HS 200: Environmental Studies

By Neha Gupta

Lecture Notes on EXTERNALITIES

Consumption Externalities

 One consumer cares directly about another agent’s production or consumption

 Examples:

 I get affected if somebody smokes or there is automobile pollution in my vicinity

-- close enough that I end up breathing that in

 There is loud music playing in my neighborhood late into the night

Production Externalities

 Production possibilities of one firm are influenced by choices of another firm or consumer

 Example of positive production externalities:

 Let’s say I am a bee-keeper

-- so I’ll get positive externalities if my neighbor has a fruit orchard
-- my neighbor will also get positive externalities from my bee-keeping

 Example of negative production externalities:

 Fishery downstream a river - its fish catch negatively affected by pollutants dumped upstream
Efficiency in the presence of externalities

 Crucial feature of externalities

-- goods people care about that are not sold on the markets

 Market mechanism capable of achieving Pareto efficient allocations

when externalities are NOT present

 In the presence of externalities, that may not happen

 Other social institutions such as

-- legal system
-- government intervention
can help achieve Pareto efficient outcomes
Production externalities example – Steel firm and Fishery

 Two firms:

 Steel firm 𝑺 -- located upstream -- produces steel 𝒔 and pollution 𝒙

 Fishery 𝑭 -- located downstream -- its output is the fish catch 𝒇

-- 𝒇 affected adversely by pollution 𝒙

 𝑺′ 𝒔 cost function : 𝒄𝒔 ( 𝒔 , 𝒙 )

 𝑭′ 𝒔 cost function : 𝒄𝒇 ( 𝒇 , 𝒙 )

𝛥 𝒄𝒔 𝛥 𝒄𝒇
 Assume : ≤ 𝟎 , > 𝟎
𝛥𝒙 𝛥𝒙
Production Externalities - Steel firm’s private optimal

 Steel firm’s profit-maximization problem:

 Fishery’s profit-maximization problem:

 Profit-maximization conditions for the steel firm:

 Profit-maximization conditions for the fishery:

Private optimal - Interpretation of conditions

 At profit-maximizing point, price of each good - steel, fish and pollution

should equal its marginal cost

𝛥 𝒄𝒔
 For 𝒙, recall that ≤ 𝟎
𝛥𝒙

 So 𝑺 keeps increasing 𝒙 till marginal benefit reduced to zero

-- note also that ‘price’ of pollution is zero

 Increase in cost of fishing associated with increase in pollution

-- part of social cost of steel production
-- ignored by 𝑺
=> 𝑺 will produce ‘too much’ pollution from the social point of view
Pareto efficient production plan for S and F

 Suppose 𝑺 and 𝑭 merge and form one firm that produces both 𝒔 and 𝒇 (and therefore 𝒙)

 Combined firm will maximize overall profits

=> externality gets ‘internalized’

 Merged firm’s profit-maximization problem:

Pareto efficient production plan for S and F contd.

 So the conditions characterizing Pareto optimality or the social optimum are given by:
Implications for the amount of pollution produced

 When steel firm and fishery are independent

-- amount of pollution determined by:

 When steel firm and fishery are merged

-- amount of pollution determined by:


Implications for the amount of pollution produced contd.

 Thus, true social cost of externality taken into account

=> optimal production of pollution is reduced

 When steel firm considers minimizing its private costs of producing steel,
-- it produces where marginal cost of extra pollution is equal to zero

 But Pareto efficient level of pollution requires minimizing social costs of pollution,
-- must produce where the sum of the marginal costs of the two firms is equal to zero
Interpretation of the Pareto optimality conditions - I

 Steel firm faces zero cost of pollution, ignores cost to fishery

 Situation can be corrected by

-- making it face the correct social cost of pollution
-- can be done by placing a tax on pollution

 Consider a tax of ‘t’ per unit of pollution

 Then, profit-maximization problem of the steel firm is given by:

Interpretation of the Pareto optimality conditions - I contd.

 So the conditions for profit-maximization are given by

and

 Comparing these conditions with those required for Pareto efficiency,

it is clear that if

then Pareto efficient level of pollution can result

when ‘t’ level of tax is imposed on the steel firm

 This kind of tax is known as PIGOUVIAN TAX

Interpretation of the Pareto optimality conditions - II

 There is a missing market for the pollutant

 Externality arises because polluter faces zero price for output that it produces

 If steel firm had the right to pollute

- fishery would be willing to pay money to have that output level reduced

 If fishery had the right to clean water

- steel firm would have to pay money to be allowed to pollute

 Consider ‘q’ to be the price per unit of pollution

Interpretation of the Pareto optimality conditions - II contd.

 So then profit-maximization exercise of the steel firm given by:

 While the profit-maximization exercise of the fishery given by:

Interpretation of the Pareto optimality conditions - II contd.

 The first-order conditions from the above two exercises are given by:

 If the price of pollution q is adjusted until the demand for pollution equals its supply,
then we have efficient equilibrium and in that case it must be that:
Social cost and Private cost

Steel firm produces pollution up to

the point where:

Marginal Private Cost = Zero

(of extra pollution)

Pareto efficient production of

pollution is at the point where:

Marginal Social Cost = Zero

(of extra pollution)