Mr. LAU san-fat CH12-Externality/Ver 2004 1 Chapter 12: Externality References: – Advanced Level...

Mr. LAU san-fatCH12-Externality/Ver 20041

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


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


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


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.


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.


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.


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.


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.


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.


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 bene

fits

The existence of external benefit implies that there is divergence between private and social products.


Harmful Externality

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


Harmful Externality

PMSC

MPC1

MUV

0 Qe Q1 Qty

A

B

Remarks:– Assuming MUV=MR– Qe = Pareto-optimal ou

tput level– QeQ1 = overproduced

amount– AB = divergence betwe

en private and social costs


Harmful Externality

Traditional solution:– Government interventio

n is required– (Pigovian) tax should b

e imposed to raise the MPC up to the level of MSC and thus eliminating the excess output.

PMSC=MPC2

MPC1

MUV

0 Qe Q1 Qty


Beneficial Externality

PMC

MSP

MPP

0 Q1 Qe Qty

A

B

Remarks:– Qe = Pareto-optimal ou

tput level– Q1Qe = underproduce

d amount– AB = divergence betwe

en private and social products


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.

PMC

MSP=MPP2

MPP

0 Q1 Qe Qty

A

B


Pigou's Two Roads

Assumptions:– Road ABD:

straight but narrow & with limited capacity

Traveling time: 1 hr

– Road ACD: broad & uncrowded but windi

ng & poorly surfaced Traveling time: 2 hrs

– Average driving time is the only cost of driving from A to D

A D

B

C


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


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.


Pigou's Two Roads

Time(hrs) Time(hrs)MC

ACAC = MC2

1

0 Q1 Q2 Q3 Users 0 Users

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


Pigou's Two Roads

Time(hrs) Time(hrs)MC

ACAC = MC2

1

0 Q1 Q2 Q3 Users 0 Users

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


Pigou's Two Roads

Pigou's argument:– The Road ABD should be taxed to force som

e drivers to use Road ACD– The diverted users lose nothing as they still

spend two hours to travel on the uncongested Road ACD


Pigou's Two Roads

Pigou's argument:– For those drivers still using Road ABD (exce

pt 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.


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.


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.


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) >TFC(=MCxQ1, given MC = W1.

$

W1

MRP ARP

MC

0 Q1 Q2 Fishing effort

= rental value


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)

$

W1

MRP ARP

MC


ARP1


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.


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.

$

W1

MRP ARP

MC


ARP1 Over-fishing


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.


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?


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.


Story of Cattle-raiser & Farmer

Ronald Coase assumes:– A farmer and a cattle-raiser share an unfenc

ed property line– The raiser's cattle eat or damage the farme

r's crops as they stray.



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.



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 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?



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 16 4 10 4 6 0 10 4 8

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



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 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?



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 16 4 10 4 6 0 10 4 8

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



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



With Piguo's analysis:– If the cattle-raiser is not liable for the crop da

mage, 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.



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



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 16 4 10 4 6 0 10 4 8

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



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 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 MG=MCL



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.



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 16 4 10 4 6 0 10 4 8

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



Herd size

TR($)

MR($)

TC($)

MC($)

Total gain($)

MG($)

Total crop

loss($)

MCL($)

MSC($)

0 0 0 0 0 0 0 0 0 01 4 4 1 1 3 3 1 1 22 8 4 3 2 5 2 3 2 43 12 4 6 3 6 1 6 3 64 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



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



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.



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?



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


The Coase Theorem

If property rights are well-defined and transaction costs are zero, then

1. the allocation of resources will be identical, regardless of the initial assignment of property rights; and

2. the allocation of resources will be efficient, so there is no problem of externality


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


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.


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


Cheung's Elaboration

Two categories of transaction costs:1. Those incurred in operating an institutional

arrangement

2. Those incurred in adopting or changing an institution


Cheung's Elaboration

Two sets of costs restraining institutional change:

1. Those associated with information gathering about alternative institutional arrangements.

2. Those of persuading those members of society whose real income would be reduced by the change.


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


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.


Possible Solutions to Externality

1. 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



Question 10: What are the possible problems for having government intervention in tackling the problem of 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



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).



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



4. By doing nothing– No action should be taken if the cost of usin

g any social arrangement to remove or reduce the externality is higher than the potential benefits.


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.



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.



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.



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.



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.


Further Reference Readings

張五常＜賣桔者言＞1. 如詩如畫的例子2. 從高斯定律看共產政制

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Mr. LAU san-fat CH12-Externality/Ver 2004 1 Chapter 12: Externality References: – Advanced Level...

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