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CHAPTER 2
Chapter 2: EXTERNAL EFFECTS
Contents
1. Importance of externalities
2. Types of externalities
3. Consequences of externalities
4. Causes of externalities
1. Importance of externalities
Definition: Externalities arise if the activities of an actor (or a group of
actors) influence the possibilities of production or consumption of a
third party (e.g., households, producers, general public, future
generations, etc.) without this influence being incorporated into prices
via the market mechanism.
Definition:
External Effects
Externalities can be positive or negative (see fig. 2.1.). However, as far as
environmental problems are concerned, negative externalities are at the
center of attention. “Negative” means a restriction of the possibilities of
production or consumption of a third party without this restriction being
mirrored in market prices.
2. Types of Externalities
Fig. 2.1:
Types of external
effects
Abb. 2.1: Types of external effects
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EXTERNAL EFFECTS
Examples for different types of externalities:
a)
Negative externality which influences the possibilities of production for a
third party:
A steel mill dumps its pollutants into a nearby river. Thereby, the fish
population declines and a fisher further down the river experiences a
decline in production. Nevertheless, since the fisher is no monopolist, the
market price for fish remains the same.
b)
Positive externality which influences the possibilities of production for a
third party:
An apple grower and a beekeeper work on adjoining premises. Both profit
from each other’s production: The bees aim on the apple’s pollen, and the
apples get pollinated by the bees. However, neither the apple’s nor the
honey price changes.
c)
Negative externality which influences the possibilities of consumption
for a third party:
Tenant A and tenant B live in the same building. Tenant A listens
extensively to very loud music, which is not enjoyed by tenant B, i.e.,
tenant B cannot consume silence. The rent, however, remains
unchanged.
d)
Positive externality which influences the possibilities of consumption
for a third party:
Tenant A and tenant B live in the same building. Tenant A listens
extensively to very loud music, which happens to be the favorite style of
tenant B as well. Hence tenant B profits from the music collection of his
neighbor. The rent, however, remains unchanged.
3. Consequences of externalities
Allocational efficiency
The existence of externalities poses a problem to economic theory. One
objective of economic analysis is to identify the mechanisms whereby scarce
economic resources (in this case: “the environment”) are allocated to the
economic actors who would value them most. If – as in the case of
externalities – not all relevant cost and benefits are incorporated in relative
prices, the allocation of resources via the market mechanism will lead to an
inefficient outcome. This relates to the concept of allocational efficiency which
lies at the very heart of economic theory. An operational definition of
allocational efficiency (and one which is omnipresent in economics) is implied
by the concept of “Pareto Efficiency” 1:
An allocation of resources is Pareto-efficient if there exists no
possibility to make one actor better off without reducing the welfare
of another.2
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The term ‘Pareto-efficiency’ is named after the economist and sociologist Vilfredo Pareto (1848-1923).
As we will see in the following chapters, this criterion is not met in the case of externalities. Those affected
by emissions, for example, could compensate the polluting actor for reducing emissions, which would make
both parties better off.
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Definition:
Pareto-Efficiency
CHAPTER 2
An efficient allocation of a certain good implies that the (social) marginal cost
of this good are equal to its (social) marginal benefit. The existence of
externalities implies that the allocation of resources will not be Pareto-efficient,
because prices do not include all marginal social costs. Hence, the social
optimum (or Pareto-optimum) is unattainable for reasons explained in the
following paragraphs.
The problem with externalities
Firms’ and individuals’ decisions with respect to supply and demand are
depending on relative prices in the economy. The existence of externalities
distort relative prices, since prices no longer mirror the relative scarcity of the
respective goods or production factors. Hence, actors’ decisions are based on
“wrong” relative prices and are, therefore, not Pareto-optimal.
Fig. 2.2:
Individually optimal
decisions
Fig. 2.2: Individually optimal decisions
The quantities xA and yA as seen in figure 2.2 mirror the household’s optimal
consumption in point A with prices being px and py, respectively.
Let’s assume that the production of X involves some externalities, like, for
example, the emission of pollutants. If these externalities were incorporated in
the price system, the market price of X would have to rise (px’ > px). If all costs
were incorporated in prices, the household’s budget restriction would be
steeper (since the slope of the budget line is determined by the price ratio –
px/py). In this case the household’s optimal consumption would be xB, yB, i.e.
the household would now consume less of good X (xB < xA). However, while
externalities change the “true” relative scarcities of goods, this change is not
mirrored in prices, because externalities are by definition not incorporated in
market prices. Therefore, the household still chooses xA and yA, respectively.
This, however, is now no longer an optimal choice, since relative prices no
longer correctly reflect relative scarcities.
The welfare loss due to externalities:
W We take a look at the market for good 1 (or X, respectively) and we’re still
assuming the existence of externalities.
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EXTERNAL EFFECTS
Fig. 2.3:
Effects of externalities
on social welfare
Fig. 2.3: Effects of externalities on welfare
Figure 2.3 shows the supply and demand curve for X. The supply curve
corresponds to the marginal costs for the firm producing X. The demand curve
corresponds to the marginal benefit of households consuming X. The market
clears at price p2U with the quantity x2 produced and consumed.
Let’s go back to the fisher-steel-mill example. The production of X (steel)
involves external costs (for example due to river pollution). These externalities,
however, are not taken into account by the firm for its cost calculation. So at
any given quantity of X, the marginal costs for society are higher than the
marginal costs for the X-producing firm (for example the steel mill). If all
relevant marginal costs are taken into account, the social optimum is no longer
at x2 and p2U (point B), but at x1 and p1, implying a higher price and a smaller
quantity of X in equilibrium.
As long as the externality exists, however, the social optimum cannot be
reached, since p2U remains unchanged and therefore neither the supply nor
the demand side has any incentive to deviate from x2.
Comparison of the social optimum to the feasible de-facto market equilibrium:
If the feasible market equilibrium is B instead of A, a net welfare loss is
implied: There are additional costs to society in B which surpass the additional
benefit resulting from a higher level of consumption of X. These additional
costs correspond to the area X1X2CA in figure 2.3, i.e., the social costs of
producing the quantity (X2-X1) of good X. These costs are higher than the
social benefit from producing the quantity (X2-X1) of X, which corresponds to
X1X2BA. Thus, the net welfare loss equals the triangle ABC in figure 2.3.
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CHAPTER 2
An alternative presentation of externalities:
Negative externalities like environmental damages are unintended by-products
of consumption or production, respectively. The prevention of environmental
damages, however, is costly. These costs of prevention have to be compared
to the costs of pollution.
Fig. 2.4:
Alternative
presentation – optimal
level of pollution
Abb. 2.4: Alternative presentation: optimal level of pollution
The GS curve in figure 2.4 depicts the marginal damage to society due to
pollution. The underlying assumption here is that not only total pollution V, but
also the additional damage to society is rising with production. That is, for any
additional unity of good X produced, the additional pollution gets increasingly
severe.
The costs of abating an additional unity of pollution are represented by the
GKV curve in figure 2.4. It is assumed that the more pollution has already
been prevented (i.e., the smaller p), the higher the costs of abatement for an
additional unit.
At v0, no prevention takes place. Prevention costs are, therefore, zero. The
Pareto-optimal amount of prevention is marked by v1 at the intersection of the
MD and the MCA curve. This is the point where the marginal damages to
society due to pollution equal the marginal costs of pollution prevention. As
this is the first order condition for a minimization of the overall cost, v1 is an
optimum from the perspective of environmental economics.
The amount of v1 depends on the position of the GS and the GKv curve,
respectively:
- the higher the position of the GS curve (i.e., the higher the damages
suffered and perceived by society), the smaller v1
- the lower the position of the GKv curve (i.e., the lower the costs of pollution
prevention), the smaller p1
Conclusion: The socially optimal amount of pollution is not zero, but
dependent on consumptive and environmental preferences of actors.
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EXTERNAL EFFECTS
Approaches for an internalization of externalities
Internalization means to modify the actors’ decision-making framework in a
way to incorporate externalities. In other words: Any change in the possibilities
of production or consumption of a third party has to be mirrored by a change
of market prices.
Internalization can be achieved in four different ways:
1. via negotiations, i.e. through private agreements between actors
2. via government regulations targeting prices (through taxes)
3. via government regulations targeting quantities
(through environmental standards or emission rights)
4. via environmental education
(heighten the public awareness of environmental problems)
4. causes for externalities
In most cases, negative externalities are related to environmental goods which
show the characteristics of ‚public’ goods and for which no specific property
rights exist.
Public goods are defined by two criteria, namely non-rivalry and nonexclusiveness in consumption (for example, the air that we breathe,
street lighting)
Pure public goods are rare, since especially non-rivalry in consumption only
holds to a certain extent (like with, for example, air pollution).
It is a crucial point in the consideration of environmental problems that
environmental goods which fulfil the criteria of a public good can be consumed
at no cost due to their non-exclusiveness. That means that nobody consuming
a public environmental good has to make any contribution to its maintenance
(like, for example, keeping the water of lakes and rivers clean). This
phenomenon is known in economics as the free-rider problem. Free-riding
behaviour can lead to a sub-optimal outcome at the societal level: the quality
of the environment deteriorates. The reason for this outcome can be analysed
using the so-called prisoners’ dilemma (see figure 2.5).
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Definition:
Public Good
CHAPTER 2
The Prisoners’ dilemma:
Fig. 2.5:
Prisoners’ dilemma
Fig. 2.5: Prisoners’ dilemma
The prisoners’ dilemma is a classical two-persons-non-zero-sum game and an
important concept of game theory. Figure 2.5 depicts the decision-making
framework of two persons who have been arrested as suspected burglars. To
prevent any dealings between the two suspects, they have been locked in
different prison cells. Since there is no definite proof that either of the suspects
is in fact guilty, the police tries to make each prisoner confess the crime by
offering him the following deal:
• If both confess, each will be convicted to four months in prison.
• If neither confesses, each will be convicted to two months in prison.
• If only one confesses, the confessor will receive one month in prison,
whilst the non-confessor will receive a harsh punishment of five
months.
Given that framework, the rational calculation of prisoner 1 goes as follows: “If
prisoner 2 confesses, I will be better off by confessing as well (four months in
prison instead of five months). If prisoner 2 does not confess, I will still be
better off by confessing (one month in prison instead of two months. So,
regardless what prisoner 2 does, I will be always better off if I confess.” And
vice versa. The resulting equilibrium of this game (Nash equilibrium) is to be
found in square one in the pay-off matrix in figure 2.5. The social optimum,
however, lies in square four and implies non-confession by both players.
The prisoners’ dilemma and environmental economics:
The prisoners’ dilemma can be used to analyse the problem of public
environmental goods. Consider the following example: Let’s assume that the
provision of an environmental good (e.g., the improvement of water quality) is
associated with the following costs and benefits for two actors (or groups of
actors, respectively):
• If only one actor makes an effort towards the provision of the good,
only one unit of the good will be provided. This provision of one unit
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EXTERNAL EFFECTS
•
•
costs 40 and implies a benefit of 30 for each actor. However, in this
case only one actor makes a contribution, whereas both actors profit
from that contribution due to non-exclusiveness (public good). Hence,
the net benefit for actor 1 would be -40 + 30= -10, whereas the noncontributing actor 2 had a net benefit of 0 + 30 = 30.
If both actors contribute towards the good, two units will be provided at
total costs of 2*40=80 and a total benefit of 2*30=60, implying a net
benefit of -40 + 60 = 20 for each actor.
If none of the actors contributes towards the provision of the good,
there will be no resulting costs and benefits, of course.
The resulting pay-off matrix is shown in figure 2.6
user 2
participation
nonparticipation
participation
( 20 , 20 )
( -10 , 30 )
nonparticipation
( 30, -10)
(0, 0)
user 1
Fig. 2.6:
Pay-off matrix in a
public good game
Abb. 2.6: example – Pay-off matrix in a public good game
Figure 2.6 is analogous to the classical prisoners’ dilemma in figure 2.5. The
resulting Nash-equilibrium is to be found in square 4, where none of the actors
makes a contribution towards the good, whilst the Pareto optimum would be in
square 1, i.e., at the co-operative solution, where both parties contribute. But
since the environmental good is a public good and therefore non-contributing
actors cannot be excluded from its benefits, contribution is not an attractive
strategy for the rational actor. This “social dilemma” results in an underprovision of environmental goods.
Conclusion: Due to the special characteristics of most environmental goods
as public goods without any specific property rights assigned, and due to the
free-rider problem, negative externalities prevail in many areas of
environmental politics.
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CHAPTER 2
Literature
Frey, René L. Staehlin-Witt, Elke, Blöchliger, Hansjörg: Mit Ökonomie zur
Ökologie, Basel/Frankfurt am Main, Stuttgart: Helbing&Lichtenhahn, 1993, 2.
Auflage, S. 39 - 55.
Bartel, R. Allgemeine Grundlagen der Umweltpolitik, in: Bartel, R. Hackl
(Hrsg.), Einführung in die Umweltpolitik, München: Vahlen, 1994. S. 3-32.
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