EXTERNALITY

PG-SEM-3
 Introduction
• Exclusivity (All benefits and costs resulting from use and ownership of the
resource should go to the owner and only to the owner, either directly or by sale
to others) is one of the chief characteristic of an efficient property right
structure. This characteristic is frequently violated in practice. One broad class
of violations occurs when an agent making a decision does not bear all of the
consequences of his or her action.
• Suppose two firms are located by a river. The first produces steel, while the
second, somewhat downstream, operates a laundry. Both use the river, although
in different ways. The steel firm uses it as a receptacle for its waste, while the
laundry owner uses river water for washing cloths.
• If these two facilities have different owners, an efficient use of the water is not
likely to result. Because the steel plant does not bear the cost of reduced the
clean water resulting from waste being dumped into the river. As a result, it
could be expected to dump too much waste into the river, and an efficient
allocation of the river would not be attained.
• This situation is called an externality. An externality exists whenever the welfare of some agent,
either a firm or household, depends not only on his or her activities, but also on activities
under the control of some other agent. In the example, the increased waste in the river
imposed an external cost on the laundry, a cost the steel firm could not be counted upon to
consider appropriately in deciding the amount of waste to dump.
• Due to externality the consumption or production activities of one individual or firm affect
another person's utility or firm's production function so that the conditions of a Pareto optimal
resource allocation are violated.
• The externality is the classic special case of incomplete markets for an environmental asset
(Arrow, 1969).
• Price of steel does not reflect this external effect. The set of markets is incomplete in that there
is no exchange institution where the person pays for the external benefits or pays a price for
imposing the external costs.
• Steel Industry and Laundry’s dispute about pollution in the river is an example of a negative
externality. Steel Industry's disposal action has a direct negative impact on laundry's production.
• If transaction costs are too great, so that the market for clean water or pollution control is non-
existent, a wedge is driven between the private and socially optimal allocation of resources.
Suppose the technology of producing laundry is given by
L=f(x1,x2,…,xN)
Where L is output of laundry. In the absence of any externality or dust, x1,x2,…xN are various
inputs used by laundry producer )
L’=f’(x1,x2…xN, e)
(L’ is output in the presence of dust or negative externality e. Higher e means lower L' )
The production of steel industry is not affected by the externality as the steel plant is producer
of externality and the laundry is victim. Therefore the output of power plant is the function of
its inputs y1,y2…yM only.
P=fp(y1,y2,…..,yM)
The quantity of externality produced (e) by power plant depends on the quantity of power (P)
which is function of its inputs hence e also depends on these inputs.
e = fe(P) = fe (y1,y2,…..,yM)
• Let’s suppose that economy has to produce both the goods. If both the goods
are important than neither P (Quantity of steel being produced) nor L (Quantity
of laundry being produced) should be zero or P ˃ 0, then e ˃ 0.
• Now we have to find the desired level of externality as it can’t be zero. The
relative importance of these two commodities, steel and laundry, for the
people will determine their prices. If steel is very important then people can
bear the burden of externality by producing the efficient levels of steel and
externality. Let’s suppose that the prices of steel and laundry are Pp and PL
respectively. Now if steel plant is producing at its maximum capacity then
externality will also be maximum and this will reduce the value of laundry.
• In figure 1 Point ‘A’ is such point where the power plant is producing the
maximum output P1 and Laundry is producing L1 which is not maximum
because of the presence of negative externality.
Figure 1
• The presence of negative externality adds marginal external cost
(MEC) to marginal private cost (MPC) of steel plant and collectively
they become marginal social cost (MSC).
MEC + MPC = MSC
In the absence of well defined property rights market prices fail to
capture the spillover effect of externality and the outcome of a free
market is either overproduction in case of negative externality or
underproduction in case of positive externality. In such case a third
party intervention (Government) is needed to achieve the efficiency.
• If the steel plant and laundry merge, the MEC becomes part of MPC for the
steel plant and the prices reflect the production efficiency. After merging the
efficient level of output of steel and laundry are denoted at point ‘B’ where the
total value (V) is maximum.
V= Pp * P + PL * L
• At point ‘B’ slope of production possibility curve is equal to relative price of
steel. At point ‘B’ the quantities of steel and laundry produced are P2 and L2
respectively. Though the negative externality exists at point ’B’ but this has
become irrelevant as the steel plant is itself bearing the marginal external cost.
At point A the steel plant is bearing only the private cost of production and the
laundry has to bear the cost of externality, therefore the steel plant is trying to
minimise only the private cost. The further reduction in the production of steel
from point B to reduce externality is not desirable as it will reduce the total
value of production for the economy. We can say that at point A externality is
relevant hence we need to reduce it and at point B it is irrelevant hence we
don’t need to reduce it.
• Explanation: An externality is Pareto relevant if the removal or fall in this
externality results in Pareto improvement and an externality is Pareto irrelevant
if its removal or fall doesn’t result in Pareto improvement.
• Figure-1, at point A the externality is maximum. We can reduce it by reducing
the production of steel plant. At point B the externality is less and the total
value of combined output is more as compared to point A therefore the
economy has Pareto improvement when moving from point A to B. As no
further improvement is possible from point B the externality here is Pareto
irrelevant and Pareto relevant at point A. The negative externality in production
increases the marginal social cost of production by adding marginal external
cost to marginal private cost. The negative externality in consumption reduces
the marginal social benefit of consumer.
• In cases of negative environmental externality MPC is much lower as compared
to MSC. In these cases, the present generations have to bear the cost of
externality but also the future generations will have to bear it. The supply and
demand curves for the steel industry are denoted by following linear
equations:
Supply P = a + bQ
Demand P = c - dQ
• Here the supply curve also represents the marginal private cost as the presence
of externality makes private cost different from social cost. The demand curve
also represents marginal private benefit. The externality will increase the cost
of water treatment hence this is production externality. The production
externality affects the supply curve which is also MPC and the consumption
externality affects the demand curve which is also marginal private benefit
curve (MPB).
MPC = a + bQ
MPB = c - dQ
Figure 2
• Figure 2 is showing the competitive equilibrium of steel production. Point E represents
equilibrium quantity and price. Here the market fails as this equilibrium is ignoring the
externality. Though it is quite difficult to estimate the cost of externality, but there are many
methods in economics to determine the approximate cost.
• Suppose the marginal external cost (MEC) is increasing function of quantity of steel:
MEC = eQ
Then MSC = MPC + MEC
= a + bQ + eQ
= a + [b+e] Q
• We can find the efficient equilibrium if we consider the point of intersection of MPB and
MSC instead of MPC to find the equilibrium. The new equilibrium point E1 in figure 3 is just
like point B of figure 1. The externality at this point E1 has become irrelevant. We can easily
find the welfare gain to the society. From the perspective of the firm, there is loss in the profit
equal the area of triangle EE1A. From the perspective of the society as a whole, there is a
gain equal to the area of rectangle EAE1B. The net gain is the welfare gain to the society
minus profit loss to steel production and that is represented by the area of triangle EE1B.
Figure 3
• Figure 3 At point E1 efficiency is restored. The externality at point E was
Pareto relevant but it became Pareto irrelevant when the equilibrium is
determined by MSC curve instead of curve MPC.
 Other Property Right Regimes

• Private property is not the only possible way of defining entitlements

to resource use. Other possibilities are as follows:
State-property regimes (the government owns and controls the
property);
Common-property regimes (the property is jointly owned and
managed by a specified group of co-owners); and
Res nullius or open-access regimes (in which no one owns or exercises
control over the resources).
• State-property regimes: Parks and forests, for example, are owned and managed by the government.
However, efficiency and sustainability might not be achieved if the incentives of bureaucrats, who implement
and/or make the rules for resource use, diverge from collective interests.
• Common-property rights: This refers to the property rights enjoyed by a group of people over a resource.
Common-property regimes exhibit varying degrees of efficiency and sustainability, depending on the rules
that emerge from collective decision making.
• Example: In Switzerland grazing rights on the Alpine meadows have been treated as common property right.
Overgrazing is protected by specific rules, enacted by an association of users, which limit the amount of
livestock permitted on the meadow. This stability has apparently facilitated reciprocity and trust, thereby
providing a foundation for continued compliance with the rules.
But the above stability is not seen in Mawelle, a small fishing village in Sri Lanka. Initially, an effective
rotating system of fishing rights was devised by villagers to assure equitable access to the best spots and best
times while protecting the fish stocks. Over time, population pressure and the influx of outsiders have
hampered efficiency and sustainability by producing overexploitation of the resource and lower incomes for
all the participants.
• Open-access resources: These are characterized by non-exclusivity and divisibility.
• Non-exclusivity implies that resources can be exploited by anyone, i.e. it is impossible to prevent anyone
from extracting these resources.
• Divisibility means that resource extraction by one person diminishes the amount available for extraction by
others. These resources are known as “common-pool” resources.
• American Bison are an example of “common-pool” resources. Initially
bison were plentiful; unrestricted hunting access was not a problem. But
after some years, the demand for bison increased and scarcity became a
factor. As hunters expend effort they not only generate a yield for
themselves but also a negative externality; each hunter’s effort
contributes to making it more difficult for the others to catch bison.
However, hunters do not take into account this negative externality while
deciding on the amount of effort to expend. Hence there is
overexploitation, beyond the point at which marginal cost of effort equals
its marginal benefit.
Figure 4
• In figure 4, the total surplus associated with any level of effort is measured as the
vertical difference between the total revenue (benefits) curve and the total cost curve
for that level of harvest.
• In the bottom panel the marginal revenue curve is downward sloping because as the
amount of hunting effort increases, the resulting bison population size decreases.
• The efficient level of hunting activity in this model (E*) maximizes the surplus.
• Under condition of completely unrestricted access to the bison, Individual hunters
would exploit the resource until their total benefit equaled total cost, implying a level
of effort equal to E.
• Two conclusions:
• (1) In the presence of sufficient demand, unrestricted access will cause resources to be
overexploited;
• (2) The scarcity rent is dissipated—no one is able to appropriate the rent, so it is lost.
• Thus, unrestricted access to scarce resources promotes an inefficient allocation.
 Public Goods
• An environmental asset is considered a pure public good if its consumption is
non-rival and non-excludable.
• Non-excludable: A public good is available to all and one person's
consumption does not reduce another person's consumption.
• Non-rivalry implies that the marginal social cost of supplying the good to an
additional individual is zero.
• Therefore it is not Pareto efficient to set prices that will exclude anyone who
derives positive marginal benefits from the public good-a market failure exists
since a private firm cannot get profit by providing a pure public good for free
as dictated by Pareto efficiency.
Figure 5: Efficient Provision of Public Goods
• In Figure 5, individual demand curves for preserving biodiversity have been
presented for two consumers, A and B.
• Given that a unit consumed by one person does not exclude the other person
from consuming the unit, the benefit from each unit to the community (A and
B) is the sum of benefits accruing to A and B.
• Thus the market demand curve is represented by the vertical summation of
the two individual demand curves.
• The efficient level of provision is given by the intersection of the market
demand, which gives the marginal benefit accruing to the community from
each unit.
• This is given by OQ* and its provision has to be supported by different price
paid by each consumer equal to her marginal benefit at OQ*: OA by A and OB
by B respectively. But for biodiversity to be provided efficiently each consumer
has to have the incentive to reveal her marginal benefit accurately.
• However, non-rival and non-excludable imply that each unit provided
by the producer can be consumed by anyone, irrespective of the
contribution she is making to that provision. Thus she will not state
her true marginal willingness to pay and free ride on the contributions
of others. As every person does the same, the estimated market
demand is very different from the true market demand curve(social
marginal benefit is understated) and there is under provision.
 Optimal Provision of Public Goods
• The optimal level of public good
• Consider an economy with only two goods one public and one private.
• Suppose there are two individuals 1 and 2 and their initial
• wealth levels are given by W1 and W2.
• The respective provision for the public good by individual 1 and 2 be given by
g1 and g2; and x1 and x2 denote the consumption of private goods.
• Let G be the total amount of public good produced and c(G) be the cost of
producing and/or providing that public good. The agents face the constraint
that their initial wealth cannot exceed their total expenditure on the private
goods and the public goods:
• x1 + x2 +c(G) = W1 + W2
A Pareto efficient provision of the public goods. The provision is
Pareto efficient if agent 1’s utility is maximised given the utility level
of agent 2. Here, both agents consume same amount of the public
goods.
The problem can be written as
Max U1(x1,G)
Subject to U2(x2,G) and
x1 + x2 +c(G) = W1 + W2
The Lagrangian function is given by:
L=U1(x1,G) + λ1{(U2* - U2(x2,G)} + λ2{W1 + W2 - x1 - x2 - c(G)}
• 
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• 
 B
BUY DON’T BUY
A BUY (-500,-500) (-500,1000)

DON’T BUY (1000,-500) (0,0)

Free Rider Problem:

Suppose that each person has a wealth of Rs. 5000/,each values the pollution
abatement technology at Rs.1000/ and the cost of the technology is Rs.1500/.
But joint valuation of the technology exceeds its cost. Now, once purchased or
established, the technology will benefit both economic agents A and B.

A Pareto improvement can be achieved if one of the agent buys the technology
and the other makes a side payment to her.
If A buys the technology and B pays here Rs. 501/, then A manages to break
even and B will still enjoys a surplus of rs.499/.
 Imperfect Market Structures
• Environmental problems also occur when one of the participants in an
exchange of property rights is able to exercise an excessive control
over the outcome. This can occur when a product is sold by a single
seller, or monopoly.
• Take the case of monopoly.
• In this case the equilibrium is given by the equality, MR=MC with the
producer maximising her producer surplus.
 • In figure 6
• Equilibrium Price= OF
• Quantity=OA
• Economic Surplus=IEDF
• =FEDH(PS) + IEF(CS)
• Under Static efficiency Price=OG
• Economic Surplus(ES)=ICH>IEDF
• Here,
• Maximum Economic Surplus=ICH
• But PS=GCH<FEDH
-the producer surplus corresponding to
monopoly price.
Figure 6: Monopoly and Inefficiency
Suggested Readings:
• N. Hanley, J. Shogren and Ben White. Environmental Economics-In
Theory and Practice, Palgrave Macmillan, 2007.

• Tom Tietenberg and Lynn Lewis. Environmental and Natural Resource

Economics, 8th Edition, Pearson, 2008.

• Charles.D. Kolstad. Environmental Economics, OUP, 2010.