2. externalities and public goods, Slide di Economia

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Market Failures:

Externalties and Public Goods

Prof. Carlo Cambini Politecnico di Torino [email protected]

Externalities z

Externalities arise between producers,between consumers, or betweenproducers and consumers

z

Externalities are the effects of productionand consumption activities not directlyreflected in the market^ {

They can be negative or positive

Externalities z

Positive^ {

Action by one party benefits another party^ z

Homeowner plants a beautiful garden where all theneighbors benefit from it z

Homeowner did not take their benefits into accountwhen deciding to plant z

Network externalities: mobile users benefits from abig installed base in order to obtain lower call prices(for

on net

calls, but not for

off net

calls!)

Negative Externalities andInefficiency z

Scenario – plant dumping waste

{

Marginal External Cost (MEC) is the increase in costimposed on users downstream for each level ofproduction {

Marginal Social Cost (MSC) is MC plus MEC {

Equilibrium in a competitive market where marketdemand crosses supply curve

z

Assumption: the firm has a fixed proportionsproduction function and cannot alter its inputcombinations

{

The only way to reduce waste is to reduce output

Negative Externalities andInefficiency z

The MC curve for the firm is the marginal cost ofproduction z

Firm maximizes profit by producing where MCequals price in a competitive firm z

As firm output increases, external costs on usersalso increase, measured by the marginalexternal cost curve z

From a social point of view, the firm producestoo much output

External Costs

Aggregatesocial cost ofnegativeexternality By not producingat the efficientlevel, there is asocial cost on

society.

MC

S = MC

I (^) D

P^1

P^1

q^1

Q^1

MSC

MSC

I

Firm output

Price

Industry output

Price

MEC

MEC

I

q*

P*

Q*

10

Network externalities •^

We face

direct

network externalities

when the

utility of an agent of type A depends on thenumber of agents belonging to the same group(say network) A:

-^

An additional agent that enter the networkgenerates a postive externality (

positive feedback

to the existing agents since “connection”possibilities are enlarged (ex. the evolution ofmobile adoption).

-^

The Metcalfe’s law

) , (

) (^

,

,^

q N

U q

U

A Ai

Ai

=

A simple model (Rohlfs, 1974)^ z

Let

p

be the (fixed) price to be connected to a

telecom network; the utility function of aconsumers of type

[0, 1] (= willingness to pay)

is: z

Utility increases if the number

n

[0, 1] of

users increases.

connect

no

if

connects

if

(^

p

n

U

θ

θ

A simple model (Rohlfs, 1974) z

Thus, in equilibrium we have: z

Two equilibria, one stable and one unstable.

is called the

critical mass

~^ ) (^1) ( ~

θ

θ^

−

= p

p 0

θ

p

θ^

1/2 n

1

˜ θ

0

0

0

L^

H

L 0 θ

A simple model (Rohlfs, 1974) z

What is the critical mass? The minimum level of coverage/penetration that a network/technologyshould reach in order to remain in the market. z

If you fail, you will exit the market. z

Relevant concept in high-tech industries: compatible vs. incompatible products. z

Relevant role of price and its impact on the coverage level. z

Important factors:

switching costs

and

lock in

effect

Market analysis in presence of networkexternalities z

From social point of view, it is easy to show that a 100% coverage should be reached (almost for c< 0.5).

Cos

ti, Be

ne

fic

i

0 0,^1

c = 0,

(^5) θ

0,^5 0,^4 0,^3 0,^2

0,^2

0,^4

0,^6

0,^8

1

c = 0,

25 c = 0,

1

Market analysis in presence of networkexternalities z

Should a private firm choose to cover all the marlet or not? z

In monopoly: z

FOC:

Costi,Ricavi 0,1^0

c^ = 0,

θ

0,5 0,4 0,3 0,

0,^

0,^

0,^

0,^

c^ 1 θ = 0,25 c = 0,

θ θ θ θ θ θ

π^

~

~ ) ~ (^1) ( ~ ~

~

) ~(

c

c

p^

− − = ⋅ − ⋅ =

2

c

Network externalities z

Generally consumers would like to be connectedto as large a network as possible. This impliesthat if there are several different providers ofnetworks, then it is very advantageous toconsumers if they interconnect z

Despite the fact that interconnection is typically inthe social interest, it may or may not be in theprivate interest. z

There may be cases where a large incumbentmay find it attractive to avoid interconnection withnew entrants in order to preserve its marketpower.

Network externalities z

It is important to understand that if the value of thenetwork increases through interconnection (due toMetcalfe law), then there should be a way to dividethat increase in value so to make all participantsbetter off. z

If the pie gets bigger, everyone can get a largerprice. However, the increased size of the pie alsomeans that

threats

not to interconnect become

more significant. And, of course, a larger pie is amore tempting target for someone to try to snatchthan a smaller one.