Externalities

Front 1

Externalities

Back 1

an external cost or benefit of an activity to tho
se not
directly involved in the activity

Front 2

Positive externalities examples:

Back 2

• Research & Development
• Education
• Immunisation of children
• Proper disposal of rubbish
• Bees pollinating crops

Front 3

Negative externalities examples:

Back 3

• Pollution (air, water, noise)
• Traffic congestion
• Smoking, drinking

Front 4

How externalities affect resource allocation...

Back 4

the bee-keeper adds hives until the added revenue she gets (marginal private benefit) from the last hive equals the cost of adding it (marginal private cost).

MPB = MPC

Front 5

Positive consumption externality:
hives are neighbouring an orchard.

Back 5

Note: MSB = MPB + MEB

(where MEB is the marg. external benefit)

Front 6

Negative production externality:
hives are neighbouring a school.

Back 6

Note: MSC = MPC + MEC

Front 7

The invisible hand

Back 7

An individual pursuit of self-interest which does not result in the largest possible economic surplus.

The result is market failure.

Front 8

Private solutions to externalities

Back 8

• Moral codes
• Charities
• Scholarships and prizes
• Business integration

Front 9

The Coase Theorem

Back 9

If private parties can bargain without transaction costs, they can solve the problem of externalities on their own. Because of the reciprocal nature of the problem.

Front 10

Coase Theorem assumptions:

Back 10

1. clearly defined and enforced property rights
2. full information and non-strategic behaviour
3. zero transactions costs

Front 11

Coase Theorem; real world issues

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• Lack of rationality whilst bargaining..

• What if there are 20 ranchers? (there will be
transactions costs, risk of strategic behaviour,
asymmetric information, coordination problems, etc.)

•Income effect between an individual and a producer (WTP of an individual farmer ≠ WTA of a wealthy rancher)

Front 12

Public policies on externalities

Back 12

1. Command-and-control policies: regulation

2. Market-based policies 1: corrective taxes
3. Market based policies 2: tradable pollution permits

Front 13

Corrective taxes

Back 13

a tax enacted to correct the effects of a negative externality

Front 14

Trade-able Pollution Permits

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• Governments sets an overall pollution cap.
• Firms can trade these permits:

→ the more costly it is for firms to cut back on pollution, the more likely they are to buy permits.
→ those firms that can reduce pollution most heaply, will do so and sell permits

=> the external cost of production is internalised.

Front 15

NZ wants to create a full scale ETS that includes a
ll sectors and all greenhouse gases (GHGs)

Three key principles for emissions trading in NZ:

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1. Low cost to NZ Inc.
2. No individuals should suffer disproportionately
large personal losses.
3. Robust – credible, feasible, durable

Front 16

Issues with an ETS (Emission Trading Scheme):

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• Point of obligation (what entity should be responsible for reporting emissions and matching them with permits?)
• Leakage problem?
• Distributional impacts?

Front 17

Private goods:
(food, clothing, toys, beers)

Back 17

Rival & excludable

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Common property resources:
(fish, water, forests)

Back 18

Rival & Non-excludable

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Club goods:
(satellite television, bridges)

Back 19

Non-rival & excluable

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Pure public goods:
(radio transmissions, national defence, etc.)

Back 20

Non-rival & non-excludable

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Exclude-able means...

Rival means...

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- access to a good is restricted, i.e. a person can be
prevented from using it.

- one person’s use diminishes other people’s use.

Front 22

Free-rider problem

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Someone who benefits from resources, goods, or services without paying for the cost of the benefit.

=> If everyone free-rides, collective benefits won’t be provided.

Front 23

1. Tragedy of Commons

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social cost > private cost

(negative production externality)

• Each herder is motivated to add more and more animals because he receives the direct benefit of his animals but bears only a share of the costs resulting from overgrazing.

Front 24

2. Prisoner’s dilemma

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individually rational strategies lead to collectively irrational outcomes.

Front 25

Prisoner’s dilemma - Dominant Strategy

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The strategy that is best for a player in a game regardless of the strategies chosen by other players.

=> (Confess, Confess) : (8, 8)

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Prisoner's dilemma- Pareto Inferior

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The best result for both parties.

=> if both had remained silent, they would have gotten 1 year.

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Prisoners Dilemma- Common Property Resource (CPR)

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Cooperate strategy: L/2 animals; profit = 10 units
Defect strategy: > L/2; profits = 0

Dominant strategy results in worst outcome.

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3. Logic of collective action

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individuals with common interest would voluntarily
act so as to try to further those interests.

Olsen Argued:

“unless the number of individuals is quite small, or unless there is coercion or some other special device to make individuals act in their common interest." => free-riding

Front 29

GOVT Intervention: Overcoming tragedy of commons:

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• 'Iron Govt' - Coercive force, eg. Military preventing poaching in South Africa .

• Private ownership

Front 30

Modification of the Herders’ game: central Govt decides on specific herding strategy

• Govt imposes penalty of 2 profit units on anyone who defects.

Assuming...

Back 30

Accurate information, perfect monitoring, sanctioning
reliability, zero admin costs, ...