Externalities

Intermediate Microeconomics
Section 10
Intermediate Microeconomics () Externalities Section 10 1 / 1
Externalities
Denition
An externality is a cost or benet generated by a transaction that aects a third party,
who was not involved in the interaction.
Intermediate Microeconomics () Externalities Section 10 2 / 1
Externalities
The Coase Thereom
When parties aected by externalities can negotiate costlessly with one another, an
ecient outcome results no matter how the law assigns responsibility for damages.
Intermediate Microeconomics () Externalities Section 10 3 / 1
Externalities
An Example
Suppose the benet to a confectioner of continuing to make noise is 40, while the cost of
the noise to the doctor is 60. If the confectioners only alternative is to produce nothing,
what will happen if he is made liable for the noise damage?
Net Benet
Legal
regime
Outcome Doctor Confectioner Total
Liable Confectioner shuts
down to avoid payment
60 0 60
Not li-
able
Doctor pays confec-
tioner P to shut down,
40 P 60
60-P P 60
Intermediate Microeconomics () Externalities Section 10 4 / 1
Externalities
An Example
Same as before, except now the doctor can the doctor can escape the noise damage by
moving his exam room to the other side of his oce. The cost to the doctor of this
rearrangement is 18.
Net Benet
Legal
regime
Outcome Doctor Confectioner Total
Liable Confectioner pays doc-
tor P to rearrange of-
ce, 18 P 20
42+P 40-P 82
Not li-
able
Doctor rearranges of-
ce at own expense.
42 40 82
Intermediate Microeconomics () Externalities Section 10 5 / 1
The Tragedy of the Commons
A village has 6 residents, each of whom has wealth of 100. Each resident may either
invest in a bond, which pays 12% per year, or buy a steer which will graze on the village
commons. One year old steers and bonds each cost exactly 100. There are not costs
associated with owning a steer. They will be sold for a price according to how much
weight is gained, and the amount of weight gained depends on the number of steers on
the commons. If investment decisions are made independently, how many steers will
graze on the commons?
Number of Steers Price per 2-year old steer
1 120
2 118
3 114
4 111
5 108
6 105
Intermediate Microeconomics () Externalities Section 10 6 / 1
The Tragedy of the Commons
Intermediate Microeconomics () Externalities Section 10 7 / 1
Taxing Away Externalities
An Example
Consider the doctor and confectioner again. Suppose the doctor gains 60 by working in a
no-noise oce, and the confectioner gains 40 by operating noisy equipment. Suppose the
doctor can solve the problem by rearranging the oce at a cost of 18. The tax approach
calls for a tax on the confectioner equal to the damage the activity would cause, which,
in the absence of a response by the doctor, means a tax of 60. What will happen.
Net Benet
Legal
regime
Outcome Doctor Confectioner Total
Tax of
60
Confectioner shuts
down
60 0 60
No tax
or lia-
bility
Doctor rearranges of-
ce at own expense.
42 40 82
Intermediate Microeconomics () Externalities Section 10 8 / 1
The Tax Approach to Pollution Reduction
An Example
Consider the following table:
Process
(smoke)
A B C D E
(4 tons/day) (3 tons/day) (2 tons/day) (1 ton/day) (0 tons/day)
Cost
to
Firm
X
100 190 600 1200 2000
Cost
to
Firm
Y
50 80 140 230 325
Where the rm currently produces with process A, and must cut pollution in half to
avoid a tax.
Intermediate Microeconomics () Externalities Section 10 9 / 1