Overview: Externalities • Effects of Production/Consumption Not Reflected in Market Transactions. • Tragedy of the Commons Markets without Externalities Pchem Pmilk S D Qchem S D Qmilk 1 Markets with Externalities S = f(cost, soot) Pchem S Pmilk D Qchem S D Qmilk Property Rights and Contracts • Impact of clear property rights and ability to contract (Coase Theorem) (1) If the farm has a right to clean air? (2) If the chemical plant has a right to dispose in the air? • More difficult with high transactions costs 2 Solving the Difficult Cases • Government intervention – Emissions constraint – Effluent taxes – Tradable permit • Tort law 3 Recall “Tragedy of the Commons” • Externality: Individual or firm sees the marginal (private) effect of actions, not the overall effect on the community as whole • Private cost/benefit ≠ Community cost/benefit • Addressed via joint ventures (cooperation), taxes, property rights, tradable permits Common Property Resources: Oil Example (Lecture 15) • Issue: Drill more wells, pressure drops for all wells • Unfettered development drives individual profits to zero 900 wells, 100 barrels/well, Πi = $0, 90,000 total barrels from field • Joint venture maximizes field profits 450 wells, 550 barrels/well, Πi = $3.04 m, 247,500 total barrels from field 4 Common Resource Management 15,000 Value per well $ per well MC 1500 450 900 Number of wells MR to the community The “Commons”: Practice • How do you see this problem being dealt with – – – – – In oil fields? In fishing? Highways? Air traffic? Other examples? 5 Take Away Points • Externalities are effects of production or consumption that are not reflected in prices. • Externalities create distortions. • Government intervention and mergers or acquisitions are important ways to deal with externalities. 6