Foldvary, Economics

Mankiw, Chapter 10, Externalities

An externality or external effect is an uncompensated effect on others.

They can be positive or negative.

Examples of positive ones?

Examples of negative ones?

My café and cell phone experience. Dogs which bark and do other nasty things.

Why do positive externalities exist?

Should government subsidize positive externalities?

Many activities with positive external effects are done anyway.

It can be difficult or impossible to determine what the marginal benefits are.

People may donate to causes they think deserve funding.

That's what charity is for.

Technology policy or industrial policy seeks to subsidize industries with positive externalities.

But these are difficult to predict, and mistakes can be costly to taxpayers.

Japan's industrial policy failed.

Companies seek subsidies, and in practice, those with clout receive it, and stifle competition.

Patents are one possibly successful way of encouraging positive technological innovation. The patents are for a limited time, 20 years.

Why do negative externalities exist?

In a pure market with property rights to all resources, would negative externalities exist?

The externality would be trespass, and would require compensation.

That would internalize the externality, making it no longer external,

since the agent causing the damage would bear the cost.

Where private property rights are lacking, as with the atmosphere, then the people are the owners, and government as the agent of the people may require the compensation.

If an externality is permitted, the social cost is greater than the private cost.

The difference is the external cost imposed.

The Coase theorem, Ronald Coase

Transaction costs: costs other than direct payments for a good.

If there are no transaction costs, parties can negotiate an efficient solution to an externality.

It becomes internalized by voluntary means.

An effective tool in negotiation: recognize that the parties have differing subjective values.

If many people are involved, transaction costs can become too high for a negotiated settlement.

Negotiations can also break down if the property rights are unclear or it is a matter of distributing some benefits.

[Several ways to deal with external effects.

Nothing (cell phones)

Social disapproval (bad language)

Negotiation (loud music)

Merging (land by airport)

Torts - law suits (neighbor's barking dogs)

Command and control, regulation (smog checks, smoking).

Pollution charges (cars).

Pollution taxes or charges are more efficient than regulatory controls because they let the agents adjust to their own costs, which can vary.

A firm may either invest in pollution reduction, or pay the penalty, according to which is less.

Either would reduce the pollution.

P. 217: gasoline tax effects.

Is it the most effective way to reduce congestion?

Why not directly charge for congestion? Both for traffic and parking.

Ditto pollution and accidents.

Tradable pollution permits.

Make polluters pay, but allow previous polluters a free pollution ride.

Revenue goes to firms with permits rather than to the government and the people.

If the permits are auctioned, then they act as a pollution charge.

Marginal cost of reducing pollution increases.
Marginal benefits decrease.

Socially optimal level of pollution is where MB of reducing pollution = MC of reducing pollution.

A pollution externality is not a failure of the market, since it is not voluntarily accepted by the victims. If the external effect takes place, it is a failure of government to make the polluter pay for the damage caused. The pollution payment is market enhancing, not market hampering.

If the polluter does not compensate society, in effect, it is subsidized.

See p. 236