L1031: Microeconomics 2

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Lecture 9 – Externalities

Autumn 2023
Matteo Madotto
Topics

• Externalities and market failure

• Market structure and externalities

• Allocating property rights to reduce externalities

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Externalities - definition

• Externality - the direct effect of the actions of a person or firm on

another person’s well-being or a firm’s production capability rather
than an indirect effect through changes in prices.
• Negative externality - an externality that harms someone.

• Positive externality – an externality that benefits others.

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 Externalities and market failure

• Example: Firms produce paper and by-products of the

production process—such as air and water pollution—
harm people who live near paper mills;
• each ton of paper that is produced increases the amount of
pollution by one unit
• the only way to decrease the volume of pollution is to reduce
the amount of paper manufactured
• no less-polluting technologies are available
• it is not possible to locate plants where the pollution bothers
no one

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Market failure (cont.)

• Private cost - the cost of production only, not including externalities

• Social cost - the private cost plus the cost of the harm from
externalities

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Welfare Effects of Pollution in a
Competitive Market
$ per ton
ice of paper, p,

450
Pr

MC p

pc = 240 ec

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Demand

0 Q c = 105 225
Q,ons
T of paper per day
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Welfare Effects of Pollution in a
Competitive Market
$ per ton
ice of paper, p,

450

MC s = MC p + MC g
Pr

A
es MC p
p s = 282 E
B
C D
p c = 240 ec
H
198 MC p
G MC g
F

84
MC g

30
Demand

0 Q s = 84 Q c = 105 225
Q,ons
T of paper per day
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Welfare Effects of Pollution in a Competitive Market
(cont.)

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Externalities and market failure (cont.)

• A deadweight loss results because the competitive

market equates price with private marginal cost
instead of with social marginal cost
• A competitive market produces excessive output if
there are negative externalities
• But the optimal amount of pollution is greater
than zero

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Reducing externalities

• The government:
• might control pollution directly by restricting the amount of pollution that
firms may produce
• emissions standard

• or could indirectly affect the level of pollution by taxing the firms for the
pollution they create
• emissions fee – tax on discharges into the air

• (note that in the example, controlling output is the same as controlling emissions – this is
not always the case)

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Emissions fee

• The government may impose costs on polluters by taxing the amount

of pollution produced or, if that is not feasible, their output

• Pigouvian taxes

• Internalize the externality - to bear the cost of the harm that one
inflicts on others (or to capture the benefit that one provides to others)

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 Taxes to Control Pollution
Two types of tax:
r, ,p $ per ton

Rising in line with MCg = t(Q)

450 Flat rate at rate τ
MCs = MCp + t(Q)
ice of pape

MCp + 
es
p s = 282 MCp
Pr

 = 84
MCp = 198
MCg

MCg = 84

Demand

0 Q s = 84 225 Q,ons
T of paper peray
d

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The cost-
benefit
analysis
of
pollution

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Cost-benefit analysis of pollution

• Result from the supply-and-demand analysis:

a competitive market produces too much pollution because the price of output
equals the marginal private cost rather than the marginal social cost.
• Cost-benefit analysis offers another interpretation of
the pollution problem in terms of the marginal cost
and benefit of the pollution itself
• Welfare is maximized by reducing output and
pollution until the marginal benefit from less
pollution equals the marginal cost of less output

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Monopoly and externalities

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Monopoly and externalities
• A monopolist may produce too little or too much
because it faces two offsetting effects:
• the monopolist tends to produce too little output because it
sets its price above its marginal cost, but
• the monopolist tends to produce too much output because its
decisions depend on its private marginal cost instead of the
social marginal cost
• This will depend on:
• if the demand curve is very elastic, the monopoly mark-up is
small therefore the monopoly equilibrium is close to the
competitive equilibrium
• if the marginal cost of pollution is very low then the
monopoly effect of lower output is likely to dominate

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Summary
• Externalities occur when the actions of one agent
impact on another outside of the price mechanism
• There is a deadweight loss to society because the
market equates demand with private MC as opposed to
social MC
• So when there is a negative externality associated with
production, by not taking into account the social
marginal cost, “too much” is produced.
• Note however that even when taking into account the
social marginal costs the optimal amount of pollution
is unlikely to be zero.

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Summary

• In the face of such market failure, governments can

reduce the amount of production (and therefore
pollution) via quantitative restrictions and
regulations, or taxes “internalising” the
externality.
• With a monopoly, production may be lower or
higher than is socially optimal – because there are
two offsetting effects
• (a) producing less because of monopoly power;
• (b) producing more because only private marginal costs
are taken into account

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Allocating property rights to deal
with externalities
• Property right - the exclusive privilege to use an asset.
• With a clearly defined property right, it becomes possible to charge for the
use of that asset.
• For some goods very hard to define property rights, e.g. the air that we
breathe.

• Coase Theorem - the optimal levels of pollution and output can result
from bargaining between polluters and their victims if property rights
are clearly defined

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 Coase theorem - scenario
• Two firms, a chemical plant and a boat rental
company, share a small lake.
The chemical firm: Boat rental firm
•Dumps its waste by-products, •Pollution damages business
which smell bad into the lake. because customers can go to non-
•Can reduce pollution only by smelly lakes,
restricting its output; it has no other •if there is pollution they have to
outlet for this waste charge a lower price

• Hard to imagine the two firms negotiating with each

other unless property rights are clearly defined.
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 A simple diagram illustrating the Coase
theorem
MB,
MC MB to polluter MC to pollutee

To the left of X3 the

MB from pollution is
greater than the MC
– so it would be
efficient to have
more pollution

X1 X3 X2 Pollution level
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 A simple diagram illustrating the Coase
theorem
MB,
MC MB to polluter MC to pollutee

If the victim has the

property right the
polluter can pay the
victim for the right to
pollute

X1 X3 X2 Pollution level
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 A simple diagram illustrating the Coase
theorem
MB,
MC MB to polluter MC to pollutee

To the right of X3
the MB from
pollution is less than
the MC – so it
would be efficient to
have less pollution

X1 X3 X2 Pollution level
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 A simple diagram illustrating the Coase
theorem
MB,
MC MB to polluter MC to pollutee

If the polluter has

the property right
the victim can pay
the polluter to
reduce the level of
pollution

X1 X3 X2 Pollution level
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Property rights without bargaining

• Chemical firm has a dominant strategy: whatever the boat rental

firm does, it maximises profits by producing 2 tons = $15
• Therefore the boat company would only rent 1 boat per day = Nash
equilibrium. The sum of the profits = $17.

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Property rights without bargaining

• Chemical firm has a dominant strategy: whatever the boat rental

firm does, it maximises profits by producing 2 tons = $15
• Therefore the boat company would only rent 1 boat per day = Nash
equilibrium. The sum of the profits = $17.

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Property rights without bargaining

• Chemical firm has a dominant strategy: whatever the boat rental

firm does, it maximises profits by producing 2 tons = $15
• Therefore the boat company would only rent 1 boat per day = Nash
equilibrium. The sum of the profits = $17.
• An “efficient” outcome would be one that maximised the sum of the
two firms’ profits 27
Who has the (non-negotiable) rights?
If the firms do not negotiate:
• If the chemical company had the right to pollute, it would produce the
output level that maximizes its profit, ignoring the effect on the boat
rental firm
• If the boat rental firm had the right to be free of pollution, it should
prevent the chemical company from dumping at all

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Property Rights for boat firm,
with bargaining

• With no negotiation, boat firm would prevent chemical firm from

producing which would go out of business.
• Better for the chemical firm to pay the boat firm for the right to
pollute. Boat firm willing to accept payment only if it can make at
least $15
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Property Rights for Boat firm,
with bargaining

• Suppose chemical firm offers $7 per ton of production.

• IF they agree to this chemical firm’s dominant strategy is to produce
1 ton, and the Nash equilibrium is with the boat firm renting 1 boat
• Equilibrium is efficient: combined profit = $20
• The chemical firm will pay between $5 (the minimum the boat firm
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will accept) and $10 (the maximum it is worth offering)
Property Rights to Chemical firm,
with Bargaining

• With no negotiation, chemical firm would produce 2 tons per day as

in the first table earlier
• Suppose boat firm offers $6 for each ton by which production is
reduced
• Dominant strategy for chemical firm = 1 ton; Nash Equilibrium is
with boat firm renting 1 boat per day
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• Equilibrium is efficient again.
Summary of results from Coase theorem
• If there are no impediments to bargaining,
assigning property rights results in the efficient
outcome at which joint profits (welfare) are
maximized.
• This is another way of internalising the externality
• Efficiency is achieved regardless of who receives the
property rights.
• Who gets the property rights affects the income
distribution.
• The property rights are valuable. The party with the
property rights may be compensated by the other party.

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Should the polluter pay?

• Coase does not imply a polluter-pay principle – who pays depends on

the initial allocation of property rights
• Might be the way to achieve efficiency – few polluters, many
pollutees
• But the income distribution effects might be undesirable

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Problems with the Coase Theorem
• It may be difficult to assign property rights
• E.g. a river that crosses national borders

• Bargaining may be difficult if there are many agents:

• Suppose there are 10 boat rental firms, and all need to agree to the chemical firm
dumping, but one does not
• Suppose the chemical firm has the property rights – if 8 rental companies pay for
reduced dumping the others may choose not to = free riding.

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Problems continued

• If transaction costs are very high, it might not pay for the two sides to
meet.

• If firms engage in strategic bargaining behavior, an agreement may not

be reached.

• If either side lacks information about the costs or benefits of reducing

pollution, an inefficient outcome may occur.

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 An application of Coase: controlling
pollution with market instruments

• Cap-and-trade system
• Suppose the cost in terms of forgone output from eliminating
each ton of pollution is $200 at one plant and $300 at another.
• If the government tells both plants to reduce pollution by 1
ton, total cost = $500
• Alternatively, suppose the government gives firms permits
which gives them the right to pollute a certain amount but less
than they are currently polluting – so each firm has to reduce
pollution OR buy a pollution permit from another firm.
• So each firm may use the permit, or sell it to another firm

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Cap and Trade

• Suppose firm 1 has cost = $200, firm 2 cost = $300

• Suppose firm 1 sells the pollution permit to firm 2.
• Firm 2 does not reduce output because it has right to
pollution. If it pays e.g. $250 for the permit, the cost to the
firm is less than the cost of reducing pollution.
• Firm 1 has to cut output by an additional 1 unit. This costs the
firm $200. As long as the firm gets more than $200 then it
would wish to sell the permit.
• So the firm that is less efficient at reducing pollution would
buy the permit from the firm that is more efficient. Least cost
solution
• Creates therefore a price for pollution
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Caps vs. Taxes vs. Cap and Trade:
Pros and Cons
• Cap gives more certainty about quantity but at an
uncertain cost and may be politically easier to
implement
• Carbon tax: more certainty about price – but requires
more information on the part of the government and
therefore uncertain effect on pollution levels
• Carbon tax raises revenue – tradeable permits raise
revenue only if they are sold rather than given away
• Tradeable permits: let the lower cost firms (w.r.t.
pollution) sell permits to the higher cost ones – hence
reducing pollution more efficiently.

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 Pros and Cons (II)
• Price related instruments (carbon taxes, cap and trade)
give incentives for polluters to choose most cost-
effective ways of reducing pollution, as well as
encouraging abatement by those for whom it is least
expensive
• An agreed carbon tax may give a more consistent price
signal across countries. The cap-and-trade system
creates a price for pollution – this can fluctuate as
demand and supply change (as the economy expands
or contracts)

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Pros and Cons (III)

• If economic activity declines (e.g. recession) then

emissions may fall below the cap, and the price of the
permits plummets – e.g. what has happened in the EU.
• Possible solutions:
• To have a system where the cap can be changed
• Delay selling permits (back-loading); or advance them

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Two important dimensions

• What is the geographical spread of the externality?

• Local (light pollution), metro-level (congestion), regional (acid rain), global (CO 2)

• What is the temporal extent?

• Immediate (noise pollution), short (air pollution), long (land poisoning), nearly
infinite (CO2)

• These define the domain of the regulations, caps and taxes

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Multi-country policies

• Different sovereign authorities with different interests.

• Needs complex coordination, necessary to achieve e.g.

• common carbon tax;

• global cap and market for permits

• If regulations differ: race to the bottom, possible because firms can
move

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 Multiple choice quiz
• Saturday 9 December from 16:00 to 17:00: mock quiz
• 20 questions
• Correct answer: 5 marks
• Wrong answer or no answer: 0 marks
• One question at a time
• Only one attempt

• The graded MCQ (with the same structure and marking scheme as the
mock) will take place on Thursday 14 December from 16:00 to 17:00
• Both the mock and the graded MCQ will cover topics up to lecture 8
(week 9) included

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