Externalities
Definition
• When the actions of one agent affect the interests of another agent other than by affecting prices, this is described as
an externality.
Consumption externality is utility, production is where a production function is affected
• Meade’s definition :an external diseconomy is an event inflicting an appreciable damage on not those who did not
fully- consent in reaching the decision which lead directly or indirectly to the event
• Meade includes distributional(pecuniary) externalities. That occurs when a change in demands leads to a change in
prices, and hence to a change in the incomes of other people. Also real income externalities arise where there is a
direct effect on real incomes
• But DEs are consistent with Pareto efficiency in perfectly-competitive markets.
- Resources are transferred from those who value them less to those valuing them more.
- RIE are not (and are sometimes termed "Pareto-relevant externalities")
- DE do not reflect a reduction in total output, unlike RIE, which has a destructive effect.
• Starlett: externality is where there is an insufficient incentive for a potential market to be created
for a good. The missing market leads to an equilibrium that isn’t Pareto-efficient.
- i.e. externalities arise due to gaps in the institutional structure of an economy.
• Markets do not exist for some goods that matter for living standards. Transaction costs prevent
efficient outcomes when agents make choices that harm others.
Efficient regulation of externalities.
• Efficient level of abatement is where MAC=MDC, then the net benefit of pollution abatement is
maximised, assuming MAC &MDC are montonic
• Marginal Abatement Cost schedule shows the cost of each successive unit of pollution abatement
•Abatements costs: lost profit from reducing output, closing polluting plants,
installing tech
•Area under MAC= total abatement costs
•MAC is monotonically-increasing if the least-cost combination of abatement
measures is implemented to achieve a given reduction in emissions. I.e. profit-
maximising firms can choose the combination of abatement measures to
achieve a given abatement target
• Marginal Damage Cost: value benefit from one extra unit of abatement
• Damage costs: lost profits or utility experienced by third party
• area under MDC= total environmental benefit
• no reason to say that the MDC schedule is monotonically related to abatement
Pigouvian Tax
• We want to cut emissions from U to Q. We could use Command-and-control regulation
• Or this can be achieved using a Pigouvian tax- a emissions tax of T per tonne. The polluter responds
by doing all abatement which costs less than the tax per tonne
• ie a cost-minimising polluter would respond to the tax T by cutting emissions to Q
• Would incur total abatement costs of A, and pay tax of TQ on remaining emissions
•The diagram considers two firms with different abatement costs. The efficient
(least-cost) division of abatement occurs where MACA=MACB i.e. A*
•If instead we forced both firms to abatement the same at A then the shaded
area shows the welfare loss
•With many polluters, with different abatement costs, emissions tax can achieve abatement at
lower total cost than uniform C&C regulation. The efficient outcome requires that polluters have
the same MAC. Otherwise, efficiency with C&C suffers from high info costs
Tradeable Permits
• Quantity constraint on emissions, applied through the quantity of permits issued. If this cap is less than “business-as-
usual” emissions, the scheme will reduce emissions to the level of the cap.
• Otherwise it has no effect and permits have no value
• Trading in Permits: the market determines which firms will undertake the required abatement to bring total emissions
in line with the cap.
• How to issue: sold at a fixed price, auctioned or grandfathered. Latter is where they are issues to polluters in
proportion to their historic emissions . How they are issued does not affect their efficacy
,Taxes VS Trading
• Tax rate and permit price will be the same for equivalent emissions outcome only if the permit market is competitive
• Same level and pattern of pollution abatement and same abatement cost incurred by firms
• If permits are sold in a competitive auction, revenue yield will be the same as from an equivalent environmental tax
• Which to choose
- Efficiency of the permit market: are there transaction costs and market power.
- Trading is not good when a small number of firms
- Initial distribution of Permits: most systems issue for free (grandfathering) but this foregoes revenue. Requires higher taxes to make up foregone
revenues. Also free distribution creates incentives for rent-seeking lobbying
- Impact of uncertainty about Marginal Abatement Costs
- Trading ("quantity" instrument) guarantees emissions level, but at uncertain MAC
- Taxes ("price" instrument) place upper bound on MAC, but have uncertain impact on pollution
Transaction costs in trading
• Cost of optimising: assessing whether to abate or buy permits
• Search costs: find info about market prices and find a trading partner
• Cost of assessing validity of rights : If “baseline and credit” trading systems allow trading before abatement verified, invalid permits may be offered for
sale
• Cost of negotiation
• Cost of release of confidential information: trading releases information of value to competitors
Market power and the efficiency of emissions trading
• In a competitive permit market, firms should be willing to trade allowances at prices reflecting their marginal abatement costs, so that all abatement-
cost-reducing emissions trades take place.
• But with market power, firms may restrict sales to get more for each permit. Some trades that would reduce abatement costs do not occur so
inefficiency.
• Market power arises due to the initial distribution of permits and the distribution of MACs
Uncertainty and instrument choice
• Quantity-based regulation: abatement outcome is guaranteed but costs of achieving outcome are uncertain
• Price-based regulation: e.g. tax, price guarantees a maximum MAC, but quantity of abatement uncertain.
• When there’s uncertainty about MACs, price and quantity regulation have different effects
Coase Theorem
• Bargaining between polluter and victim may lead to the efficient level of pollution abatement, without the need for government regulation.
• Waste of legal effort to find whose fault the externality is as it’s ambiguous. More important to assign rights clearly and unambiguously to someone, so
that bargaining can then proceed.
• In a competitive economy with complete information and zero transactions costs, the allocation of resources will be efficient, and invariant with respect
to the legal rules of entitlement
• Efficiency thesis :Under the required conditions, bargaining will lead to a Pareto-efficient outcome, regardless of whether we give the rights to the
polluter or the “victim”.
• Invariance thesis : Under the required conditions, the outcome will be the same equilibrium,
regardless of who is assigned the rights.
• The former is generally true. The latter is not true where income / wealth effects are present.
• Permissive assignment of rights: Polluter has the legal right to pollute so they choose xP.
• Optimum is at x*, moving here will involve extra abatement costs of c but victims benefit from reduced damage costs of c+d. Net
gain from Coasean bargain is d.
- x* can be achieved if victim pays polluter between c and c+d to reduce emissions
• Restrictive assignment of rights: Victim has the legal right to clean air so they choose xR
moving to x* involves extra damage costs of b (using MDC) , but reduced abatement costs of a+b.
- Net gain from Coasean bargain is a.
- x* can be reached if if polluter pays victim between b and a+b for the right to increase emissions
Conditions required
• Clear definition and enforcement of property rights
- else if uncertain over property rights then either party may be reluctant to pay as much as the other wants
• Zero transactions costs
- else costs of negotiation and enforcement may exceed potential gains from Coasean bargaining
- Transactions costs depend on the number of participants. When many people are involved, a deal is less likely. eg If there are many victims, each
may try to free-ride.
• Full-information, non-strategic bargaining : else asymmetric info leads to parties trying to grab more of the gains from trade
Wealth effects in Coasian Bargaining
• Invariance thesis: the assignment of legal rights alters the wealth of the polluter and victims. When the victims had the rights then the victim is wealthier
than in the other case because he gets payments from the polluter
• The invariance thesis will not hold where income / wealth effects affect either MAC or MDC
• Where the parties bargaining are firms, wealth effects do not arise. Because MAC and MDC reflect effects of pollution on profits which are unaffected
by wealth of the firm
• If either or both the victim and polluter are individuals then we can get wealth effects. MAC and MDC can include effects of pollution on utility, and
these may vary depending on the wealth of the individual.
• If the polluter is an individual, MAC may include behavioural changes (eg turn down loud music that upsets neighbours). The
money-equivalent of this will depend on the individual's wealth: a wealthier individual would be willing to pay more to play loud
music.
If the victim is an individual, MDC may include utility losses (eg health effects from pollution, or irritation from neighbour's noise).
Wealthier people would be willing to pay more than poor people to avoid the pollution.
• If MAC and/or MDC includes wealth effects, outcome of bargaining will depend on assignment of rights
• In diagram, wealth effects enter the MDC function eg because the victim is an individual
• MDC(R) and MDC(P) are the MDC schedules with restrictive (R) and permissive (P) initial assignments of rights.
• The individual is wealthier with R, and MDC(R) will lie above MDC(P).
, • If L types are offered a point above S then H types will pretend to be L types as they can reach a higher IC
• But where adverse selection is present, low-risk individuals will be unable to purchase as much insurance as they
would like, at rates reflecting their expected level of claims.
Implications of Adverse Selection
• Market failures in private insurance
- inadequate or inequitable insurance so some people are not insured and rely on the private sector
• Benefits of private insurance over public insurance
- Incentives for productive efficiency and innovation may be sharper in private insurance firms
- Private insurance easily allows individuals to choose different levels or qualities of insurance.
• Does adverse selection affect the possibility of a co-existence of public and private systems of insurance?
- If public sector insurance ("welfare state") is redistributive, allowing contracting-out on the basis of average
premiums will result in self-selection
- Public sector scheme will end up with those who expect to be net "gainers" from redistribution (ie whose
contributions are less than their expected benefits). I.e. H types stay with the public scheme
- Public schemes will have an aggregate public expenditure requirement equal to the sum of the net redistribution
they create.
Private unemployment insurance?
• Individual risks of unemployment vary but contribution through taxes is not linked to individual risks.
• Using private insurance leads to strong selection incentives.
• Those who opt out would be disproportionately those facing relatively low risks of unemployment, and consequently
paying high payroll taxes relative to their expected claims on unemployment benefits. The public sector would be left
insuring the bad risks, with revenue insufficient to cover costs of claims.
Moral Hazard:
• Post-contractual opportunism arising because actions after signing the contract have efficiency consequences are not
freely observable. Not possible to write enforceable contracts that specify permitted actions and behaviour.
• Individual may choose (rationally) to act in ways that benefit them, to the disadvantage of other party in contract.
• In insurance, moral hazard means that people take actions that increase the expected value of loss.
• Moral hazard is an efficiency problem because the insured person's decisions no longer reflect the full costs and
benefits of their decisions. Some of the costs are subsidised by the insurer.
- The benefits enjoyed by the insured (eg of unnecessary medication) may not be worth the full costs.
• Controlling Moral Hazard: deductibles and co-insurance (increase the cost to the individual); better information and
monitoring; rationing on the basis of assessments of need
• Public insurers have less incentive to control moral hazard as private insurers can go bankrupt.Economies of scale in
info gathering may mean state is better at handling moral hazard.
- Rationing entitlements may be more "acceptable" if made by the state than by a (profit-motivated) private insurer.
Principal-agent relationships
• Agent works on behalf of the principal who can’t monitor if the agent’s actions match the principal’s
goals or if they are self-interested. Moral hazard again.
• To reduce the moral hazard, use incentive/performance contracts and align interests
• Model: shareholders hiring a manager, can only observe profits which depend on manager’s effort
and other factors called state of the world
• Manager’s utility is U=y1/2 –4e . manager’s outside option gives U=10
• If salary is fixed then effort is 0. A fixed salary of 100 is needed to hire the manager as that gives U=10
• Table shows gross profits for different states of the world
• In states of the world A and C, effort makes no difference to the gross profits of the firm.
• In state of the work B, gross profits are higher if the manager works hard. But the same level of profit could be earned
in state of the world C, without manager effort.
• Shareholders can’t tell whether profit of 400 means manager worked hard, or if external factors were favourable.
• An incentive scheme can be Pareto improving for shareholders and manager. The scheme links the incentive to an
observable (profits) which is correlated with the unobservable (effort). But may not capture all aspects
Public Sector Link
• In many public sector activities, we may not be able to measure every aspect of output. Often we can measure volume
of activity more easily than quality. Incentives based on measurable output can distort unmeasurable outputs.
• Principal agent in public sector: voters can’t be sure politicians follow their interests, bureaucracy model, hard to
measure public sector output and quality
• Strategies to improve public sector performance: bonuses, Decentralisation. Multiple agencies / units can provide
comparative information on performance. Known as “yardstick competition” = reward best-performing units.
• Contracting-out. Transfer certain activities to private sector firms, working under contract to supply services, in the
belief that the private sector operates more efficiently.
Consumer pressure: Publish tables of performance (hospitals, etc), and allow people to choose. Privatisation: shift
activities entirely to the private sector.
Definition
• When the actions of one agent affect the interests of another agent other than by affecting prices, this is described as
an externality.
Consumption externality is utility, production is where a production function is affected
• Meade’s definition :an external diseconomy is an event inflicting an appreciable damage on not those who did not
fully- consent in reaching the decision which lead directly or indirectly to the event
• Meade includes distributional(pecuniary) externalities. That occurs when a change in demands leads to a change in
prices, and hence to a change in the incomes of other people. Also real income externalities arise where there is a
direct effect on real incomes
• But DEs are consistent with Pareto efficiency in perfectly-competitive markets.
- Resources are transferred from those who value them less to those valuing them more.
- RIE are not (and are sometimes termed "Pareto-relevant externalities")
- DE do not reflect a reduction in total output, unlike RIE, which has a destructive effect.
• Starlett: externality is where there is an insufficient incentive for a potential market to be created
for a good. The missing market leads to an equilibrium that isn’t Pareto-efficient.
- i.e. externalities arise due to gaps in the institutional structure of an economy.
• Markets do not exist for some goods that matter for living standards. Transaction costs prevent
efficient outcomes when agents make choices that harm others.
Efficient regulation of externalities.
• Efficient level of abatement is where MAC=MDC, then the net benefit of pollution abatement is
maximised, assuming MAC &MDC are montonic
• Marginal Abatement Cost schedule shows the cost of each successive unit of pollution abatement
•Abatements costs: lost profit from reducing output, closing polluting plants,
installing tech
•Area under MAC= total abatement costs
•MAC is monotonically-increasing if the least-cost combination of abatement
measures is implemented to achieve a given reduction in emissions. I.e. profit-
maximising firms can choose the combination of abatement measures to
achieve a given abatement target
• Marginal Damage Cost: value benefit from one extra unit of abatement
• Damage costs: lost profits or utility experienced by third party
• area under MDC= total environmental benefit
• no reason to say that the MDC schedule is monotonically related to abatement
Pigouvian Tax
• We want to cut emissions from U to Q. We could use Command-and-control regulation
• Or this can be achieved using a Pigouvian tax- a emissions tax of T per tonne. The polluter responds
by doing all abatement which costs less than the tax per tonne
• ie a cost-minimising polluter would respond to the tax T by cutting emissions to Q
• Would incur total abatement costs of A, and pay tax of TQ on remaining emissions
•The diagram considers two firms with different abatement costs. The efficient
(least-cost) division of abatement occurs where MACA=MACB i.e. A*
•If instead we forced both firms to abatement the same at A then the shaded
area shows the welfare loss
•With many polluters, with different abatement costs, emissions tax can achieve abatement at
lower total cost than uniform C&C regulation. The efficient outcome requires that polluters have
the same MAC. Otherwise, efficiency with C&C suffers from high info costs
Tradeable Permits
• Quantity constraint on emissions, applied through the quantity of permits issued. If this cap is less than “business-as-
usual” emissions, the scheme will reduce emissions to the level of the cap.
• Otherwise it has no effect and permits have no value
• Trading in Permits: the market determines which firms will undertake the required abatement to bring total emissions
in line with the cap.
• How to issue: sold at a fixed price, auctioned or grandfathered. Latter is where they are issues to polluters in
proportion to their historic emissions . How they are issued does not affect their efficacy
,Taxes VS Trading
• Tax rate and permit price will be the same for equivalent emissions outcome only if the permit market is competitive
• Same level and pattern of pollution abatement and same abatement cost incurred by firms
• If permits are sold in a competitive auction, revenue yield will be the same as from an equivalent environmental tax
• Which to choose
- Efficiency of the permit market: are there transaction costs and market power.
- Trading is not good when a small number of firms
- Initial distribution of Permits: most systems issue for free (grandfathering) but this foregoes revenue. Requires higher taxes to make up foregone
revenues. Also free distribution creates incentives for rent-seeking lobbying
- Impact of uncertainty about Marginal Abatement Costs
- Trading ("quantity" instrument) guarantees emissions level, but at uncertain MAC
- Taxes ("price" instrument) place upper bound on MAC, but have uncertain impact on pollution
Transaction costs in trading
• Cost of optimising: assessing whether to abate or buy permits
• Search costs: find info about market prices and find a trading partner
• Cost of assessing validity of rights : If “baseline and credit” trading systems allow trading before abatement verified, invalid permits may be offered for
sale
• Cost of negotiation
• Cost of release of confidential information: trading releases information of value to competitors
Market power and the efficiency of emissions trading
• In a competitive permit market, firms should be willing to trade allowances at prices reflecting their marginal abatement costs, so that all abatement-
cost-reducing emissions trades take place.
• But with market power, firms may restrict sales to get more for each permit. Some trades that would reduce abatement costs do not occur so
inefficiency.
• Market power arises due to the initial distribution of permits and the distribution of MACs
Uncertainty and instrument choice
• Quantity-based regulation: abatement outcome is guaranteed but costs of achieving outcome are uncertain
• Price-based regulation: e.g. tax, price guarantees a maximum MAC, but quantity of abatement uncertain.
• When there’s uncertainty about MACs, price and quantity regulation have different effects
Coase Theorem
• Bargaining between polluter and victim may lead to the efficient level of pollution abatement, without the need for government regulation.
• Waste of legal effort to find whose fault the externality is as it’s ambiguous. More important to assign rights clearly and unambiguously to someone, so
that bargaining can then proceed.
• In a competitive economy with complete information and zero transactions costs, the allocation of resources will be efficient, and invariant with respect
to the legal rules of entitlement
• Efficiency thesis :Under the required conditions, bargaining will lead to a Pareto-efficient outcome, regardless of whether we give the rights to the
polluter or the “victim”.
• Invariance thesis : Under the required conditions, the outcome will be the same equilibrium,
regardless of who is assigned the rights.
• The former is generally true. The latter is not true where income / wealth effects are present.
• Permissive assignment of rights: Polluter has the legal right to pollute so they choose xP.
• Optimum is at x*, moving here will involve extra abatement costs of c but victims benefit from reduced damage costs of c+d. Net
gain from Coasean bargain is d.
- x* can be achieved if victim pays polluter between c and c+d to reduce emissions
• Restrictive assignment of rights: Victim has the legal right to clean air so they choose xR
moving to x* involves extra damage costs of b (using MDC) , but reduced abatement costs of a+b.
- Net gain from Coasean bargain is a.
- x* can be reached if if polluter pays victim between b and a+b for the right to increase emissions
Conditions required
• Clear definition and enforcement of property rights
- else if uncertain over property rights then either party may be reluctant to pay as much as the other wants
• Zero transactions costs
- else costs of negotiation and enforcement may exceed potential gains from Coasean bargaining
- Transactions costs depend on the number of participants. When many people are involved, a deal is less likely. eg If there are many victims, each
may try to free-ride.
• Full-information, non-strategic bargaining : else asymmetric info leads to parties trying to grab more of the gains from trade
Wealth effects in Coasian Bargaining
• Invariance thesis: the assignment of legal rights alters the wealth of the polluter and victims. When the victims had the rights then the victim is wealthier
than in the other case because he gets payments from the polluter
• The invariance thesis will not hold where income / wealth effects affect either MAC or MDC
• Where the parties bargaining are firms, wealth effects do not arise. Because MAC and MDC reflect effects of pollution on profits which are unaffected
by wealth of the firm
• If either or both the victim and polluter are individuals then we can get wealth effects. MAC and MDC can include effects of pollution on utility, and
these may vary depending on the wealth of the individual.
• If the polluter is an individual, MAC may include behavioural changes (eg turn down loud music that upsets neighbours). The
money-equivalent of this will depend on the individual's wealth: a wealthier individual would be willing to pay more to play loud
music.
If the victim is an individual, MDC may include utility losses (eg health effects from pollution, or irritation from neighbour's noise).
Wealthier people would be willing to pay more than poor people to avoid the pollution.
• If MAC and/or MDC includes wealth effects, outcome of bargaining will depend on assignment of rights
• In diagram, wealth effects enter the MDC function eg because the victim is an individual
• MDC(R) and MDC(P) are the MDC schedules with restrictive (R) and permissive (P) initial assignments of rights.
• The individual is wealthier with R, and MDC(R) will lie above MDC(P).
, • If L types are offered a point above S then H types will pretend to be L types as they can reach a higher IC
• But where adverse selection is present, low-risk individuals will be unable to purchase as much insurance as they
would like, at rates reflecting their expected level of claims.
Implications of Adverse Selection
• Market failures in private insurance
- inadequate or inequitable insurance so some people are not insured and rely on the private sector
• Benefits of private insurance over public insurance
- Incentives for productive efficiency and innovation may be sharper in private insurance firms
- Private insurance easily allows individuals to choose different levels or qualities of insurance.
• Does adverse selection affect the possibility of a co-existence of public and private systems of insurance?
- If public sector insurance ("welfare state") is redistributive, allowing contracting-out on the basis of average
premiums will result in self-selection
- Public sector scheme will end up with those who expect to be net "gainers" from redistribution (ie whose
contributions are less than their expected benefits). I.e. H types stay with the public scheme
- Public schemes will have an aggregate public expenditure requirement equal to the sum of the net redistribution
they create.
Private unemployment insurance?
• Individual risks of unemployment vary but contribution through taxes is not linked to individual risks.
• Using private insurance leads to strong selection incentives.
• Those who opt out would be disproportionately those facing relatively low risks of unemployment, and consequently
paying high payroll taxes relative to their expected claims on unemployment benefits. The public sector would be left
insuring the bad risks, with revenue insufficient to cover costs of claims.
Moral Hazard:
• Post-contractual opportunism arising because actions after signing the contract have efficiency consequences are not
freely observable. Not possible to write enforceable contracts that specify permitted actions and behaviour.
• Individual may choose (rationally) to act in ways that benefit them, to the disadvantage of other party in contract.
• In insurance, moral hazard means that people take actions that increase the expected value of loss.
• Moral hazard is an efficiency problem because the insured person's decisions no longer reflect the full costs and
benefits of their decisions. Some of the costs are subsidised by the insurer.
- The benefits enjoyed by the insured (eg of unnecessary medication) may not be worth the full costs.
• Controlling Moral Hazard: deductibles and co-insurance (increase the cost to the individual); better information and
monitoring; rationing on the basis of assessments of need
• Public insurers have less incentive to control moral hazard as private insurers can go bankrupt.Economies of scale in
info gathering may mean state is better at handling moral hazard.
- Rationing entitlements may be more "acceptable" if made by the state than by a (profit-motivated) private insurer.
Principal-agent relationships
• Agent works on behalf of the principal who can’t monitor if the agent’s actions match the principal’s
goals or if they are self-interested. Moral hazard again.
• To reduce the moral hazard, use incentive/performance contracts and align interests
• Model: shareholders hiring a manager, can only observe profits which depend on manager’s effort
and other factors called state of the world
• Manager’s utility is U=y1/2 –4e . manager’s outside option gives U=10
• If salary is fixed then effort is 0. A fixed salary of 100 is needed to hire the manager as that gives U=10
• Table shows gross profits for different states of the world
• In states of the world A and C, effort makes no difference to the gross profits of the firm.
• In state of the work B, gross profits are higher if the manager works hard. But the same level of profit could be earned
in state of the world C, without manager effort.
• Shareholders can’t tell whether profit of 400 means manager worked hard, or if external factors were favourable.
• An incentive scheme can be Pareto improving for shareholders and manager. The scheme links the incentive to an
observable (profits) which is correlated with the unobservable (effort). But may not capture all aspects
Public Sector Link
• In many public sector activities, we may not be able to measure every aspect of output. Often we can measure volume
of activity more easily than quality. Incentives based on measurable output can distort unmeasurable outputs.
• Principal agent in public sector: voters can’t be sure politicians follow their interests, bureaucracy model, hard to
measure public sector output and quality
• Strategies to improve public sector performance: bonuses, Decentralisation. Multiple agencies / units can provide
comparative information on performance. Known as “yardstick competition” = reward best-performing units.
• Contracting-out. Transfer certain activities to private sector firms, working under contract to supply services, in the
belief that the private sector operates more efficiently.
Consumer pressure: Publish tables of performance (hospitals, etc), and allow people to choose. Privatisation: shift
activities entirely to the private sector.
