Economic Externalities: Definition, Types, and Market Inefficiencies, Appunti di Economia Politica

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Externalities

Economia Pubblica 02805

Introduction

• An externality is a link between economic agents

that lies outside the price system

• Pollution from a factory
• Envy of a neighbor
• Externalities are not under the control of the

affected agent

• Efficiency theorems do not apply
• Competitive equilibrium unlikely to be efficient
• Externalities are of practical importance
• Possibility of global warming
• Damage to the ozone layer

Externalities Defined

• Pecuniary externality: an external effect that works

through prices

• An oil price rise affects the profitability of a fishery
• Pecuniary externalities do not create an inefficiency

Externalities Defined

• With externalities the actions of agents are not

independent nor determined solely by prices

• Strategic interdependence arises
• This is the source of inefficiency

Market Inefficiency

Market Inefficiency

Market Inefficiency

• The efficient allocation is described by '   '  1 1 2 1 1

u z   z 

'   '  1 2 1 2 2

u z   z 

Market Inefficiency

• The externality leads to a divergence of private

valuation ( ) from social valuation ( )

• If the externality is positive then
  • Marginal utility of each consumer is lower at efficient allocation than at market equilibrium
  • Too little good z is consumed in equilibrium
• If the externality is negative then
  • Marginal utility of each consumer is higher at efficient allocation than at market equilibrium
  • Too much good z is consumed in equilibrium

h

h 

u h ' ' ~'

h h

u  

Externality Examples

• The River Pollution Example
• Two firms located on a river
• The upstream firm, u, pollutes the river
• The pollution reduces the output of the downstream

firm, d

• Both produce the same output and sell at a price of 1
• Technologies are , where is labor

use of firm i with decreasing return to scale

• The profit level of firm i is (price-

taker)

u u

F L  

d d u

F L ,L

i i i   F  wL i L

Externality Examples

• Fig. 7.2 depicts the allocation of labor
• Production function of downstream shifts down when increases
• Profit maximization leads to and
• A small reallocation of labor from u to d does not affect but raises
• The equilibrium is inefficient u * L Figure 7. Equilibrium with river pollution d * L u L u  d  w 0 u^ w 0 d Upstream Downstream Revenue Revenue Cost Cost ^ u Lu*^ , Ld^ * ^ d

Externality Examples

• The Traffic Jam Example
• This example considers the externalities that car

drivers impose on each other

• Assume there are N commuters with a choice of

commuting by train or car

• Travel by train takes 40 minutes
• The travel time by car increases as the number of car

users increases

• Commuters make the choice which minimizes their

personal travel time

Externality Examples

• In Fig. 7.3 the equilibrium choice of commuting mode equalizes travel time by train and car
• x*% of commuters choose travel by car
• The optimum choice minimizes total travel time
• This occurs when x°% travel by car
• The equilibrium has too many commuters choosing to use cars Figure 7. Choice of commuting mode Minutes commuting Train Maximum time saving 0 Car x° x* 20 40 % of car users

Externality Examples

• Fig. 7.4 shows income in each occupation
• In equilibrium the income levels are equal
• A percentage E choose to be economists
• This equilibrium is efficient
• A reduction in income is a cost for an employee but a benefit for an employer
• Pecuniary externalities do not cause inefficiency Figure 7. Job choice Income of lawyers Economist 0 Lawyer 100 Percentage of economists Income of economists E

Externality Examples

• The equilibrium is efficient
• Any public policy that aims to limit the access to some profession is not efficient
• Market forces will correctly allocate the right number of people to each of the different professions. Figure 7. Job choice Income of lawyers Economist 0 Lawyer 100 Percentage of economists Income of economists E