Revision: externalities

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Revisionexternalities

• Unit 01

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Externality
An externality is the effect of the action of an
economic agent on the welfare of other - not
directly involved - parties. If the effect is
noxious negative externality. If the effect is
beneficial positive externality.

• The interest of society is not limited to that of
  buyers and sellers, since the latter have a
  tendency to disregard externalities in their
  choices. Therefore
• Market equilibrium does not always maximise
  social welfare
• Market failure. Government intervention may be
  required.
• Examples - refurbishment of historical and
  artistic goods in the hands of private owners.
• - a barking dog
• - car emissions
• - technological and scientific research

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Remember that as a rule market equilibrium is
efficient, as it maximises the difference between
the (private) value consumers attribute to goods
and the (private) cost incurred by producers.
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negative externalities in production
Ex. A factory emanating pollutants. Due to
negative externalities, the social cost of
production is higher than the cost incurred by
producers. (for each produced unit, we should
compute not only the producers private cost, but
also the costs incurred by third parties damaged
by pollutants)
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The curve of social cost is higher then the curve
of private cost. The distance between these
curves measures the cost of pollution.
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Which quantity should be produced in order to
maximise total welfare, i.e. the total surplus
generated by the market? ? The quantity
corresponding to the intersection between the
demand curve and the social cost curve.
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NB. The market equilibrium quantity is higher
than the social equilibrium quantity, since the
former does not include the social cost ? by
reducing production we can increase total welfare.
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Means to optimum social equilibrium Ex. A tax
on production, which shifts the private supply
curve towards the social cost curve ? the
externality is internalised
? Producers are encouraged to take into account
the externalities they produce (making the social
cost their own private cost).
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positive externalities in production

• These are the cases in which the social cost is
  lower than private cost.
• Ex. production of industrial robots ?
  technological diffusion is a positive
  externality.
• ? The quantity that maximises social welfare is
  higher than the quantity determined by market
  equilibrium.

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A way of internalising externalities could
consist in offering subsidies to the producers of
robots. ? Their supply curve moves downwards.
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However economists look with suspicion to
subsidies of this kind, for the reason that it is
hard to measure the social advantages of
technological diffusion. But without subsidies
the supply of advanced technologies could be
lower than social optimum. That is why patents
are considered a more viable incentive they
generate a property right on inventions and
therefore they give a temporary monopoly on the
profits derived from their commercial
exploitation. ? they encourage inventions. Patent
s internalise the positive externalities of
inventions.
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private solutions to externalities

• In some cases private individuals, in the absence
  of government intervention, can autonomously
  remedy market failures, transforming the
  allocation of resources into a social optimum.
• Examples
• ethical codes
• social sanctions
• charity and non profit organisations
• integration between different activities ex.
  bee-keeping and fruit-growing.
• contracts between private agents (ex.
  bee-keeping and fruit-growing).

Coase Theorem. (R. Coase, The Problem of Social
Cost, 1960) This theorem suggests that if
parties are able to negotiate without costs the
allocation of resources, the market solves
externality problems, efficiently distributing
resources.
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Classical example. Steam train Opening a new
railway line may produce occasional fire on
bordering properties, owing to the fortuitous
fall of burning particles What is the solution?
Regulation? Reducing train speed so that steam
boilers do not overheat? Clearing bordering
areas? According to the Coase theorem, the
market can spontaneously reach an efficient
settlement the railway company can offer a
compensation to bordering landlords and run
trains at ordinary speed. landlords accept if the
compensation is higher than the cost of clearing
bordering grounds or extinguishing fire. Ex.1
profits of the railway company 800.000
bordering landlords costs 500.000
compensation 600.000 ? accepted! Ex.2
bordering landlords costs 1.000.000 ? not
accepted but the outcome is equally efficient!
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• Another aspect of the Coase theorem is that the
  initial distribution of property rights does non
  influence the attainment of an efficient
  solution.
• The above example presupposed that landlords have
  a right to compensation for damages
• Let us assume that the government decrees that
  failing an agreement landlords must clear
  bordering areas within 20 mt
• if landlords estimate that this activity is too
  costly, they can offer railway companies a
  compensation for reducing train speed.
• if company profits are lower than landlords
  costs, the parties reach an efficient agreement.
• Ex1. profits of the railway company 800.000
• bordering landlords costs 1.000.000
• compensation 900.000
• ? accepted!

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Ex.2 bordering landlords costs 500.000 ?
not accepted but the outcome is equally
efficient! Obviously the initial distribution
of property rights is influential since it
determines the distribution of economic welfare!
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• Coase theorem when legal entitlements are well
  defined, regardless of their initial
  distribution, if there are zero transaction
  costs, parties can bargain for an efficient
  outcome.
• Main limit of the Coase theorem it is valid only
  without transaction costs.
• If there are transaction costs, the profits of
  the agreement could be more than compensated by
  total costs.
• Other limits
• parties might protract negotiations in order to
  get better conditions
• parties are numerous and coordination is costly.
• ? in these cases State intervention might be
  necessary