Externalities and Public Goods From free-riding to the Coase theorem.

Externalities and Public Goods

From free-riding to the Coase theorem


Up until now we have made several implicit assumptions when analysing “agents”

1.Agents are independent : their welfare depends only on their own consumption / production decisions But maybe people’s satisfaction/welfare

depends indirectly on what other people decide? Does this influence the market outcome? How? How can these effects be taken into account?


2. The characteristics of goods are “well behaved” Goods and services are always clearly defined,

dividable into measurable units and exchangeable on a specified market

But what about goods or services that can’t be divided, valued (priced), or exchanged on a market?

What does economics have to say about these kinds of goods?


Public goods and free riding

Externalities and inefficiency

The Coase theorem


Goods can be classified according to two fundamental, intrinsic properties :

Rivalry : Two agents cannot simultaneously benefit from the consumption of a given unit of a good

Exclusion (through price): an agent can only dispose of a given unit of a good once he has paid its price. This concept is closely linked to the existence of property rights.


Typology of goods

Exclusion Possible?

Yes No

Rival?

Yes

Private Good

Car, medical drugs

Impure Public goodCongested road

14th July Fireworks

NoClub Good

Pay per view TV, Patents

Public GoodPublic lights

Defence


A “pure” public good satisfies three conditions:

1. Impossibility of exclusion (possibility of freeriding)

One cannot restrict the use of the good to specific agents (i.e. To those who pay)

Examples:

Public lighting? Defence? Fireworks display? Motorway? Lighthouse? Rule of Law?



2. Non-congestion (Non-rivalry)

The satisfaction obtained from the good does not depend on the number of users

Examples:




3. Compulsory consumption

The agent cannot decide not to consume the good (has no choice in the matter)

Examples:



As a result, for public goods, the coordination of agents cannot happen on the market Everybody is a consumer whether they want it

or not. A supplier of the public good cannot exclude

people who refuse to pay the good (free riders) This supplier has not way of recuperating his

costs There is a market failure on public goods:

they will not be provided on a free market


The central aspect of this was shown by Ronald CoaseFree-riding and externalities occur when

property rights are either: Not defined: who owns light of a lighthouse

or the security provided by a police force? Not enforceable: there is a lack of

institutions to enforce the property rights (example: “free” internet downloads)

As a result, there is no market to extract compensation from freeriders




The Coase theorem


An externality is a possible cause of market failures. It corresponds to the direct (non-market) impact of

an agents decision on another agent’s welfare

External economies, external effects, externalities In production (the bees and orchard example) In consumption (internet or telephone)

This impact can be negative or positive Negative : leads to over-investment Positive : leads to under-investment


Definition of a negative externality The Marginal social cost (msC) is larger that the

marginal private cost (mpC)

msC > mpC

In other words, I do not bear all the costs of my production/consumption decisions, Some costs “leak” out and are borne by other

agents


q

p*

msC

mpC

q* q1

Marginal external cost

The polluter pays principle internalises the externality by making the polluter carry the negative externality

C


Example of negative production externalities The effect of oil spills on local fishermen My neighbour's trees shading my garden from

the sun

Examples of negative consumption externalities Smokers in restaurants Neighbours playing techno very loudly at 3am!


What policies can be used to remove the inefficiency ? Regulation (emission standards, smoking bans) Taxation (problem: what is the optimal level of

taxes what is the size of the externality?)

Importantly, in terms of policy there is an optimal level of pollution !! It is not socially desirable to reduce it to zero.


Definition of a positive externality The Marginal social benefit (msB) is larger that

the marginal private benefit (mpB)

msB > mpB

In other words, I do not reap all the benefits of my production/consumption decisions, some benefits “leak” out and benefit other

agents


q

p*

msB

mpB

B

q1 q*

Example : intellectual property rights attempt to increase the marginal private benefit by capturing the externality

Marginal external benefit


Example of positive production externalitiesThe classical bees/orchard exampleTechnological innovations (spillovers)

Examples of positive consumption externalitiesNetwork goods (internet, telephone)HomeownershipEducationVaccination


What policies can be used to remove the inefficiency ? Subsidies (tax deductions on mortgages, public

network infrastructure investment) Intellectual property rights (IPR) Regulations

As for the optimal level of pollution, there is an optimal level of intellectual protection! It is not socially desirable to reduce IPR to zero




The Coase theorem

The Coase theorem

Named after Ronald Coase (Nobel 1991)

No state intervention is required to correct externalities if: There are defined property rights (remember

what was said above) There are no transaction costs between agents

In this ideal case, all the state has to do is define some property rights, and the market will internalise the externality

The Coase theorem

Coase’s initial work: Radio stations

Initially, no frequency bands are defined: radio stations can interfere Negative production externality

The state needs to create frequency bands enforceable property rights

Interactions between agents produce : The allocation of these bands between the various

radio stations The compensation of externalities is carried out by

transactions between stations

The Coase theorem

In real life, however, transaction costs existAsymmetric/imperfect information about the

externality Proving the existence of an externality can take a

lot of time and effort (see Erin Brockovich vs Pacific Gas),

Asymmetric relations between agents Imagine a litigation between a big chemical

consortium and a local association on pollution. What is the likelihood of the association making its

case with no external help ?

The Coase theorem

In that case, a 2nd role appears for the state: Reduce transactions costs between agents

Encourage the creation of consumers rights associations (increase coordination between agents)

Create environmental watchdogs with a monitoring mission (reduces the information asymmetries)

Reinforce legal / mediation /dispute resolution institutions (reduces the transaction costs)

The Coase theorem

This decentralised approach to reducing externalities is becoming increasingly popular

In theory it is cheaper: Taxes on pollution do provide an income, but monitoring costs are usually higher

In theory it is also more efficient: The state doesn’t need to figure out what the size of the externality is, which is a problem with taxation or regulation

Recent example: the market for Carbon dioxide

Externalities and Public Goods From free-riding to the Coase theorem.

Documents

Transcript of Externalities and Public Goods From free-riding to the Coase theorem.