Chapter 12: Externality

1
Chapter 12 Externality

• References
• Advanced Level Microeconomics, LAM pun-lee, CH 17
• A-Level Microeconomics, CHAN KWOK, CH 17
• HKALE Microeconomics, LEUNG man-por, CH 18

2
Pareto-optimal Condition

• Pareto-optimal condition is a state where
• it is no longer possible to reallocate the use of
  resources so that one individual will gain
  without loss to another
• Product P MUV MC

3
Market Failure

• If the market is allowed to function without any
  intervention, market failure means
• the Pareto-optimal condition is not reached
• non-market institutions would provide a more
  desirable result

4
Externality

• Externality occurs when the decision-maker does
  not bear all of the costs or reap all of the
  gains from his action
• As a result, in a competitive market too much or
  too little of the good will be produced from the
  point of view of society.

5
Externality

• Positive/Beneifical externality/Social benefit
• If the world around the person making the
  decision benefits more than he does, then the
  good will be underconsumed and underproduced by
  individual decision makers.

6
Externality

• Negative/Harmful externality/Social cost
• if the costs to the world exceed the costs to the
  individual making the choice (pollution, crime)
  then the good will be overconsumed and
  overproduced from society's point of view.

7
Private Cost vs. Social Cost

• Private cost measures the value of the
  highest-valued alternative uses of the resources
  available to the decision maker
• Social cost measures the value of the
  highest-valued alternative uses of the resources
  available to the whole society.

8
Private Cost vs. Social Cost

• External/Spillover/Third-party cost or harmful
  externality occurs when one person's action
  imposes costs on others without bearing the cost.
• Social cost private cost external cost
• The existence of external cost implies that there
  is a divergence between private and social costs.

9
Private Product vs. Social Product

• Private product measures the value of the product
  to the decision maker.
• Social product measures the value of the product
  to the whole society.

10
Private Product vs. Social Product

• Social product or spillover/third-party/external
  benefit exists when one person's action benefits
  others without receiving payment.
• Beneficial externality private product
  external benefits
• The existence of external benefit implies that
  there is divergence between private and social
  products.

11
Harmful Externality

• With the existence of negative externality, the
  marginal private cost (MPC) is smaller than the
  marginal social cost (MSC), resulting in
  overproduction.

12
Harmful Externality

• Remarks
• Assuming MUVMR
• Qe Pareto-optimal output level
• QeQ1 overproduced amount
• AB divergence between private and social costs

13
Harmful Externality
P

• Traditional solution
• Government intervention is required
• (Pigovian) tax should be imposed to raise the MPC
  up to the level of MSC and thus eliminating the
  excess output.

MSCMPC2
MPC1
MUV
0 Qe Q1 Qty
14
Beneficial Externality

• Remarks
• Qe Pareto-optimal output level
• Q1Qe underproduced amount
• AB divergence between private and social
  products

15
Beneficial Externality

• Traditional solution
• Government intervention is required
• Subsidy should be granted to raise the MPP up to
  the level of MSP and thus avoiding the
  underproduction.

16
Pigou's Two Roads

• Assumptions
• Road ABD
• straight but narrow with limited capacity
• Traveling time 1 hr
• Road ACD
• broad uncrowded but winding poorly surfaced
• Traveling time 2 hrs
• Average driving time is the only cost of driving
  from A to D

17
Pigou's Two Roads

• Drivers originally will use Road ABD only
• If traffic increases to the point of congestion
  on Road ABD, each road user will slow down the
  speed of others, thus imposing time cost upon one
  another

18
Pigou's Two Roads

• Harmful externality occurs since the driver only
  consider his or her private time cost and ignores
  the time cost imposed upon all other drivers,
  there is a divergence between private and social
  costs.

19
Pigou's Two Roads

• At Q1, congestion sets in Road ABD, an extra user
  imposes external time cost on all other users,
  thus the average time cost will increase

Road ABD
Road ACD
20
Pigou's Two Roads

• With external costs, a road user considers now
  only the average time cost instead of marginal
  time cost
• Drivers after Q3 would choose Road ACD, resulting
  in the AC in using both roads is the same, 2
  hours.

Road ABD
Road ACD
21
Pigou's Two Roads

• Pigou's argument
• The Road ABD should be taxed to force some
  drivers to use Road ACD
• The diverted users lose nothing as they still
  spend two hours to travel on the uncongested Road
  ACD

22
Pigou's Two Roads

• Pigou's argument
• For those drivers still using Road ABD (except
  for the marginal user) will still gain as the
  time saved from being congestion-free is worth
  more than the amount they are taxed.
• The market fails to achieve the optimal condition
  as it is still possible to make someone better
  off without hurting others.

23
Knight's Attack on Pigou

• Pigou did not specify the nature of property
  rights governing the use of the roads
• No private property rights to roads
• If the road is privately owned, a toll for its
  use would be charged, which will be equal to the
  difference between the values of travel times for
  the two roads.

24
Knight's Attack on Pigou

• At the margin, the value of travel time for Road
  ACD and the value of travel time plus the toll
  for Road ABD will be equal.

25
Gordon's Fishery

• If the fishing ground is privately owned, the
  equilibrium fishing effort is Q1 and a rental
  value will be received as the TRP(ARPxQ1)
  gtTFC(MCxQ1, given MC W1.

26
Gordon's Fishery

• If the fishing ground is commonly owned, an
  individual fisherman will enter only if the
  expected average revenue product (say ARP1) is
  larger than the marginal cost (in terms of the
  forgone alternative earning in using his or her
  labor)

27
Gordon's Fishery

• However, the entering of an extra fisherman into
  the fishing ground will reduce the catch of other
  fishermen, i.e. they have to bear a spillover
  cost in fishing.
• With external cost, there is a divergence between
  private and social costs, the MRP is thus less
  than the ARP.

28
Gordon's Fishery

• A fisherman will enter the fishing ground until
  the falling ARP equals W1, TRP equals
  TVC(MCxQ2), then the rental value becomes zero,
  i.e. the rent is dissipated.
• Over-fishing(Q1Q2) occurs.

29
Gordon's Fishery

• With private property rights, the owner of the
  fishing ground has an incentive to maximize
  rental value by restricting fishing up to point
  at where the MRP equals MC.

30
Gordon's Fishery

• Question 1 Why are not all the fishing grounds
  privatized to eliminate the problem of negative
  externality in fishing? Must overfishing lead to
  dissipation of rent? Waste?

31
Gordon's Fishery

• A property may be held in common because the
  value of capturing its potential rent is lower
  than the cost of enforcing exclusivity or private
  property.
• With prohibitive huge transaction costs,
  overfishing may be regarded as economically
  unavoidable and constitutes no wastage.

32
Story of Cattle-raiser Farmer

• Ronald Coase assumes
• A farmer and a cattle-raiser share an unfenced
  property line
• The raiser's cattle eat or damage the farmer's
  crops as they stray.

33
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0
1 4 1 3 1
2 8 3 5 2 3
3 12 6 6 6 6
4 16 10 6 10

• Question 2 Fill in the table above.

34
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• Question 3 What is the size of herd if the
  cattle-raiser ignores the crop damage?

35
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• The herd size is determined when MR MC 4,
  i.e. four steers

36
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• Question 4 What is the size of herd if the
  cattle-raiser taking the external cost (crop
  loss) into account?

37
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• The herd size is determined when MG MCL 2,
  i.e. two steers

38
Story of Cattle-raiser Farmer

• Question 5 What would possibly be suggested in
  dealing with the cattle-raising phenomenon?

39
Story of Cattle-raiser Farmer

• With Piguo's analysis
• If the cattle-raiser is not liable for the crop
  damage, there are too many cattle raised but too
  few the crop grow
• Resources are misallocated
• Government should intervene the market by
  imposing taxes and subsidies, or legal
  prohibition in order to eliminate the negative
  externality.

40
Story of Cattle-raiser Farmer

• Case 1 if the farmer has the right to restrain
  the cattle-raiser from damaging his or her crops,
• An exchange of the right allows mutual gains
• The cattle-raiser has to compensate the farmer
  for buying the right to allow his or her steers
  to eat crops

41
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• Question 6 What is then the optimal size of
  herd?

42
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• An extra steer should be raised if its expected
  MG ? MCL
• The optimal size is 2 steers as MGMCL

43
Story of Cattle-raiser Farmer

• Case 2 if the cattle-raiser has the right to
  impose damage on the farmer,
• An exchange of the right allows mutual gains
• The farmer has to make compensation (equals the
  forgone MG for not raising a steer) to the
  cattle-raiser for buying the right to avoid
  damage by reducing the herd size
• By doing so, the farmer's marginal gain equals
  the saved MCL.

44
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• Question 7 What is then the optimal size of
  herd?

45
Story of Cattle-raiser Farmer
Herd size TR () MR () TC () MC () Total gain () MG () Total crop loss() MCL () MSC ()
0 0 0 0 0 0 0 0 0 0
1 4 4 1 1 3 3 1 1 2
2 8 4 3 2 5 2 3 2 4
3 12 4 6 3 6 1 6 3 6
4 16 4 10 4 6 0 10 4 8

• Compensation should continue to be made if the
  saved MCL ? MG,
• The optimal herd size is 2 steers as the saved
  MCL MG

46
Story of Cattle-raiser Farmer

• Question 8 What happen if the farmer and the
  cattle-raiser jointly own the land for
  crop-farming and cattle-raising?

47
Story of Cattle-raiser Farmer

• For joint ownership of a property, the incentive
  to maximize wealth will guarantee that an
  efficient allocation of resources.
• This is simply because the decision of either
  party will take the external cost into account,
  i.e. the third party cost now is internalized,
  eliminating the divergence between private and
  social costs.

48
Story of Cattle-raiser Farmer

• Question 9 Suppose that the farmer has the right
  to restrain the cattle-raiser from damaging his
  or her crops. The raiser may choose to compensate
  the farmer or erect fences to prevent his or her
  steers from straying. Will the cattle-raiser
  always choose to compensate?

49
Story of Cattle-raiser Farmer

• The cattle-raiser will choose to compensate if
  the value of crop loss is smaller than the cost
  of erecting fences vice versa.

50
The Coase Theorem

• If property rights are well-defined and
  transaction costs are zero, then
• the allocation of resources will be identical,
  regardless of the initial assignment of property
  rights and
• the allocation of resources will be efficient, so
  there is no problem of externality

51
Coase's Insights

• With the existence of externality, there are
  potential gains from exchange.
• Contractual re-arrangements allow the market
  participants to capture these gains
• The initial assignment of property rights will
  affect only income distribution

52
Coase's Insights

• With positive transaction costs in reality,
  however, there is still no inefficiency even if
  the output level exceeds the optimal level
  because the saved transaction costs are greater
  than the potential gains from re-arranging
  contractual arrangement.

53
Coase's Insights

• We should consider both the total and marginal
  effects of different social arrangements for
  solving the problem of externality
• We should not just compare a state of free market
  to some kind of ideal world (without transaction
  costs)
• Externality is reciprocal in nature

54
Cheung's Elaboration

• Two categories of transaction costs
• Those incurred in operating an institutional
  arrangement
• Those incurred in adopting or changing an
  institution

55
Cheung's Elaboration

• Two sets of costs restraining institutional
  change
• Those associated with information gathering about
  alternative institutional arrangements.
• Those of persuading those members of society
  whose real income would be reduced by the change.

56
The Nature of Externality

• Externality is universal and pervasive.
• Externality is reciprocal in nature.
• Externality arises from inadequate definition of
  property rights
• Externality implies the existence of excessive
  transaction costs

57
The Role of Government

• The basic role of the government is to define
  clearly the property rights to scarce resources
  and to protect and uphold firmly the private
  property rights.
• Government intervention should be employed to
  correct externalities only if her cost is less
  than that of employing other social arrangements.

58
Possible Solutions to Externality

• Government intervention
• Taxation and subsidization
• Restricting output levels
• Removing the firm to other location
• Establishing public ownership
• Defining or granting property rights and let the
  market operate

59
Possible Solutions to Externality

• Question 10 What are the possible problems for
  having government intervention in tackling the
  problem of externality?

60
Possible Solutions to Externality

• Possible problems with government intervention
• High costs in identifying the levels of
  divergences, calculating the associated gains
  costs in removing industries, determining the
  appropriate output level
• Government is not all-mighty and may herself
  creates externality

61
Possible Solutions to Externality

• 2. Internalization or self-restraint
• With prohibitive transaction costs in making
  contractual re-arrangement, it is more
  economically to reduce or eliminate the
  externality by having self-restraint or
  internalization (i.e. equalizing MPC with MSC by
  taking the external costs into account for
  calculating private marginal cost).

62
Possible Solutions to Externality

• 3. By merging
• Merging the parties concerned in an externality
  by establishing joint ownership has similar
  effect with internalization on enhancing
  incentive to reduce or eliminate the third party
  effect

63
Possible Solutions to Externality

• 4. By doing nothing
• No action should be taken if the cost of using
  any social arrangement to remove or reduce the
  externality is higher than the potential benefits.

64
The Fable of the Bees

• The apple-grower's orchard provides nectar for
  the beekeeper.
• Since the nectar is not marketed, the orchard
  owner does not receive any payment, resulting in
  too few trees will be planted.

65
The Fable of the Bees

• On the other hand, the bees in turn pollinate the
  apple blossoms.
• Since the pollination service to the apple-grower
  is not paid, resulting in too few hives will be
  established.

66
The Fable of the Bees

• The reciprocal external benefits illustrate the
  problem of market failure and thus government
  intervention is supposed to be the way out.
• However, Prof Cheung found that the invisible
  hand functions well for creating active market
  dealings governing the placement of beehives.

67
The Fable of the Bees

• For plants that require pollination services for
  fruit setting but yield little or no honey, the
  orchard-owners pay pollination fees to the
  beekeepers for the privilege of having hives
  placed in their orchards.

68
The Fable of the Bees

• For plants that yield honey but require no
  pollination services, the beekeepers pay apiary
  rents to the orchardists for the right to place
  their hives in their orchards.
• For plants that yield honey and require
  pollination services, no pollination fees or
  apiary rents are charged.

69
Further Reference Readings

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