Externalities Consumption Externalities Production Externalities Consumption Externalities Occurs when one consumer cares directly about another consumer s consumption or a firm s production Negative consumption externalities smokers automobile pollution Positive consumption externality neighbor s flowers Production Externalities Production possibilities of one firm are influenced by choices of another firm or consumer Negative production externality fishery cares about pollutants dumped by upstream firm Positive production externality R D of one firm has positive effects on R D of other firms Crucial Feature of Externalities There are goods people care about that are not sold on markets no market for automobile pollution pollutants etc Absence of markets implies equilibrium when there are externalities is inefficient too much negative externalities not enough positive ones Example Smoking 1 smoke 0 E E money Example Smoking E 1 smoke X 0 E money Example Smoking 1 smoke 0 E X E money Example Smoking At an efficient equilibrium we have MRS A money smoke MRS B money smoke Example Smoking Introducing a market for smoke improves the utility of both consumers Problem with setting up such market poorly defined property rights Example Smoking Q If a market for smoke can be organized how much smoke will be produced A In general it depends on the initial distribution of property rights Example Production Externalities Firm S produces 1 steel s 2 pollution x which is dumped into a river Firm F a fishery is located downstream and is adversely affected by S s pollution Example Production Externalities Cost function for S cs s x Cost function for F cf f x Example Production Externalities Profit maximization for S max ps s cs s x s x Profit maximization for F max p f f c f f x f Example Production Externalities Optimal choices for S cs s x ps s cs s x 0 x Example Production Externalities Optimal choice for F pf c f f x f Example Production Externalities When setting optimal quantity of pollution the steel firm does not take into account the cost of pollution for the fishery Social cost of steel production increase in the cost of fishing associated with an increase in pollution Example Production Externalities What does a Pareto efficient production plan for steel and fish look like Suppose the two firms merged max ps s p f f cs s x c f f x s x f Example Production Externalities Optimal choice of f s x cs s x ps s c f f x pf f c f f x cs s x x x Example Production Externalities Compare pollution produced by merged firm pollution produced by steel firm cs s x x c f cs s x 0 x f f x 0 Example Production Externalities MC MCs MC f MC f MCs x x x Example Production Externalities At the Pareto efficient level of production the profits of the merged firm are larger than the sum of the profits of the two firms How can the Pareto efficient outcome be achieved Internalizing Production Externalities Taxation Steel firm faces the wrong price for pollution i e zero To correct this impose a quantity tax t on pollutants max ps s cs s x tx s x Internalizing Production Externalities Taxation Optimal choice of pollution with tax cs s x t x Optimal choice of t t c f f x x Internalizing Production Externalities Create Market Missing market Create market by assigning fishery the right to clean water Fishery can sell right to steel firm Or create market by assigning steel firm the right to pollute water Steel firm can sell right to fishery Internalizing Production Externalities Create Market The amount of pollution does not depend on how property rights are distributed different from consumption externalities Distribution of property rights affects firms profits Production Externalities Incentives Are Already There Steel firm and fishery have an incentive to merge higher profits why don t they merge Or somebody could buy both firms merge them and then enjoy higher profits