SES Econ Camp Fall 2021: Session 5

Externalities. Review

Instructor: Arnab Sarker

Outline
• Warm-up: Quasi-linear Preferences
• Problem Setting
• Natural Outcomes and Optimality
• Interventions
• Coase’s Theorem
• Example
• Review

1 Warm-up: Quasi-linear Preferences

Before we go into the discussion of externalities, I first want to recall the notion of quasi-linear
preferences, because they can help simplify our analysis a bit. We actually observed an example of
quasi-linear preferences in Session 2 Example 2.
Quasi-linear preferences occur when a consumer has a utility function of the form

u(x1 , x2 , . . . , xn ) = x1 + f (x2 , . . . , xn ) ,

where f is some arbitrary function of the last n 1 goods. We also assume that the budget set
X is such that x1 can take any value in ( 1, 1), and without loss of generality we can assume
p1 = 1. When preferences and the budget set look like this, something very nice happens in terms
of wealth e↵ects. Specifically, for fixed prices, the demands for goods x2 through xn are constants
which depend only on f , and not on the wealth. Meanwhile, the demand for good 1 is a simple
affine function of wealth. Mathematically, we can represent this as

x1 (p, w) = w h(p)
xi (p, w) = gi (p) (i 6= 1)

So, when wealth increases by a fixed value D, the demand for good 1 increases by exactly D, and
the utility also increases by exactly D.

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Quasi-linear preferences end up being very convenient when we discuss di↵erent settings, because
they allow us to convert changes in wealth to changes in utility. So, for example, when we talk
about wealth transfers between people, we can relate that precisely to changes in utility.

2 Problem Setting
The basic idea of an externality is that one agent’s consumption somehow directly a↵ects someone
else. Externalities can be positive or negative, depending whether consumption increases or de-
creases the utility of other agents. A good way to think about externalities is by having examples
in mind. For example, negative externalities could occur when a company dumps waste into a river
or when your roommate starts playing music too loudly. Positive externalities can occur when your
neighbor plants a nice garden for everyone to enjoy, or when someone chooses to get vaccinated.
Mathematically, we can start to model externalities with two consumers. If both consumers have
quasi-linear utilities, and we write the externality as h, then indirect utilities can be written

v1 (p, w1 , h) = f1 (p) + 1 (h) + w1 ,

v2 (p, w2 , h) = f2 (p) + 2 (h) + w2 .

It is convenient to assume 1 and 2 are strictly concave, which is realistic and makes the math
more tractable. We’ll also make the assumption that only agent 1 has any choice over what h ends
up being.

In the rest of this session, we are going to answer a few questions: What happens if we let agent 1
choose h on their own? Can that be sub-optimal in some sense, and how so? If it is sub-optimal,
then can someone intervene to remedy the situation? Or, is there a way to allow the two agents to
sort out an intervention for themselves?

3 Natural Outcomes and Optimality

In the natural outcome where agent 1 selects the amount of the externality, they will want to
optimize their utility with respect to h, so they would select h⇤ such that
0 ⇤
1 (h ) = 0.

(If there is a boundary condition on h, such as h 0, then this condition would be 0 (0)  0
with equality if h > 0, but that does not change too much). So, agent 2 would get utility
v2 (p, w2 , h⇤ ) = f2 (p) + 2 (h⇤ ) + w2 , as they wouldn’t have any control over 2 (h⇤ ).

To see how this can be sub-optimal, we need to define an appropriate measure of optimality. For
this, we’ll use the concept of Pareto optimality. We say an allocation is Pareto optimal if there is
no other allocation such that one of the consumers is made strictly better o↵ without hurting the
other consumer. Although not all Pareto optimal solutions are equitable (why?), it does seem that
Pareto optimality is at least necessary to say that we have a good solution. So, Pareto optimality
does give a valuable condition to study externalities.
Externalities. Review 3

Condition for Optimality: Suppose we allow a transfer of T from agent 1 to agent 2. Then, the
utility for the agents becomes

v1 (p, w1 , h, T ) = f1 (p) + 1 (h) + w1 T,

v2 (p, w2 , h, T ) = f2 (p) + 2 (h) + w2 + T ,

because of the assumption of quasi-linear utility.

One simple way to determine the structure of a Pareto optimal solution is to lower bound the
utility of one agent by a constant ū and have the other agent maximize their utility subject to this
constraint. That is, I claim that solving

max v1 (p, w1 , h, T )
h,T

s.t. v2 (p, w1 , h, T ) ū ,

will always provide a Pareto optimal solution. Clearly, by definition of the maximization, agent 1
can’t increase their utility any more unless agent 2 gets a decrease in utility. The fact that agent
2 can’t increase their utility without a↵ecting agent 1 depends on the fact that preferences are
quasi-linear, although this condition can be relaxed with less strict assumptions.
So, we know that the Pareto optimal solution solves

max f1 (p) + 1 (h) + w1 T

h,T

s.t. f2 (p) + 2 (h) + w2 + T ū .

Given the quasi-linear preferences, we know that the constraint is satisfied with equality. So, solving
for T , we can just solve

max f1 (p) + f2 (p) + 1 (h) + 2 (h) + w2 + w1 ū ,

h,T

or, equivalently, we see that any Pareto optimal solution satisfies

0 PO 0 PO
max 1 (h) + 2 (h) =) 1 (h ) = 2 (h ).
h

The transfer T still matters as it determines which Pareto optimal solution occurs, but for any
Pareto optimal solution, the above constraint must be satisfied.
So, is the Pareto optimal constraint satisfied in the natural outcome where player 1 selects h as h⇤ ?
Not necessarily. Therefore, in many cases there is a way to make at least one player strictly better
o↵ while the other remains at least as well o↵ as previously. In the next section, we’ll discuss two
possible ways to ensure a Pareto optimal solution.

4 Interventions
There are two particular ways a government can intervene to ensure a Pareto optimal outcome:
Through quotas and taxes.
In a quota, there are two cases: If it is a negative externality, h⇤ > hP O , so the government restricts
agent 1 to only use at most hP O of the externality. In the case of positive externalities, where
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h⇤ < hP O , the government sets a minimum level of h to be used, namely hP O . Clearly, in both
cases, the e↵ect is to ensure the Pareto optimal amount of the externality is consumed.
A tax takes a di↵erent approach to the problem. Here, the government forces agent 1 to pay a tax
of th per unit on the externality, so agent 1’s utility becomes

v1 (p, w1 , h, th ) = f1 (p) + w1 + 1 (h) th ⇥ h ,

and the player would choose h which satisfies

0
1 (h) th = 0 ,

to satisfy the optimality condition. Setting th = 0 (hP O ) ensures that the selected value of h is
2
Pareto optimal. In the case where the externality is positive, it’s the case that 02 (hP O ) > 0, so
that the tax is actually a subsidy and agent 1 ends up getting paid per unit.

So, both quotas and taxes work to guarantee the Pareto optimal amount of externality is used. A
good question comes from wanting to know when one approach is preferred, and as it turns out
there can be di↵erences between the two when we incorporate uncertainty. This will be discussed
in detail in the course.
Before concluding this section, I also want to mention that it’s possible for a Pareto optimal outcome
to occur without government intervention. This observation underlies Coase’s theorem, which is
often asked about in the course.

5 Coase’s Theorem
Imagine agent 2 could simply bribe agent 1, and agent 1 could decide whether or not to take the
bribe to a↵ect the level of the externality. What would the agents do?
Agent 1’s decision is simple. They should accept the bribe B to set the level of externality to be h
if
f1 (p) + 1 (h) + w1 + B f1 (p) + 1 (h⇤ ) + w1 =) 1 (h) + B ⇤
1 (h ) .

So, given this condition, agent 2 would want to maximize their utility, i.e. they face the problem

max f2 (p) + 2 (h) + w2 B

h,B
⇤
s.t. 1 (h) +B 1 (h )

From the above, it is clear agent 2 would need to set B = 1 (h⇤ ) 1 (h), which makes it such that
h will need to maximize 1 (h) + 2 (h), which is exactly the case for the Pareto optimal level of the
externality.
This idea underlies Coase’s theorem. Roughly, the theorem states that if exchanges are allowed
between agents, and the property rights are still specified (i.e. it’s clear who can make transactions
with whom and for what), then a Pareto optimal allocation will be the result.
Exercise: Suppose that the property rights were defined di↵erently, and instead agent 2 had the
right to say whether agent 1 could or could not use the externality at all (that is, agent 2 has the
right to force h = 0). If agent 1 is allowed to pay agent 2 for the privilege to set h however they
wanted, what would happen? Show that Coase’s theorem still applies.
Externalities. Review 5

6 Example
MWG 11.B.1, from M. Weitzman.

On Farmer Jones’ farm, only honey is produced. There are two ways to make honey: with and
without bees. A bucket full of artificial honey, absolutely indistinguishable from the real thing, is
made out of one gallon of maple syrup and one unit of labor. If the same honey is made the old
fashioned way (with bees), k units of labor total are required (including bee-keeping) and b bees
are required per bucket. Either way, Farmer Jones has the capacity to produce up to H buckets of
honey on his farm.

The neighboring farm, belonging to Smith, produces apples. If bees are present, less labor is needed
because the bees pollinate the blossoms instead of workers doing it. For this reason, c bees replace
one worker in the task of pollinating. Up to A bushels of apples can be produced on Smith’s farm.

Suppose the market wage is w, bees cost pb per bee, and maple syrup costs pm per gallon. If each
farmer produces her maximal output at the cheapest cost to her (assume the output prices they
face make maximal production efficient), is the resulting outcome efficient?

How does the answer depend on k, b, c, w, pb and pm ? Give an intuitive explanation of your result.
Up to how much would Smith be willing to bribe Jones to produce honey with bees? What would
happen to efficiency if both farms belonged to the same owner? How could the government achieve
efficient production through taxes?
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7 Review
In this section I plan to ask students which parts of the camp are still unclear, and fill in the section
based on questions.

Our five sessions were structured as follows:

1. Introduction to the Consumer Choice Model.

We broadly discussed the consumer choice model and the importance of budget
sets and utility functions, with an emphasis on the graphical perspective.

2. Consumer Theory.

We spent time going into the details of the Consumer Choice Model, discussing the
di↵erent types of demands and their properties. A key takeaway from this section
was to be comfortable going back and forth between the di↵erent types of demands,
indirect utility, and the expenditure function.

3. Producer Theory.

In this session we talked about the problem producers faced, as opposed to con-
sumers. The problems had very similar structures, but whereas utility was a func-
tion that could be transformed, production functions represent something more
tangible. There is also di↵erent terminology when we discuss production functions.

4. General Equilibrium.

In this section, we began to look at what happens when we put consumers and
producers together to let them interact. We looked at settings where consumers
are in an exchange economy, as well as the case where there are firms. We discussed
the concept of Pareto optimality, and we computed Walrassian equilibrium for many
examples.

5. Externalities.

We discussed a setting where one agent’s actions a↵ected another’s utility, and how
that can result in situations which are not Pareto optimal. We then discussed ways
the government can intervene in such settings, by setting quotas or taxes. Moreover,
we mentioned Coase’s Theorem, which shows how we can achieve a Pareto optimal
solution by letting individuals make transfers with one another when property rights
are clearly specified.