Final Project on Externality

EXTERNALITY

“An externality (or spillover) is a cost or benefit arising

From an economic activity that falls on people who do

Not participate in that activity.”

e.g

Disposal of chemical wastes in a river (negative production externality)

Proving a mathematical theorem (positive production externality)

Consumption of Liquor (negative consumption externality)

Consumption of education (positive consumption externality)

How effective do the private resolve the

problem of externality?

Consider a doctor whose ability to examine patients is disrupted by the noise of machinery operated by a confectioner (candy maker) in an adjacent building.

Positive and Negative Externalities

•          The effects of a decision by consumers and producers that has an impact on a third party

Positive Externalities – beneficial effects on third parties

Negative Externalities – costs incurred by third parties

External costs – socially efficient output is less than current output

External benefits – socially efficient output is greater than current output

Positive Externality:

n  Beneficial impact on the bystander is called a positive externality

A positive externality exists when an individual or firm making a decision does not receive the full benefit of the decision. The benefit to the individual or firm is less than the benefit to society. Thus when a positive externality exists in an unregulated market, the marginal benefit curve (the demand curve) of the individual making the decision is less than the marginal benefit curve to society. With positive externalities, less is produced and consumed than the socially optimal level.

When a positive externality exists in an unregulated market, consumers pay a lower price and consume less quantity than the socially efficient outcome. This can be seen on the graph. Consumers pay price P' and consume quantity Q', but at that quantity society would have them pay more. At P' Q' the marginal benefit to society is much higher than marginal cost, resulting in a deadweight welfare loss. The socially efficient outcome is to pay price P* and consume quantity Q*. At this price and quantity the marginal benefit to society is equal to the marginal cost.

Negative Externality:

n  Adverse impact on the bystander is called a negative externality

A negative externality occurs when an individual or firm making a decision does not have to pay the full cost of the decision. If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it. Since consumers make a decision based on where their marginal cost equals their marginal benefit, and since they don't take into account the cost of the negative externality, negative externalities result in market inefficiencies unless proper action is taken.

When a negative externality exists in an unregulated market, producers don't take responsibility for external costs that exist--these are passed on to society. Thus producers have lower marginal costs than they would otherwise have and the supply curve is effectively shifted down (to the right) of the supply curve that society faces. Because the supply curve is increased, more of the product is bought than the efficient amount--that is, too much of the product is produced and sold. Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results.

This graph shows the effect of a negative externality. The red line represents society's supply curve/marginal cost curve while the black line represents the marginal cost curve that the firm or industry with the negative externality faces. The optimal production quantity is Q', but the negative externality results in production of Q*. The deadweight welfare loss is shown in gray.

A common example of a negative externality is pollution. For example, a steel producing firm might pump pollutants into the air. While the firm has to pay for electricity, materials, etc., the individuals living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of life, reduced aestetic appeal of the air, etc. Thus the production of steel by the firm has a negative cost to the people surrounding the factory--a cost that the steel firm doesn't have to pay.

Positional Externality:

Positional externalities refer to a special type of externality that depends on the relative rankings of actors in a situation. Because every actor is attempting to "one up" other actors, the consequences are unintended and economically inefficient.

Example:

One example is the phenomenon of "overeducation" (referring to post-secondary education) in the North American labour market. In the 1960s, many young middle-class North Americans prepared for their careers by completing a bachelor's degree. However, by the 1990s, many people from the same social milieu were completing master's degrees, hoping to "one up" the other competitors in the job market by signalling their higher quality as potential employees. By the 2000s, some jobs which had previously only demanded bachelor's degrees, such as policy analysis posts, were requiring master's degrees. Some economists argue that this increase in educational requirements was above that which was efficient, and that it was a misuse of the societal and personal resources that go into the completion of these master's degrees.

Example:

Another example is the buying of jewelry as a gift for another person. In order for Person A to show that he values his spouse more than Person B values his spouse, Person A must buy his spouse more expensive jewelry than Person B buys. As in the first example, the cycle continues to get worse, because every actor positions himself/herself in relation to the other actors

One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against firms requiring master's degrees unless the job actually required these advanced skills.

Consumption Externality:

Most of the problems associated with plastic bags are consumption externalities. These externalities occur so readily because nearly all of the over a billion bags consumed per day are given out for free.  People overuse plastic bags because although the price of the bags is included in the cost of the item, people don't realize that they are paying for them.  Although we don't realize it, plastic bags cost consumers in US approximately 4 billion dollars in increased good costs per year.

A large plastic bag externality is how to dispose of them once they are used. Plastic bags can be recycled into other plastic bags; however, this is rarely the case. According to the EPA only 1% of plastic bags were recyled in US in 2004.  Most plastic bags are not recycled instead they wind up in landfills, in the ocean, or even as litter.

Production Externality:

• Air pollution from burning coal
• Ground water pollution from fertilizer use
•  Food contamination and farm worker exposure to toxic chemicals from pesticide use

• Irrigation water and consequential decline of waterfowl population in nearby wildlife refuge
• Production of refrigerators using CFC’s
• Health issues resulting from gold mining

The COASE THEOREM:

The proposition that if the private parties can bargain without cost over the allocation of resources they can solve the problem of externalities on their own.

It means that the private economic actors can solve the problem of externality among themselves. Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient.

Example:1

Suppose that Abdul Rehman has dog named tiger. Tiger barks and disturb kashif, Abdul Rehman’s neighbour, Abdul Rehman gets the benefit from owning the dog.but the dog confers a negative externality on kashif. Should Abdul Rehman be forced to send the dog to the pound. Or should kashif have to suffer sleepless nitghts because of tiger’s barking?

Consider first what outcome is socially efficient. A social planner considering two alternative would compare the benefits that Abdul Rehman gets from the dog to the cost that kashif bears for barking. If the benefit exceeds the cost. It is effiecient for the Abdul Rehman to keep the dog and for kashif to live with the barking. Yet if the cost exceeds the benefit then Abdul Rehman should get rid of the dog.

By bargaining over the price Abdul Rehman annd Kashif can always reach the efficient outcome. For instance. Suppose that Abdul Rehman get a 500$ benefit from the dog and kashif bears a 800$ cost from the barking. In this case kashif can offer Abdul Rehman 600$ to get rid of the dog. And Abdul Rehman will gladly accept the offer. Both parties are better off than they were before. And the efficient point is reached.

Example:2

Suppose in another example, that the gain to the doctor in the noise free environment is 40.while the gain to the confectioner from unfettered operation is 60. Suppose also that the confectioner has access to a sound proofing device that eliminates all noise damage at a cost of 20. And suppose finally that it costs to the doctor and confectioner 25 to negotiate a private agreement among themselves. For negotiations to be a worthwhile alternative they must be able to share this cost in some way that makes each of them better off than if they did not negotiate.

Private Solutions to externalities:

Sometimes the problems of externalities are solved with moral codes and social sanctions. Consider for instance, if we invite someone on the dinner and as she comes we leave house and go to our friend’s place. How would she react to this condition although its not the binding on us that we must have to take her to the dinner. But its socially and morally wrong that we ignore her and go to another place leaving her in our home waiting for us to come and have dinner.

So the moral rule taught to the most people is “fulfilling the commitments.”

That is the essence of coase theorem

1-Key is to internalize the cost or benefit of the externality

2-Alternatives: private actions or government actions

3-Privet solutions likely to work when barraging or transaction cost are low.

Example:

Another example of the private solutions other than the government is donations by the private sectors in the non-profit organizations like hospitals and health care centers to give maximum benefit to the person that causes positive externalities for the well being of the people.

Why private solutions do not always work?

–        The transaction costs (bargaining costs) can be so high that private agreement is not possible.

–        Failure to achieve a private solution may require that the government intervene.

Transaction costs are costs that parties incur in the process of agreeing and following through on a bargain

Market Inefficiency:

A condition in which current prices do not reflect all the publicly available information about a security (i.e. when some individuals get certain information before others).

•          Often incomplete or absent markets for environmental assets

•          Prices then understate the full range of services by environmental assets or do not exist to signal the market value of the asset

Market becomes inefficient when private decisions based on prices, or lack of them, do not generate Pareto-efficient allocation of resources

•          Pareto inefficiency implies that resources could be reallocated to make at least one person better off without anyone worse off

•          Wedge is driven between what individuals want privately and what society wants collectively

Public Policies toward Externalities

•          Two types of public policies:

•          1. Command-and-control

•          Regulate behavior directly

•          Quotas, licenses, other quantity controls, technology standards

•          Regulation: Command-and-Control Policy

•          Government remedies an externality by making certain behaviors either required or forbidden

•          Called command-and-control policy

•          Examples: quotas on fish caught, technology standards for type of fishing gear used

•          2. Market-based

•          Provide economic incentives so that private decision-makers will choose to solve the problems on their own

•          1. Property Rights

•          2. Pigouvian taxes and subsidies (price controls)

•          Instead of regulating behavior in response to an externality, government can use market-based policies to align private incentives with social efficiency

•          Government can internalize externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities

•          Government can also issue property rights

•          In effect, property rights and a Pigouvian tax or subsidy induce firms to behave as if the externality were a market (priced) good.

•          They “internalize” the externality

•          Pigou was economist who discussed taxes when there are technological externalities

•          As opposed to other types of tax

•          More on these later in the class

Pigovian Tax:

A Pigovian tax (also spelled Pigouvian tax) is a tax levied to correct the negative externalities of a market activity.

For example:

The government imposes the taxes on the firms to reduce the effect of negative externality like pollution or damaging wastes produced by the firms.

And can offer subsidies to the firms or the private sector to enhance the effect of positive externality like the government has offered the subsidy on flour to provide breads to the general public on cheaper rates.

Pollution taxes:

The alternative, regulation, is viewed as having a higher cost to society because Pigovian taxes raise revenue and respond automatically to changes in the market such as lowered cost of production or pollution mitigation. With a Pigovian tax there is always an incentive to reduce pollution, whereas with direct regulation, a polluting company has no incentive to pollute any less than what is allowable.

Criticism:

Like all taxes, Pigovian Taxes can encourage smuggling and black marketing. Especially if they create large difference in the prices of the popular products in neighboring jurisdiction.

Subsidies:

In standard supply and demand curve diagrams, a subsidy will shift either the demand curve up or the supply curve down. A subsidy that increases production will tend to result in a lower price, while a subsidy that increases demand will tend to result in an increase in price. Both cases result in a new economic equilibrium.

Types of Subsidies:

Direct subsidies

Direct subsidies are the most simple, and arguably the least frequently used. They involve a direct cash transfer to the recipient, for example an unemployed person or an agricultural corporation.

Indirect Subsidies

Indirect subsidy is a term sufficiently broad that it may cover most other forms of subsidy. The term would cover any form of subsidy that does not involve a direct transfer.

CONCLUSION

As we know that the externality refers to the effect of one person’s action on the well-being of a bystander.

This means that any action of any person that has some effect on the other person is called externality. As we have discussed the externality from many aspects in the above mentioned detail, we infer that any effect of externality whether positive or negative can be minimized or maximized with the private and public intervention. Like positive externality can be maximized by subsidies by the government and the negative externalities can be minimized by imposing some legal taxes like pigovian tax on the industries or individuals.

This way the problem of the externalities and the market failure can be controlled either by private or public sector.

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What Does Pigovian Tax Mean?

A special tax that is often levied on companies that pollute the environment or create excess social costs, called negative externalities, through business practices. In a true market economy, a Pigovian tax is the most efficient and effective way to correct negative externalities.

A type of a Pigovian tax is a "sin tax", which is a special tax on tobacco products and alcohol.

Investopedia explains Pigovian Tax...

Pigovian tax is applicable only because market economies often fail to provide a proper incentive to reduce negative externalities. For example, a coal-powered plant may be polluting a nearby river by disposing its harmful byproducts in the river instead of shipping the byproducts to a special facility. A sufficient Pigovian tax would punish this firm economically when it chooses to dispose of the harmful byproducts in the river, creating an incentive to use more environmentally friendly methods of disposal.