Session 6 (Async)

Sisir Debnath
Indian School of Business

Sisir Debnath, Managerial Economics, Indian School of Business 1

 BP Oil Spill
• BP drills a well in the depths of the Gulf of
Mexico, hoping that the benefits from large oil
deposits exceed the costs of drilling
• The explosion of Deepwater Horizon creates
an oil spill that threatens the livelihoods of
Louisiana fishermen
• The fishermen were not party to the decision
to drill
• Drilling creates a social problem that is not
addressed through unrestricted markets
► Over exploration of deep-water drilling

Sisir Debnath, Managerial Economics, Indian School of Business 3

 Fable of Bees
• Apiaries produce
► Honey
► Pollination services
• Honey can be sold in the market
• There is no (hardly any) market for pollination services
• The number of apiaries in the market will be less than
optimum (Meade)
• Steven Cheung (1973)
► The pollination services in the US is $15 billion
industry
► Beekeepers transport their beehives next to
orchards and fields to sell pollination services

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 Transactions and Non-participants
• Transactions in free markets with price
systems always make market participants
better off
• If all participants were not better off, the
transaction would not take place
• But what about non-participants? They might
either benefit or suffer from transactions
between market participants
• The objective of today's class is to analyze the
provision of goods and services that impact
both market participants and non-participants

Sisir Debnath, Managerial Economics, Indian School of Business 6

 Today
6. Externalities & Public Goods
• Externalities
• Coasian bargaining
• Pigouvian taxes
• Cap and trade
• Public Goods
• Optimal provision of Public goods
7. Individual Behavior under Uncertainty
8. Market Competition
9. Simultaneous Games
10. Sequential and Repeated Games

Sisir Debnath, Managerial Economics, Indian School of Business 7

 Externalities
• Think about the following examples:
• Introducing a knowledgeable worker to a team
of employees increases the team's productivity
• Vaccination against communicable diseases
protects not only vaccine receivers, but reduces
the probability others around them get the
disease
• Literacy not only improves a person's job
prospects, but also allows society to use written
contracts and forms of communication

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 Externalities
• An externality is the effect of a decision by one
set of parties on others who were not
participants in that decision.
• Externalities are not always beneficial
► Air pollution from a factory or a car's tailpipe
has a negative impact on asthma sufferers
who live or work close by
► A business that underfunds the pension fund
pushes the cost of providing retirement
income on society
► Noisy neighbours upstairs
Sisir Debnath, Managerial Economics, Indian School of Business 9
 Externalities within a Firm
• In what context do managers deal with externalities?
• Externalities that involve the government and the
public
► Professional education
► Pollution
► Consumer safety
• Externalities within the firm
► Employees who are particularly helpful or disruptive
► Knowledge sharing
• Externalities between a firm and other firms
► Intellectual property generated through research

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 Negative Externality

If there are no
Deadweight externalities, (P0,Q0) is
Cost, P
loss
the equilibrium
S1 = Social Cost
If there are negative
externalities, the
S0 = Private Cost
marginal social cost
P1 Cost of externality
differs from the
marginal private cost,
P0 and P0 is too low and Q0
is too high to maximize
social welfare
D = Social Benefit
Quantity of Government
Q1 Q0 antibiotics intervention may be
necessary to decrease
consumption
Sisir Debnath, Managerial Economics, Indian School of Business 13
 Positive Externality
If there are no
externalities, P0Q0 is the
Cost, P Deadweight equilibrium
loss
If there are positive
externalities, the
S = Private Cost marginal social benefit
differs from the
Benefit of marginal private
P1
externality
benefit, and both P0 and
P0 Q0 are too low to
D1 = Social Benefit
maximize social welfare
D0 = Private Benefit Government
Quantity of intervention may be
vaccines necessary to increase
Q0 Q1 consumption

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 Externality Problems
• Goods and services with negative externalities
are over-supplied by private markets
• Goods and services with positive externalities
are under-supplied by private markets
• If externalities have a significant negative
(positive) impact, how does one mitigate
(encourage) their incidence?
• Internalize the externality
• Alter incentives so that individuals take
account of externality in their own actions

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 Externality Solutions
• Private solutions
• Moral codes
• Private charities
• Bargaining (Coase theorem)
• Public (government) solutions
• Regulation via mandating maximum (negative
externality) or minimum (positive externality)
provision
• Pigouvian Taxes (negative externality) and
subsidies (positive externality)
• Cap and trade
• Privately developed public solutions
• Social institutions

Sisir Debnath, Managerial Economics, Indian School of Business 16

 Mandated Maximum Provision
Cost, P

If there are no externalities,

P0Q0 is the equilibrium
S1 = Social Cost
If there are externalities, the
S0 = Private Cost marginal social cost differs
from the marginal private
P1 cost, and P0 is too low and
Q0 is too high to maximize
P0 Cost of externality
social welfare

Government intervention
D = Social Benefit
may be necessary to reduce
Q consumption
Q1 Q0

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 Bargaining Solution (Example)
• A perfume factory is downstream to a paper
mill. Gunk from the paper mill impose a
negative externality on the operations of the
perfume factory.
• The paper mill could reduce effluents by
installing filters.
• The perfume factory could eliminate the
impact of the gunk by treating water before
use.

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 Coase Bargaining
• Coase pointed out that the problem of external
benefits and costs is not that they are external
but the property rights are defined poorly and
transaction costs are high
• A property right is a legal rule that describes
what economic agents can do with an object or
idea.
• Example:
► Deed to parcel of land
► Patent on an idea

Sisir Debnath, Managerial Economics, Indian School of Business 21

 Coase Bargaining
• Example: Case 1: No explicit rights allocation. Both the
paper mill and the perfume factory can do whatever they
wish.
Perfume Factory
No
Treatment Treatment
Paper No Filter (500,100) (500,200)
Mill Filter (300,500) (300,300)

• The paper mill will not install a filter

• The perfume factory will install a treatment plant
• Joint payoff will be 700 → Can they do better?

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 Coase Bargaining
• Example: Case 2: The perfume factory has the right to
clean water and sets a fee of Rs. 500 for receiving gunk.

Perfume Factory
No
Treatment Treatment
Paper No Filter (0,600) (0,700)
Mill Filter (300,500) (300,300)

• The paper mill will install a filter

• The perfume factory will not install a treatment plant
• Joint payoff will be 800 → The best they can do
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 Coase Bargaining
• Example: Case 3: The mill has a right to pollute
and sells fresh water for Rs. 250.
Perfume Factory
No
Treatment Treatment
Paper No Filter (500,100) (500, 200)
Mill Filter (550, 250) (550, 50)

• The paper mill will install a filter

• The perfume factory will not install a treatment
plant
• Joint payoff will be 800 → The best they can do

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 Coase Bargaining
• Summary of the main results
• Ownership of property rights affects income
distribution
► Party with property rights is compensated by
other party
► Property rights are valuable
• With no impediments to bargaining, assigning
property rights results in efficient outcome
► Joint profits are maximized at this outcome
• Efficiency is achieved regardless of who
receives the property rights!
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 My Energy Your Sound
• Caithness Energy (NY) is trying to set up 338
wind turbines in Shephard’s Flat, Eastern Oregon
• Invenergy, operates a wind farm in a nearby
Willow Creek with 48 turbines
• Invenergy, is already facing lawsuits from locals
about windmill noise and flicker
• Invenergy, has been ordered to come into
compliance within six months
• Patricia Pilz, CEO of Caithness want to pre-empt
the lawsuits. What could be her strategy?

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 Challenges to Coase Bargaining
• Why doesn't Coase bargaining solve every
negative externality?
• High transaction costs
► Ex: In Bhopal Gas case, defendants are far
away
• Large numbers of injured parties
► Ex: In Erin Brockovich's suit, 1 defendant
but 634 plaintiffs
• Incomplete or asymmetric information
► Ex: In carbon emission case, exact abatement
costs for each emitter are not known
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 Pigouvian Taxes and Subsidies
• A Pigouvian tax (subsidy) is levied on a
market activity that generates negative
(positive) externalities.
• Such taxes are not intended to raise funds, or
to tax sinful activities.
• Examples of Pigouvian taxes and subsidies
► Subsidies for higher education
► Taxes on high sugar sodas and snacks to
combat obesity
► Carbon taxes to combat global warming

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Pigouvian Taxes and Subsidies
Cost, P Deadweight
loss
S = Private Cost = Social
S1 = Social
Cost
Cost

S0 = Private Cost
P1 Pigouvian
Cost tax
of externality
P0

D = Social Benefit
Quantity of
Q1 Q0 antibiotics

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 Emission Standards & Fees
Marginal
Abatement
Costs

Pigouvian
Tax
MAC > Tax MAC < Tax
Firm prefers to pay tax Firm prefers to abate emissions

E0 Level of emissions

Firm has to either abate pollution or pay a tax

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 Emission Standards or Fees
Marginal MAC1 MAC2
Abatement • Fees are more efficient
Costs to reduce emissions
• If the cost of not
reducing emissions are
very high, a standard is
MACS2 preferable
MACS1

1 2
2 Level of emissions

Sisir Debnath, Managerial Economics, Indian School of Business 33

 Cap and Trade
• How does cap and trade work?
• Cap or limit on total quantity of production
(across the industry)
• Producers need a permit for every unit of
production
• Cap is equal to total number of permits in
market
• Permits are tradable → Market price for
permits
• Leads to known quantity, unknown price

Sisir Debnath, Managerial Economics, Indian School of Business 34

 Rs./ton
Cap and Trade Rs./ton

Same levels of pollution but different abatement costs

MAC2

MAC1

Firm-1 0 5 10
Firm-2 10 5 0
Pollution abatement

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 Cap and Trade
• Each firm must either abate pollution, or pollute with a
permit
• Initially, each firm is allocated five permits (to pollute 5
units)
► Both Firm 1 and Firm 2 can pollute first 5 units and must
buy the permit to pollute beyond 5 units
• Total pollution limit is 10 units
• But Firm 1 can sell its permit to Firm 2
► Firm 2 will be happy to buy, since using the permit lowers
TAC2 (Total Abatement Cost).
► Increase in TAC1 is less than reduction in TAC2 for Firm 2.
► Price of permits is net cost savings for Firm 2.
• Keep trading till MAC1 = MAC2.
► No additional gains from further trading for either firm.

Sisir Debnath, Managerial Economics, Indian School of Business 36

 Rs./ton
Cap and Trade Rs./ton

Each firm can do better if Firm 1 sells its permits to Firm-2

MAC2

Trade 1 unit
of right to
pollute
MAC1
Net
Cost
Saving

Firm-1 0 5 6 10
Firm-2 10 5 4 0
Pollution abatement

Sisir Debnath, Managerial Economics, Indian School of Business 37

 Rs./ton
Cap and Trade Rs./ton

Keep trading till MACs are equalized

MAC2

MAC1
Net
Cost
Saving

Firm-1 0 5 6 7 10
Firm-2 10 5 4 3 0
Pollution abatement

Sisir Debnath, Managerial Economics, Indian School of Business 38

 Carbon tax vs. Cap-and-Trade
• Revenue
• Direct tax revenues from carbon taxes
• Government can redistribute carbon tax
revenues as transfers to individuals or firms
• Revenues from cap-and-trade only if permits
are auctioned
• Free permits are a hidden transfer to emitters
• Allocation
• Who should receive permits initially?
• Distribution to current emitters?
• Distribution by auction?
• Distribution to affected parties?

Sisir Debnath, Managerial Economics, Indian School of Business 39

 Public Goods
• Apart from “usual” goods and services, we
consume many public services everyday
• The military protects us even without a
conscious choice to consume their services
• Roads, railways and telecommunications
enable us to access different goods and services
• Health and education services increase our
ability to appreciate different goods and
services
• Imagine life without public goods and services
• Libertarian paradise?

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 Public Goods
• Public goods are goods and services that are non-
rivalled and non-excludable in consumption.
• National defence is a pure public good.
► Non-rivalled: marginal cost of protecting another
citizen given the level of defence is zero.
► Non-excluded: One person cannot exclude
another from protection.
• Radio broadcasts are a pure public good.
► Non-rivalled: Cost for a marginal listener is
negligible.
► Non-excluded: One listener cannot exclude
another tuning in.
Sisir Debnath, Managerial Economics, Indian School of Business 42
 Other Types of Public Goods
• Marketable public goods are non-rivalled but
excludable
► Also called club goods
► Examples?
► Expressways with low traffic, satellite television
• Common property goods are rivalled and non-
excludable
► Suffer from congestion problems
► Examples?
► Fish stock, Grazing in common area
• Private goods are both rivalled and excludable
► Most goods and services
► Examples?
Sisir Debnath, Managerial Economics, Indian School of Business 43
 Features of Public Goods
• Even when everyone consumes equal quantities of
a public good, not everyone has same value of
consumption
• Classification of public good is not absolute
► Depends on market conditions and state of
technology
► Example: Broadcast, Cable and Satellite TV
• Difficult for the private sector to provide non-
excludable goods and make a profit
► Example: Basic research
• Not necessary that public goods are produced only
by public sector

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 Excludability and Rivalry
Defense services Netflix Tuna in the ocean Public Firework
display
Totally non-rival
in consumption

IV I
Totally rival in

III II
consumption

Totally excludable Totally non-excludable

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 Aggregate Demand for Public Goods
• For private goods aggregate demand is
obtained by summing up individual demand at
each price
• How to obtain aggregate demand for public
good?
• Recall that the same amount of public good
may be consumed by many at the same time.

Sisir Debnath, Managerial Economics, Indian School of Business 46

Public Goods & Market Failure
P
At efficient output
marginal benefits must
be equal to marginal cost

Market Demand
MC
Inefficient
Efficient

D1 D2
Q
1 3
Sisir Debnath, Managerial Economics, Indian School of Business 47
 Takeaways from Today's Class
• Externalities are impact of market transactions on
non-participants
► Public policy should encourage positive
externalities and discourage negative ones
► If property rights are well-designed and
transaction costs are low, bargaining will remedy
externalities
► Bargaining cannot fix every situation, so role for
government through mandates, Pigouvian taxes
and subsidies, cap and trade etc.
• Public goods are non-rivaled and non-excludable in
consumption
► Voluntary provision tends to undersupply public
goods and oversupply public bads
► Remedy through government action

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 References for Today's Class
• Pindyck and Rubinfeld Microeconomics,
Chapter 18 on “Externalities and Public Goods"

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 Readings for Next Session
• “In Manhattan pizza war, price of slice keeps
dropping" The New York Times, March 30,
2012.
• “Price-bots can collude against consumers”,
The Economist, May 6, 2017

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