost of firms 1and 2 will be the same.
This is the case of quantity regulation.
In the case of price regulation or corrective taxation also, the efficient level of reduction can be attained if the tax is equal
to the marginal damage or social marginal benefit.
Quantity regulation can be made slightly mode flexible by way of introducing tradeable permits. If equal number of
• If taxes are imposed, the optimal quantity of pollution reduction will depend on the tax amount. If the cost of pollution pollution permits are obtained by both firms, firm 2 will buy permits from firm 1 as the latter cannot treat more than the
optimum quantity.
abatement is lesser than the tax, then the firms will go for pollution abatement and not pay the taxes; and vice-versa.
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 Public Goods Optimal Provision of Private Goods
• A freely available public good (where property rights are not properly defined), will most likely be over exploited as • At private market equilibrium, different consumers prefer different amounts of goods at the same price. The market
there are no costs associated with the usage of the good. When a pure public good is provided/accessible to all takes in to consideration this difference in tastes and preferences and adds up the individual demand to attain the
irrespective of their contribution, people will not be willing to pay for it and rather use if freely. aggregate demand curve. Equilibrium is attained when this aggregate demand curve intersects the aggregate supply
• Reluctance of individuals to contribute voluntarily to support the provision/consumption of public goods is known as curve.
the free rider problem.
• An individual’s optimal consumption level is attained when the budget line is tangent to the highest possible
• When a good is provided freely, there is most likely an overconsumption of the good. As the individuals do not have to indifference curve; i.e. when the marginal rate of substitution equals the price ratio of goods. The optimality condition
pay for the good, they will demand it to a point where the marginal benefit derived out of it becomes zero even though (when A and B are two individuals):
the cost of providing it is positive. 𝑀𝑈 "
! 𝑃
" = 𝑀𝑅𝑆 $ = !
= 𝑀𝑅𝑆!,# !,#
• Publicly provided goods which involve huge marginal costs for the provision of an extra unit, is called publicly 𝑀𝑈#$ 𝑃#
provided private goods.
• E.g. Free education, drinking water. • If price of x is 4 and price of y is 1 then, at equilibrium, each individual (A or B) will be indifferent between giving up
4 units of good y for one extra unit of good x. But the level of consumption at which each individual is willing to make
• In case of certain goods like water, saturation point in consumption will be reached quickly and thus, the loss of this trade off will be different
welfare due to over consumption will be less compared to that of goods with relatively elastic demand like medical • The supply side equilibrium is attained when the marginal cost of production for the good equals the marginal benefit
services, education etc.. Illustrate graphically. which is price in a competitive market (𝑀𝐶! = 𝑃! ). Thus, at equilibrium, 𝑀𝑅𝑆!,# = MC
Efficient provision of public goods depends on the distribution of income. Why? The private market equilibrium is a social-efficiency-maximising equilibrium. Why?
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Public Goods Public Goods
Characteristics of pure public good : To prevent over consumption of goods, three ways of rationing the goods have been devised:
• Non-excludable : The opportunity of any one individual to consume the good cannot be cannot be denied by any other
• User fees
individual
When user fees are imposed to restrict the consumption, it leads to underconsumption and thereby loss of welfare.
• Non-rivalrous : One individual’s consumption of the good does not affect other individual’s ability to consume the How do user fees result in underconsumption of goods? Illustrate graphically.
same good.
• Uniform provisioning
The goods that do not satisfy the above-mentioned conditions fully are termed as impure public goods. E.g.: Network
Under uniform provisioning, goods are provided to all strata in uniform quantities. In this case, welfare loss due to
service, Congested highways inefficiency is likely if the percentage of population who demands more of the good is higher compared to the percentage
of population who demands less of the good. The high demanders will supplement the public consumption levels and this
Market failure in the case of public goods may arise due to inefficiencies that results in either underconsumption and will increase the transaction costs.
undersupply.
• Charging for a non-rival good will result in certain people being excluded from enjoying it. This results in • Queuing
underconsumption (MB will be positive and MC will be zero). Queuing is used as a method of identifying the set of people who are the most need group in case of the good and at the
same time has no other way of accessing the good. A lot of time might be wasted in the process and is favourable to
• If no charge is levied for a non-rival good, it will result in undersupply as there is no incentive to supply the good. people who can wait to get the goods.
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 Private Provision of Public Goods Provision of Public Goods
• Free rider problem results in under provision of public goods when they are provided privately. How? In some cases, we find that the private sector is able to resolve the issues caused by the free-rider problem.
Let us set the per unit price of both good x (public good) and good y (private good) as Re. 1. Good x is a public good [Example, private provision of lighthouse]
which means both the individuals A and B can enjoy the good without affecting each other’s consumption. Neither of
them care about who spends on the public good, but focuses only on the total amount of public good available for When is private provision likely to overcome the free-rider problem?
consumption. To simplify it further, we assume that both A and B have similar preferences.
• When some individuals are particular about the goods than others. Such cases of higher income or strong
Private provision of public good:
preferences may solve the free-rider problem to a certain extent, but will not completely remove it.
𝑀𝑈!" 𝑀𝑈!$ 𝑃!
= =
𝑀𝑈#" 𝑀𝑈#$ 𝑃#
• When some individuals are altruistic; i.e., when they consider the outcomes (benefits and costs) of other
individuals as well, while deciding their consumption.
&'!"
The condition narrows down to =1;
&'#"
• When individuals care about both the total amount of public good and their particular contribution. This is known
Which implies 𝑀𝑈! = 𝑀𝑈# as the “warm glow” model.
Thus, the public good is consumed till a point where the marginal utility derived from public good equals the marginal
utility from private good by an individual.
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Optimal Provision of Public Goods Public Provision of Public Goods
• As public goods are non-excludable and non-rivalrous, whatever amount is provided is to be consumed by all • In the case of public provision of public good, the condition becomes:
individuals jointly and equally. But as different individuals might have different tastes and preferences, they might be
willing to pay different prices for each unit of the good. 𝑀𝑈!" 𝑀𝑈!$ 𝑃!
+ =
𝑀𝑈#" 𝑀𝑈#$ 𝑃#
• Thus, for public goods, we take the vertical sum of the demands of individuals so as to get the aggregate demand for
the good. The willingness to pay for the public good by all individuals is added up to find the total willingness to
pay/social value of the public good. Equilibrium is determined at the point where the aggregate demand curve
intersects the supply curve. &'!" &'!$
Then, the condition narrows down to + =1;
&'#" &'#$
As the value of a marginal unit of public good will be a summation of the marginal rates of substitution of individuals A
and B, which will again be equal to the marginal cost of production; the optimality condition maybe written as: If both A and B have identical preferences, it means that the marginal rate of substitution of good x for y of individual A
equals the marginal rate of substitution of good x for y of individual B.
" + 𝑀𝑅𝑆 $ = 𝑀𝐶 &' (
𝑀𝑅𝑆!,# !,# Then, 2 * &'! = 1 which implies 𝑀𝑈! = ) ∗ 𝑀𝑈#
#
Thus, in case of public provision of public good consumption is till a point where the marginal utility derived from public
Thus, in the case of public goods, social efficiency is maximised when the marginal cost of production is set equal to the good is equal to half of the marginal utility derived from private good. This indicates that the consumption of public good
sum of marginal rates of substitution as public goods are jointly consumed. is much higher in the case if public provision of public good.
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 Public Goods
Suppose there are two goods: good X (private) and good Y (public); and two individuals A and B.
Utility function (of each individual) to be maximised is given as:
𝑈 = 2 log 𝑋 + log (𝑌" + 𝑌$ )
Subject to the budget constraint 𝑋 + 𝑌 = 100
• What will be the total units of public good (𝑌 = 𝑌" + 𝑌$ ), if there is ONLY private provision?
• What will be the socially optimal level of Y, if there is ONLY public provision?
• If govt. steps in to provide the gap between the private optimum and social optimum, will there be any crowding
out effect?
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Crowding Out
What happens when a public good is provided both by private and public methods?
• As the government provides more of a public good, the private sector will provide less (“Crowding Out” effect).
The extent of crowding out depends on the preferences of the private agents providing the good.
• If each Re. spent for public provision will crowd out the private provision one-on-one, then there will be no net
effect in case of govt. intervention. But, such a case of full crowd-out is rare.
• Partial crowd out occurs in reality, mainly when; (i) when non-contributors (previously) to the public good are
taxed for financing the provision of public good, (ii) when individuals derive utility from the total amount of the
good as well as their own contribution to the good.
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Practice Questions C = 1000 + 40Q
where Q = QB + QA.
1. A monopolist is deciding how to allocate output between two geographically separated a. What are the profit-maximizing prices and quantities for markets in regions
markets (East Coast and Midwest). Demand and marginal revenue for the two markets A and B?
are:
Equate MR and MC to find 𝑸𝑨 = 𝟒𝟎 and 𝑸𝑩 = 𝟐𝟓
P1 = 15 - Q1 MR1 = 15 - 2Q1
𝑷𝑨 = 𝟏𝟐𝟎 and 𝑷𝑩 = 𝟏𝟒𝟎
P2 = 25 - 2Q2 MR2 = 25 - 4Q2
The monopolist’s total cost is C = 5 + 3(Q1 + Q2).
b. As a consequence of a new satellite recently deployed, people in region A
(i) What will be the price, output, profits and deadweight loss if the monopolist can receive both broadcasts, and people in New York also receive both
price discriminate? broadcasts. As a result, anyone in region A or B can receive the company’s
broadcasts by subscribing in either city. Thus, the company can charge only
(ii) What will be the output, price and profits if the law prohibits charging different a single price. What price should it charge, and what quantities will it sell in
prices in the two regions? A and B?
Add up the demand curve to get Q = 160 – 0.75 P
(i) Equate marginal revenue and marginal costs in each of the markets. Inverse demand function P = 213.33 – 1.33 Q
𝑄1 = 6
𝑄2 = 5.5 MR = 213.33 – 2.67 Q
Equating MR = 40, we get Q = 65
Corresponding price will be 9 and 14.
P = 126.67
Total quantity produced is 11.5 and hence profits (TR – TC) = 91.50
𝑸𝑨 = 𝟑𝟔. 𝟕 and 𝑸𝑩 = 𝟐𝟖. 𝟑
DWL in market 1 = 0.5(12-6)(9-3) = 18
DWL in market 2 = 0.5(11-5.5)(14-3) = 30.25 c. In which of the above situations, (a) or (b), is the company better off? In
terms of consumer surplus, which situation do people in region A
Total DWL = 48.25 prefer?
Company will be better off in case (a), going by the profit calculations.
(ii) Add up the market demand curves to find that a kink exists at Q = 5 or P =15.
In (a), CS for A = 0.5(40)(200-120) = 1600
 25 − 2Q, if Q  5 In (b), CS for A = 0.5(36.7)(200-126.67) = 1345.67
P=
18.33 − 0.67Q, if Q  5.
 25 − 4Q, if Q  5 A is better off in case (a).
MR = 
18.33 − 1.33Q, if Q  5. 3. A company Z which rents out super computers,
Equate the total demand equation with MC to get Q = 11.5 receives a fixed rental payment per time period in exchange for the right to unlimited
computing at a rate of P paise per second. Company has two types of potential
P = 10.67 customers of equal number —10 businesses and 10 academic institutions. Each
business customer has the demand function Q = 10 - P, each academic institution has
Profits = 83.21. the demand Q = 8 - P. Q is 1000 seconds per month. The marginal cost to company of
additional computing is 2 paise per second, regardless of volume.
2. A satellite company broadcasts TV to subscribers in regions A and B. The demand
functions for each of these two groups are:
QB = 60 - 0.25PB QA = 100 - 0.50PA a. Suppose that you could separate business and academic customers. What rental
fee and usage fee would you charge each group? What would be your profits?
The cost of providing Q units of service is given by Rental fee will be equal to the consumer surplus of each group. For academic
customers,