EXTERNALITY

Recall what we saw in the lectures on welfare economics: the equilibrium of supply and
demand is typically an efficient allocation of resources. We concluded that any kind of
government intervention would lead to a decrease in the total surplus to the society.
But then, why does the government intervene in the market?
We overlooked something while making this analysis: the presence of the ‘bystander’.
While calculating the total surplus of the society, we considered the consumer surplus and
the producer surplus, but we completely forgot that the benefit/loss to a bystander
(someone who is neither a seller nor a buyer in a particular market, but is getting affected)
would also make a difference to the total surplus. After all, this bystander is also a part of
this society.
This situation would be an externality. An externality arises when a person engages in an
activity that influences the well-being (either positively or negatively) of a bystander but
neither pays (in case of negative effect) nor receives any compensation (in case of positive
effect). If the impact on the bystander is adverse, it is called a negative externality. If it is
beneficial, it is called a positive externality. Examples of Negative Externality: Pollution
from a factory, Barking of your neighbour’s dog, Secondhand smoke/loud music because
of your roommate. Examples of Positive Externality: Research, Education, Fire
extinguishers
Can you see why the equilibrium fails to maximise the total benefit of the society? Because
buyers and sellers neglect the external effects of their actions when deciding how much to
demand or supply.

Negative Externality
Finance minister Arun Jaitley imposed levy of up to 4% on new passenger vehicles as part
of this year’s annual union budget. Why do you think was this tax imposed? Do you
think it is motivated by a market failure that the government tried to correct?
Is there any externality from the use of cars? Assume you are a bystander. You neither sold
nor bought a car. How will you be affected by somebody’s purchase of a car? New cars on
the road will add to the congestion, pollution and accidents. That is the externality in the
car market. It is negative. The value to the car buyers is the value they derive from the car.
This is the private value. The costs to the car seller is the costs they have to endure in the
production. This is the private cost. There is also a cost to the bystanders (in terms of
congestion, accidents, pollution). This is the external cost. Therefore, social cost of this car
= private cost + external cost. The demand curve represents the private value. The supply
curve represents the private cost. The social cost curve represents the social cost.
Consider the aluminium market now. There is an externality present here in the form of
pollution from the aluminium factories. Because consumers and sellers will ignore the
external costs, the equilibrium quantity is Qmarket. Now, imagine a social planner making
all the decisions instead. Since he is thinking from the POV of the entire society (buyers,
sellers, bystanders), he would take into account the external costs as well and therefore the
‘ideal’ quantity level is Qoptimum, the socially optimal level. Qmarket > Qoptimum
because external costs are overlooked, leading to overproduction.
Is there a way this social planner can bring the equilibrium to the efficient level,
Qoptimum? Try to recall what a tax does. Let’s impose a tax on the seller. Make the tax
size=external cost. What would happen? The supply curve will shift leftward by the size
of the external cost (=tax size). That is, the new ‘private cost’ curve (the new supply curve)
will coincide with the ‘social cost’ curve. Now, the equilibrium would be Qoptimum. What
we have done through this tax is that we have made the sellers and buyers take into
account the external costs of their costs. This tax is a way to internalise the externality. It is
called a corrective tax. We have made the seller take into account the external cost by
increasing his costs of production and we have made the buyer take into account the
external cost by incentivising him to consume less since the market price (reflecting the
tax) goes up. (Also, recall that it does not matter who the tax is imposed upon. So, taxing
the buyer by the size of the external cost would bear the same results. Check for yourself.)
Now can you see why the car sales tax was imposed in the union budget?

Positive Externality
Think about why education is subsidised (in terms of scholarships, government funds,
loans on zero interest rate, etc)? Is there an externality from education? Would you prefer
having more educated people in your neighbourhood? Having better educated people
around you would ensure better informed choices, lower crime rates and better
technological advances. This is the externality from education. It is positive. The value to
the buyer (of education) is the higher wage that he would get because of higher education.
This is the private value. The cost to the seller is the costs he has to endure in providing
this service. This is the private cost. There is a value to the bystander (in term of lower
crime rate, better technological advance, more informed decisions). This is the external
benefit. Therefore, social value of education= private value + external benefit. The demand
curve represents the private value. The social value curve represents the social value. Once
again, consumers and sellers will ignore the external benefit, the equilibrium quantity is
Qmarket. Imagine a social planner making all the decisions. He would take into account
the external benefit and therefore the ‘ideal’ equilibrium is Qoptimum, the socially optimal
level. Qmarket < Qoptimum because external benefit is overlooked, leading to
underproduction. Is there a way this social planner can bring the equilibrium to
Qoptimum? Try to recall what a subsidy does. Let’s impose a subsidy on the buyer. Make
the subsidy size=external benefit. What would happen? The demand curve will shift
rightward by the size of the external benefit That is, the new ‘private value’ curve (the new
demand curve) will coincide with the ‘social value’ curve. Now the equilibrium would be
Qoptimum. Once again, we have internalised the externality. This is a corrective subsidy.
What we have done through this subsidy is that we have made the sellers and buyers take
into account the external value of their actions. This subsidy is a way to internalise the
externality. We have made the buyer take into account the external value by increasing his
willingness to pay and we have made the seller take into account the external value by
incentivising him to supply more since the market price (reflecting the subsidy) goes up.

Now can you see why the government would fund/subsidize education?

Public Solutions of Externalities

Let’s talk a bit more about how to deal with externalities. We have already talked about tax
and subsidy. What else? How else can the government intervene and makes things better ?
The government can remedy an externality by making certain behaviours either required
or forbidden. These are called command-and-control policies. In most cases, total
prohibition would not be possible, therefore the government resorts to enforcing
regulation instead. For example, instead of trying to prohibit pollution, the government
tries to regulate it (either by setting a maximum level or by requiring firms to adapt a
particular technology). One drawback here is that government regulators should have
sound knowledge about the firms and about alternative technologies that can be adapted.
The alternative option to regulation is market-based policies to align private incentives to
social efficiency. One way is through corrective taxes/subsidies, which we have already
discussed.
What do you think would be better? Taxation or regulation? Regulation requires each
factory to reduce pollution by the same amount. It is possible that one factory can reduce
pollution at lower cost than some other factory (for example, a factory already uses better
technology so reducing pollution would be easy whereas another factory might have to
invest in new technology in order to successfully reduce pollution). If so, then the first
factory would respond to the tax by reducing pollution substantially to avoid the tax,
whereas the second factory would respond by reducing pollution less and paying the tax.
In essence, the corrective tax places a price on the right to pollute. Under regulation, the
factories have no reason to reduce emission further once they have reached the target
prescribed by the government. By contrast, the tax gives the factories an incentive to
develop cleaner technologies because a cleaner technology would reduce the amount of
tax the factory has to pay.
There is another market-based policy. We could have a market for tradable permits. The
government would put a fixed number of pollution permits in circulation. The permits
will end up in the hands of those firms that value them most highly, as judged by their
willingness to pay (the higher the cost of reducing pollution, the higher would be their
willingness to pay to obtain a pollution permit).
What do you think is better? Tax or permit? An advantage of allowing a market for
pollution permits is that the initial allocation of pollution permits among firms does not
matter from the standpoint of economic efficiency. Those firms that can reduce pollution at
a low cost will sell whatever permits they get, and the firms that can reduce pollution only
at a high cost will buy whatever permits they need. As long as there is a free market for the
pollution rights, the final allocation will be efficient regardless of the initial allocation.
Pollution permit is a better solution in the sense that the government can limit the quantity
of pollution by choosing the number of pollution permits. Moreover, to impose a
corrective tax, the size of the external cost needs to be known.

Private Solutions of Externalities

Government action is not always needed to solve the problem. In some circumstances,
people can develop private solutions.
Sometimes the problem of externalities is solved with moral codes and social sanctions,
charities and fundraisers. “Do unto others as you would have them do unto you.”
Sometimes the solution takes the form of integrating different types of businesses. Imagine
an apple producer and a honey producer are neighbours. They both impose positive
externality on each other. Bees pollinate the apple flowers and apple flowers provide
nectar to the bees. Right now, the production of either product is below the optimal level.
If they integrate, external benefits become private values and therefore equilibrium
quantity will now coincide with the socially optimal value.
Another way for the private market to deal with external effects is for the interested
parties to enter into a contract. The apple and honey producers can do this as well.
But, how effective is the private market in dealing with externalities?
According to the Coase theorem, if private parties can bargain over the allocation of
resources at no cost, then the private market will always solve the problem of externalities
and allocate resources efficiently.
To see how the Coase theorem works, consider an example. Suppose that Dick owns a dog
named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets a benefit from
owning the dog, but the dog confers a negative externality on Jane. Should Dick be forced
to send Spot to the pound, or should Jane have to suffer sleepless nights because of Spot’s
barking? Consider first what outcome is socially efficient. A social planner, considering the
two alternatives, would compare the benefit that Dick gets from the dog to the cost that
Jane bears from the barking. If the benefit exceeds the cost, it is efficient for Dick to keep
the dog and for Jane to live with the barking. Yet if the cost exceeds the benefit, then Dick
should get rid of the dog. According to the Coase theorem, the private market will reach
the efficient outcome on its own. How? Jane can simply offer to pay Dick to get rid of the
dog. Dick will accept the deal if the amount of money Jane offers is greater than the benefit
of keeping the dog. By bargaining over the price, Dick and Jane can always reach the
efficient outcome. For instance, suppose that Dick gets a $500 benefit from the dog and
Jane bears an $800 cost from the barking. In this case, Jane can offer Dick $600 to get rid of
the dog, and Dick will gladly accept. Both parties are better off than they were before, and
the efficient outcome is reached. It is possible, of course, that Jane would not be willing to
offer any price that Dick would accept. For instance, suppose that Dick gets a $1,000
benefit from the dog and Jane bears an $800 cost from the barking. In this case, Dick would
turn down any offer below $1,000, while Jane would not offer any amount above $800.
Therefore, Dick ends up keeping the dog. Given these costs and benefits, however, this
outcome is efficient. So far, we have assumed that Dick has the legal right to keep a
barking dog. In other words, we have assumed that Dick can keep Spot unless Jane pays
him enough to induce him to give up the dog voluntarily. But how different would the
outcome be if Jane had the legal right to peace and quiet? According to the Coase theorem,
the initial distribution of rights does not matter for the market’s ability to reach the
efficient outcome. For instance, suppose that Jane can legally compel Dick to get rid of the
dog. Having this right works to Jane’s advantage, but it probably will not change the
outcome. In this case, Dick can offer to pay Jane to allow him to keep the dog. If the benefit
of the dog to Dick exceeds the cost of the barking to Jane, then Dick and Jane will strike a
bargain in which Dick keeps the dog. Although Dick and Jane can reach the efficient
outcome regardless of how rights are initially distributed, the distribution of rights is not
irrelevant: It determines the distribution of economic well-being. Whether Dick has the
right to a barking dog or Jane the right to peace and quiet determines who pays whom in
the final bargain. But in either case, the two parties can bargain with each other and solve
the externality problem. Dick will end up keeping the dog only if the benefit exceeds the
cost.
The Coase theorem applies only when the interested parties have no trouble reaching and
enforcing an agreement. In the real world, however, bargaining does not always work,
even when a mutually beneficial agreement is possible.
Sometimes the interested parties fail to solve an externality problem because of transaction
costs, the costs that parties incur in the process of agreeing to and following through on a
bargain. At other times, bargaining simply breaks down. Reaching an efficient bargain is
especially difficult when the number of interested parties is large because coordinating
everyone is costly.

So far the discussion has answered our question, ‘why despite causing inefficiencies,
government imposes taxes and subsidies?’ A similar question that arises is:
Why does the government supply certain goods and services like health, education, roads?

Consider the following four kinds of goods:

1. Congested toll roads

Can I stop you from using this road? I can. ( if you don’t pay the toll)
Does my usage of this road affect your ability to use it? Yes. (it’s a congested road)

2. Uncongested non toll road

Can I stop you from using it? I can’t. (there is no toll)
Does my usage of this road affect your ability to use it? No. ( it i’s uncongested)

3. Congested non toll road

Can I stop you from using it? I can’t. (there is no toll)
Does my usage of this road affect your ability to use it? Yes. ( it is congested)

4. Uncongested toll road

Can i stop you from using it? I can. (there is a toll)
Does my usage of this road affect your ability to use it? No. ( it is uncongested)

Four types of goods

Congested toll road is a private good. It is excludable (I can prevent you from using it) and
rival in consumption (my usage of this road will reduce your ability to use it).
Uncongested non toll road is a public good. It is not excludable and not rival in
consumption.
Congested non toll road is a common resource. It is not excludable but rival in
consumption.
Uncongested toll road is a club good. It is excludable but not rival in consumption.

We examine goods that are not excludable: public goods and common resources. There is
no price tag on such goods. People cannot be prevented from using these goods, they are
available to everyone free of charge. The study of public goods and common resources is
closely related to the study of externalities. For both of these types of goods, externalities
arise because something of value has no price attached to it. If one person were to provide

a public good, such as rainwater harvesting, other people would be better off. They would
receive a benefit without paying for it—a positive externality. Similarly, when one person
uses a common resource such as the fish in the ocean, other people are worse off because
there are fewer fish to catch. They suffer a loss but are not compensated for it—a negative
externality.

Free Rider Problem

Back to our question: why are some goods provided by the government? Why is the
cleanliness of your room taken care of by Sodexo? Let’s assume a scenario where
housekeeping is absent. Assume that you have four roommates. Who’s going to keep the
room clean? Sure, the four of the roommates can try to work out an arrangement and have
each person contribute to keeping the room clean, but will this arrangement work out? If
your roommate works toward keeping the room clean, can he prevent you from enjoying
the ‘clean room’? No. Does his use of a ‘clean room’ reduce your ability to use it? No. That
is, a clean room is not excludable and not rival in consumption. It is a public good. You can
enjoy a clean room without having to clean it, if one of your roommates cleans it. If you
indulge in this kind of behaviour, you are a free rider. A free rider is a person who receives
the benefit of a good but does not pay for it. How will your roommate react to your
behaviour? He would stop cleaning the room. A clean room would have been socially
desirable but privately it might not be optimum for your roommate to clean such a big
room all by himself all the time. He does not take into the account the external benefits he
bestows on you by cleaning the room. His own private benefit is too small compared to his
private cost of cleaning. The presence of a free rider (an externality) like you has led to a
socially inefficient allocation (a market failure). Left by themselves, most people would be
leaving their rooms too dirty. Therefore, housekeeping is in place.
Consider another example. The citizens of Smalltown like seeing fireworks on New Year’s
Eve. Each of the town’s 500 residents places a $10 value on the experience for a total
benefit of $5,000. The cost of putting on a fireworks display is $1,000. Because the $5,000
benefit exceeds the $1,000 cost, it is efficient for Smalltown to have a fireworks display on
New Year’s Eve. Imagine that Ellen, a Smalltown entrepreneur, decided to put on a
fireworks display. Ellen would surely have trouble selling tickets to the event because her
potential customers would quickly figure out that they could see the fireworks even
without a ticket. Because fireworks are not excludable, people have an incentive to be free
riders. If Ellen puts on the fireworks display, she confers an external benefit on those who
see the display without paying for it. When deciding whether to put on the display,
however, Ellen does not take the external benefits into account. Even though the fireworks
display is socially desirable, it is not profitable. As a result, Ellen makes the privately
rational but socially inefficient decision not to put on the display.
The local government can sponsor a New Year’s Eve celebration. The town council can
raise everyone’s taxes by $2 and use the revenue to hire Ellen to produce the fireworks.
Everyone in Smalltown is better off by $8—the $10 at which residents value the fireworks
minus the $2 tax bill.

The Tragedy of the Commons

Consider life in a small medieval town. Many of the town’s families own flocks of
sheep and support themselves by selling the sheep’s wool, which is used to make
clothing.T he sheep spend much of their time grazing on the land surrounding
the town, called the Town Common. No family owns the land. Instead, the town
residents own the land collectively, and all the residents are allowed to graze
their sheep on it. Collective ownership works well because land is plentiful. As
long as everyone can get all the good grazing land they want, the Town Common
is not rival in consumption, and allowing residents’ sheep to graze for free causes
no problems. Everyone in the town is happy. As the years pass, the population of
the town grows, and so does the number of sheep grazing on the Town Common.
With a growing number of sheep and a fixed amount of land, the land starts to
lose its ability to replenish itself. Eventually, the land is grazed so heavily that it
becomes barren. With no grass left on the Town Common, raising sheep is
impossible, and the town’s once prosperous wool industry disappears. Many
families lose their source of livelihood. What causes the tragedy? Why do the
shepherds allow the sheep population to grow so large that it destroys the Town
Common? The reason is that social and private incentives differ. Avoiding the
destruction of the grazing land depends on the collective action of the shepherds.
If the shepherds acted together, they could reduce the sheep population to a size
that the Town Common can support. Yet no single family has an incentive to
reduce the size of its own flock because each flock represents only a small part of
the problem.

In essence, the Tragedy of the Commons arises because of an externality. When

one family’s flock grazes on the common land, it reduces the quality of the land
available for other families. Because people neglect this negative externality when
deciding how many sheep to own, the result is an excessive number of sheep.
If the tragedy had been foreseen, the town could have solved the problem in
various ways. It could have regulated the number of sheep in each family’s flock,
internalized the externality by taxing sheep, or auctioned off a limited number of
sheep-grazing permits. The town can divide the land among town families. Each
family can enclose its parcel of land with a fence and then protect it from
excessive grazing. In this way, the land becomes a private good rather than a
common resource. This outcome in fact occurred during the enclosure movement
in England in the 17th century.

The Tragedy of the Commons is a story with a general lesson: When one person
uses a common resource, he or she diminishes other people’s enjoyment of it.
Because of this negative externality, common resources tend to be used
excessively. The government can solve the problem by using regulation or taxes
to reduce consumption of the common resource or auctioning off tradable
permits. Alternatively, the government can sometimes turn the common resource
into a private good.