Externalities, Exercises of Cost Accounting

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34 ExternalitiesExternalities

ExternalitiesExternalities

-^ An^ externality is

a^ cost^ or^ a^

benefit^ imposed y^

p

upon^ someone

by^ actions^ taken

by^ others. The cost or benefit is thus generated externallyThe^ cost^ or^

benefit^ is^ thus

generated^ externally to^ that^ somebody.ll

d b

f

-^ An^ externally

imposed^ benefit

is^ a^ positive externality. • An^ externally

imposed^ cost

is^ a^ negative externalityexternality.

Examples of Positive ExternalitiesExamples

of^ Positive

Externalities

-^ A^ well‐maintained

property^ next

door^ that p^ p^ y raises^ the^ market

value^ of^ your

property.

-^ A pleasant cologne or scent worn by the•^ A^ pleasant

cologne^ or^

scent^ worn^

by^ the person^ seated

next^ to^ you.

-^ Improved

driving^ habits

that^ reduce accident risks.accident^ risks. • A^ scientific^

advance.

Externalities and EfficiencyExternalities

and^ Efficiency

-^ Crucially,^

an^ externality

impacts^ a^ third

party;

i.e.^ somebody

who^ is^ not^

a^ participant

in^ the y^

p^ p activity^ that

produces^ the

external^ cost

or

benefitbenefit.

Externalities and Property RightsExternalities

and^ Property

Rights

-^ An^ externality

will^ viewed

as^ a^ purely^

public

commodity. • A commodity is purely public ifA^ commodity

is^ purely^ public

if

-^ it^ is^ consumed

by^ everyone^

(nonexcludability), andand – everybody^ consumes

the^ entire^ amount

of^ the di^ (^ i^ l

i^

i^ ) commodity^ (nonrivalry

in^ consumption).

-^ E.g.^ a^ broadcast

television^ program.

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

-^ Consider^

two^ agents,

A^ and^ B,^ and

two

commodities,

money^ and

smoke.y

-^ Both^ smoke

and^ money

are^ goods^ for

Agent^ A.

M^ i^

d^ d^ k

i^ b d f^

A

-^ Money^ is^

a^ good^ and^

smoke^ is^ a^ b

ad^ for^ Agent B. • Smoke^ is^ a^ purely

public^ commodity.

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

Smoke^1

Money and smoke areMoney and smoke areboth goods for Agent A. (^00) O^ A

m^ A yA

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

Smoke^

Money and smoke are 1

both goods for Agent A. (^00) O^ A

m^ A yA

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities^ Smoke

Money is a good and smokeis a bad for Agent B

is a bad for Agent B.

00 O^ B

m^ B^

yB

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

-^ What^ are

the^ efficient

allocations^

of^ smoke and^ money?y

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

Smoke^

Smoke 1

0 O^ A

0 O^ B

yA^

yB m^ A^

m^ B

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

Smoke^

Smoke 1

0 O^ A

0 O^ B

yA^

yB m^ A^

m^ B

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

Smoke^

Smoke 1

1 Efficientallocationsallocations 0

0 O^ A

0 O^ B

yA^

yB m^ A^

m^ B

Inefficiency & Negative ExternalitiesInefficiency

&^ Negative

Externalities

-^ Suppose^ there

is^ no^ means

by^ which^ money can^ be^ exchanged

for^ changes

in^ smoke^ level. g^

g

-^ What^ then

is^ Agent^ A’s

most^ preferred allocation?allocation? • Is^ this^ allocation

efficient?