Information Externalities Ext.

and Market Failure Correcting Externalities

ECON 459: PUBLIC FINANCE I

EXTERNALITIES

LECTURE 5

1
Dr. Raphael E. Ayibor

Department of Economics
KNUST

First Semester, 2024

1
raphaelayibor@gmail.com; raphael.ayibor@knust.edu.gh
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Information Externalities Ext. and Market Failure Correcting Externalities

Lecture Description

In this lecture we will:

⋄ Define Externalities.

⋄ Explain the various types of Externalities.

⋄ Examine how externalities lead to market failure.

⋄ Identify ways to correct externalities.

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Information Externalities Ext. and Market Failure Correcting Externalities

QUESTIONS FOR THOUGHT (QFT)

• What are Externalities?

• Why does market failure arise when there are Externalities?

• How can we correct Externalities?

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WHAT ARE EXTERNALITIES

• Market efficiency is base on the two presumptions:

1. The welfare of each consumer depended solely on their own
consumption decision.
2. The production of each firm depended only on its own input
and output choices.
• However, an economic agent (consumer or a firm) may be
directly affected by the actions of other agents in the
economy.
• That is, there may be external effects from the actions of
other consumers or firms.

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WHAT ARE EXTERNALITIES

An externality arises whenever the utility or profit of an agent

depends directly on the actions of another agent (individual
or firm).

• The actions of these agents will either make the utility or

profit worse or better off, yet these agents neither bears the
costs nor receives the benefits of doing so.
• Because the effect is not transmitted through prices (i.e.,
through a market mechanism).
• Example:
• Pollution/consumption of loud music. This externality enters
directly into the utility or production functions without price
mediation.
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Information Externalities Ext. and Market Failure Correcting Externalities

WHAT ARE EXTERNALITIES

Important Distinction

This definition of externality distinguishes between two broad

categories.

1. Production Externality: occurs when the effect of the

externality is on a profit

2. Consumption Externality: occurs whenever a utility level of

an individual is affected.
• Note: an externality can be simultaneously both a
consumption and a production externality.

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Information Externalities Ext. and Market Failure Correcting Externalities

WHAT ARE EXTERNALITIES

Important Distinction

These two categories can further be classified as positive or

negative. That is:
1. Production Externality:
• Positive Production Externalities
• Negative Production Externalities

2. Consumption externality:
• Positive Consumption Externalities
• Negative Consumption Externalities

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Definitions
• A market failure is a problem that causes the market economy
to deliver an outcome that does not maximize efficiency.
• Private marginal cost (PMC): The direct cost to producers of
producing an additional unit of a good.
• Social marginal cost (SMC): The private marginal cost to
producers + any costs associated with the production of the
good that are imposed on others.
• Private marginal benefit (PMB): The direct benefit to
consumers of consuming an additional unit of a good by the
consumer.
• Social marginal benefit (SMB): The private marginal benefit
to consumers - any costs associated with the consumption of
the good that are imposed on others.
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Information Externalities Ext. and Market Failure Correcting Externalities

Market Without Externalities

Without externalities, these conditions holds:

• Private Marginal Cost (PMC) = Social Marginal Cost
(SMC)= Supply

• Private Marginal Benefit (PMB) = Social Marginal Benefit

(SMB)= Demand

• Then, private market competitive equilibrium is

• PMB = PMC
• This provides social-efficiency-maximizing level of quantity and
market price.

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Information Externalities Ext. and Market Failure Correcting Externalities

Graphical Illustration
Price

S = P M C = SM C

P1 A

D = P M B = SM B
0 Q1 Qty
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Information Externalities Ext. and Market Failure Correcting Externalities

Market With Externalities

• Assume a negative production externalities.

• Social Marginal Cost (SMC) ̸= Private Marginal Cost.

• ∵ Social marginal cost = Private marginal cost + MD
⋆ where MD is the marginal damage done to others.
⋆ marginal because it is the damage from that additional unit of
production.

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Information Externalities Ext. and Market Failure Correcting Externalities

Graphical Illustration
Price
SM C = P M C + M D
Deadweight loss
S = PMC
B
C MD

P1 A

D = P M B = SM B
0 Q2 Q1 Qty
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Information Externalities Ext. and Market Failure Correcting Externalities

Market With Externalities

• Assume a negative consumption externalities.

• Social Marginal Benefit (SMB) ̸= Private Marginal Benefit

(PMB).
• ∵ Social Marginal benefit = Private marginal benefit - MD
⋆ where MD is the marginal damage done to others by your
consumption of that unit.

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Information Externalities Ext. and Market Failure Correcting Externalities

Graphical Illustration
Price

M arginal Damage(M D)
S = P M C = SM C

P1
C DW L
B

SM B = P M B − M D D = P MB

0 Q2 Q1 Qty
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Information Externalities Ext. and Market Failure Correcting Externalities

The remedies for externalities include:

1. The Coasian solution.

2. Emission taxes or Pigouvian corrective taxation.

3. Regulation: Command and Control.

4. Permits (cap-and-trade).

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Information Externalities Ext. and Market Failure Correcting Externalities

The Coasian Solution

• Externalities emerge because property rights are not well

defined.
• There is the need to define property rights and create markets
for pollution.
• Creating a market for buying the right to pollute would lead
to the Pareto efficient outcome
• Suppose that the firm pollutes a river. If the river is owned by
the consumer, then the firm has no right to pollute the river
without the agreement of the consumer.

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Information Externalities Ext. and Market Failure Correcting Externalities

The Coasian Solution

Price
SM C

DW L S = P M C1
B
C P ayment($100)

P1 A

MD =
$100
D = P M B = SM B
0 Q2 Q1 Qty
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Information Externalities Ext. and Market Failure Correcting Externalities

The Coasian Solution

Price
SM C = P M C2

S = P M C1

B P ayment($100)
P2
P1 A

D = P M B = SM B
0 Q2Q1 Qty
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Information Externalities Ext. and Market Failure Correcting Externalities

The Coasian Solution

• What happens if the firm owns the property right?

• Then it would offer to sell the consumer rights access to a less

polluted river.
• Once again, the private marginal cost curve would incorporate
this extra (opportunity) cost and shift out to the SMC curve.
• Note that it does not matter who is assigned the property
rights for the Coasian solution.
• Assignment of property rights affects distribution but not
efficiency.

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Information Externalities Ext. and Market Failure Correcting Externalities

The Coasian Solution

Two major problems with the Coasian Solution
1. Cost of bargaining neglected. Cost of bargaining very large
when the number of agents involved is large.
⋄ Example: air pollution. Millions of people suffer from
atmospheric pollution.
⋄ Need an association to come in to bargain in the name of
agents who are affected. This association is precisely the role
of the government.

2. Asymmetric information problem: Resource owners need to be

able to identify source of damage.
⋄ For atmospheric pollution, difficult to identify precisely what
harm each polluter is doing.
⋄ Competitive equilibrium can break down if information is not
perfect.
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Information Externalities Ext. and Market Failure Correcting Externalities

Emission taxes or Pigouvian corrective taxation

• Impose a tax equal to the marginal damage.

• Optimal Pigouvian tax of t = MD restores Pareto efficiency

and maximizes welfare.

Before tax
• private marginal cost = M C

• social marginal cost = M C + M D(EM C)

After tax, t = EM C
• private marginal cost = M C + t

• social marginal cost = M C + M D(EM C)

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Emission taxes or Pigouvian corrective taxation

Price
SM C = P M C2 = P M C1 + M D

S = P M C1

B MD = t
P2
P1 A

D = P M B = SM B
0 Q2 Q1 Qty
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Information Externalities Ext. and Market Failure Correcting Externalities

Emission taxes or Pigouvian corrective taxation

Major issue with corrective tax:

• You need to know MD function to set-up the optimal tax.

• For instance: Cars produce pollution, but difficult to measure

the marginal damage done by cars.

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Information Externalities Ext. and Market Failure Correcting Externalities

Regulation: Command and Control

• Each polluter has to cut pollution down to a certain level or

use only certain types of production processes or else face
legal sanctions.
• It could also be in the form of complete ban.
• In 1987, countries wanted to phase out the use of
chlorofluorocarbons (CFCs), which were damaging the ozone
layer.
• As a result, most countries banned the use of CFCs rather
than impose a large tax on products that used CFCs.

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Information Externalities Ext. and Market Failure Correcting Externalities

Regulation: Permits (Cap-and-trade)

• Cap total amount of pollution and allow firms to sort out

between themselves who pollutes more and less using
tradeable permits
• In equilibrium, firms with highest marginal costs of reducing
pollution will end up buying the most permits.
• These measures of correcting Externalities can be grouped
into:
⋄ price mechanism (tax) and
⋄ permit (quantity) mechanism

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Information Externalities Ext. and Market Failure Correcting Externalities

Regulation

Advantages
• Easier to enforce

• It can be useful to quickly reduce pollution levels if the aim is

to meet a certain salient target.

Disadvantages
• Inefficient allocation when there is heterogeneity in the costs
of pollution reduction across firms.
• Discourages innovation: no monetary incentives to discover
new technologies to reduce pollution further. With a tax,
there is such an incentive.

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Information Externalities Ext. and Market Failure Correcting Externalities

Trial Question

Firms A and B each produce 80 units of pollution. Assume the government wants to
reduce pollution levels. The marginal costs (MC) associated with pollution reduction
are M CA = 50 + 3QA for firm A and M CB = 20 + 6QB for firm B, where QA and
QB are the quantities of pollution reduced by each firm. Society’s marginal benefit
from pollution reduction is given by M B = 200.
a What is the socially optimal level of each firm’s pollution reduction?
b How much total pollution is there in the social optimum?
c Is it efficient for government to require firm A and B to each reduce pollution by
40 units and does not allow them to trade the right to pollute?
d If the government grants firm A and firm B each the right to pollute 40 units
and allows them to trade those rights, which firm would sell the first permit to
which?
e Can the social optimum be achieved using a tax on pollution?

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