Prof. Bryan Caplan

Econ 103

Spring, 2000


Week 13: Externalities, I: Market Failure

I.                  Return to the Tragedy of the Commons: Negative Externalities

A.                 Previously, we discussed the "tragedy of the commons."  Basic idea: when no one owns a resource, it gets over-used.

B.                 Question: But what exactly does "over-use" mean in economic terms?

C.                Answer: It means that there are costly side effects that selfish agents don't factor into their decisions.  Economists call these costly side effects "negative externalities."

D.                How do you diagram negative externalities?  In addition to the demand curve, draw a "social benefits curve."  With negative externalities, the social benefits curve will lie below the demand curve. 

E.                 Social optimum is at the intersection of the social benefits curve and the supply curve, but market equilibrium is at the intersection of the demand curve and the supply curve. 

F.                 Economists call this a market failure, since self-interested behavior leads to inefficient results.

G.                Negative externalities are also often called "public bads," especially when the externalities are large relative to demand (so the socially optimal quantity is close to zero).

H.                 Ex: Pollution.  People value better air, but polluters normally have no incentive to care. 

I.                     The key: non-excludability.

1.                  There is no feasible way to exclude non-payers from the cleaner air.  

2.                  Since you do not have to pay to use it, selfish people will not pay to use it. 

3.                  And if no one will pay for it, why would selfish producers provide it?

II.               Positive Externalities

A.                 Positive externalities are the other side of the coin.  Positive externalities are beneficial side effects that selfish agents don't factor into their decisions.

B.                 How to diagram?  Draw a social benefits curve above the demand curve. 

C.                Positive externalities are also often called "public goods," especially when the externalities are large relative to demand (so the equilibrium quantity is close to zero).

D.                Non-excludability is once again the key attribute.  If you can't exclude, there is no incentive to pay; if there is no incentive to pay, there is no incentive to produce.

E.                 Ex: Defense.  People value defense, but how can suppliers be paid to provide it?

III.            Understanding Externalities

A.                 Friedman's caveats:

1.                  Must distinguish benefits from external benefits.  (E.g. education).

2.                  Must include both positive and negative externalities in your calculations.  (Important case: "pecuniary externalities").

B.                 Some popular and plausible examples: air pollution, national defense, highways and roads (especially local roads), law enforcement (especially victimless crimes)...

C.                Some popular but dubious examples: education, health and safety, fire, R&D...

D.                Some unpopular but plausible examples (depending on the society): censorship, persecution of religious minorities...

IV.            Externalities, Efficiency, and Fairness

A.                 Further insight from Friedman: "It is easy to misinterpret problems of market failure as unfairness rather than inefficiency... The problem with public goods is not that one person pays for what someone else gets but that nobody pays and nobody gets, even though the good is worth more that it would cost to produce." (p.278)

B.                 Common sense ethics tells us to distinguish e.g. polluters from pollutees.

C.                But from an economic point of view it can be equally efficient to make polluters pay pollutees for the right to pollute, or have pollutees pay the pollutees to pollute less.

D.                Thus, as the economist Ronald Coase argued, many externalities problems can be solved by defining property rights, then allowing parties to bargain.  So long as "transactions costs" are low, externalities won't be a problem.

E.                 Corollary: eliminating property rights can turn any situation into a public goods problem.  (E.g. provision of food).

V.               Regulation vs. Tradable Permits

A.                 Most pollution regulation imposes either quantitative limits (so many tons per year for each firm), or mandates "best available technology."

B.                 Simple alternative: Issue "rights to pollute," then let firms buy and sell these rights.

C.                Advantage: This gets you the same pollution level at a lower price.  Firms that can easily switch to less polluting technologies sell their permits to firms where reducing pollution is expensive.

D.                Further application: World pollution trading.