Externalities refer to external effects that are not accounted for by buyers or sellers. It therefore means that, consumer may be paying be failing to pay for some benefit derived from a good or service; marginal external benefit (MEB) or in case of producers they may fail to account for some cost that they cause to the society; marginal external cost (MEC).
A positive externality refers to a situation where the society benefits from services or good produced in a way that the producers do not profit fully from benefits derived. In such cases, these goods end up being under produced as guided by the law of demand and supply. On the other hand, a negative externality arise when producer cause some damage to the society in their production but do not account for the cost of the damage.
- Economies of scale; when one firm expands it lead to development of such things as infrastructure, disposal systems that may benefit other firms without having to pay for them.
- Education; when an individual gets educated and is able to make innovation, the society benefits from that without having to pay for it.
- Health programs; when health program such as immunization are conducted, disases do not spread and hence the rest of the society is protected from infection and hence a positive externality.
- Pollution by firms; society is negatively affected by pollution of the environment by firms and yet the firms do not compensate them for that.
- Smoking by people; when smoking, smokers pollute the environment which causes some external cost through diseases such as lung cancers and yet the smokers do not account for such costs.
- Another external cost may be the cost of cleaning the environment from dropped litter by people.
Where SMC- Social marginal cost
PMC- Private marginal cost
MEC – Marginal external cost
SMB- Social marginal benefit
Assuming two firms X (fishery) and Y (steel),
Let’s assume that firm Y pollutes the river and therefore causes some external cost to the Fishery firm.
Firm Y’s problem when not accounting for the externality
Where PS- total revenue from steel
Cs- cost as a function of steel
When forced to account for externality the profit function becomes
Π= Ps-Cs- q(S)
Where q(s) – cost of externality as a function of producing steel
Getting the first order condition with respect to S we note that:
From the first profit equation
MC(s) = P
i.e. private marginal cost= social marginal benefit
From the second profit equation
MC(s) = P + q’(s)
Private marginal cost + marginal external coat= social marginal benefit
The above equations are represented by the graph above. That, a firm tends to over produce a good when it does not account for externality, quantity q1 at price p1, but when forced to internalize e.g. Through a Piggovian tax, they reduce production e.g. to q2 at price p2.
Assuming two firms, firm X and Y, where X produces some positive externality enjoyed by Y but Y do not pay for it.
Firm X’s maximization problem is
f.o.c with respect to S,
When it gets compensated for the positive externalities then
This represents a case when social marginal cost equals private marginal benefit.
Π= PS-Cs + q(s)
F.O.C with respect to S
P+ q’(s) = MCs
This represents a case where social marginal cost equals private marginal benefit plus marginal external benefit (social marginal benefit).
In the above case, as also demonstrated by the graph, when the producer is not compensated for the marginal external benefit, he tends to under produce. An incentive such as subsidy that compensates him for the external benefit makes him increase production to the socially optimal level, q2 for p2 from q1 for p1.
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As much as private investor’s interest is to maximize returns is to achieve a well set predetermine goal such as profit, sales and capital gains for the investors through positive publicity, firms are becoming more sensitive on social implications of their operations. The executive of broadcasting company notes that, notes that there is need to curb violence in the society.
The violence content in his network produces negative externality, by instilling violent traits to children who grow without it conscious against violence. The society that is violent is a society that cannot sustain or be able to engage or exploit the development potentials. This is because; there is a social threat of co-existence among people.
The spillover effect is that, the broadcasting company would be operating at a detriment of its own future. This is because, either there would be no much competition that may require commercials as witnessed in highly competitive markets. At the same time, assurance for security to any person, by itself, improves social welfare. For these reasons, an executive in a broadcasting company may recommend to authority to come up with policy to regulate amount of violent contents that are optimal.
There many reason why a firm may advertise such as, to create awareness of the quality of the existence and quality of the product among other features, the location of the product while other advertising are merely to persuade the customers into buying the products. Ideally the extent to which a firm advertises depends on competition. An oligopolistic market for example, which competes on non-price strategies, may engage in heavy advertisements to get and safeguard its market share.
For the case of Verizon Wireless, AT&T, T-Mobiles and Sprint which together provide over 90% of cell phone services in the US wireless voice & data market may find competition inevitable based on the high market concentration ratio. It’s reasonable to say that each of these firms have a substantial market power. Given their market share, the marginal benefit from advertisement is low and hence there would be mutual benefit if the firms agree to lower their advertisement costs. Therefore a policy that lowers advertisement cost may see the firm realize more profit without the fear of market loss.
The same case will be for Budweiser (now owned by a Belgium based beer company called InBev), Miller and Coors because of the concentration ratio of the market there is no threat of loss of the market to each other if they all reduce their advertisement expenditure. This is because they produce 85% of all beer consumed in the US and hence like any oligopolistic market, there would be mutual benefit in case of a policy that require advertisement cost be limited to $1 million as opposed to the current $250 million.
a.) A competitive market is said to have efficient allocation of resources because, the feature of the market such information symmetry and good being homogeneous, free entry and exit make firms to only make normal profits in long run. Here the prices and quantities supplied are determined by the market forces of supply and demand. In this sense, the market are said to be efficient. In this case, firms operate up to a point where price is equal to marginal cost, and this is a Pareto efficient condition.
b.) However, for the case of fishermen and the annul vessels of fish, it raises the problem of overexploitation if they are unregulated. This by itself is ann externality when compared with the availability of fish for the future generation. Fishermen will operate to point where profit is equals to zero.
Algebraically, the problem may be represented as follows
P=Cs/F= marginal product of fishing
Compare a social optimal condition, operates where marginal product is equal to price but in case they are regulated they can be allowed to operate efficiently where price is equal marginal cost.
Due to overexploitation due to lack of regulation, fishermen overexploit the resources but if there was regulation they can be forced to fish only F1 as opposed to F2.
- When tradable permits are issued, the markets forces operate to determine how these permits are distributed. This may be Pareto improving compared to a situation when the government requires that each farm to reduce use of pesticides by 40%
- By giving permits, there is some incentives for the farmers to invest in abatement of pollution.
- Use of permit will provide allowances for farm development. For instance, new farmers can be able to buy permits from existing farmers.
- New farmers and the old one are forced to adopt efficient use of pesticides.
- Use of permit raises some revenue for the government which can help to purify the water from underground water sources.
- The market for permit may fail to be perfectly competitive hence big farms may exert undue influence to small ones.
- There may not exist a well developed market for the permits to be traded.
- The cost of administration, monitoring and enforcement may be extremely high.
P= 50-05Q where Q=q1 + q2
Π1= (50-0.5q1- 0.5q2) q1
50- q1- 0.5q2=0
Q1= 50- 0.5q2
Similarly, for the other firm
Q2= 50- 0.5q1
Solving the two equation simultaneously
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The price is obtained by substituting in the demand function
P= 50 – 0.5(33.3 + 33.3)
The joint profit is given by
Π= (50-0.5Q) Q
50- Q= 0
We substitute in the demand function to get the price
P= 50- 0.5(25+25)
Apart from oligopolistic market changing their price as a reaction to change by another firm, they may also change their prices simultaneously. This is an asymmetric strategy. In such a case, all the firms in the market are exposed to the same environment such as in our case where the good product offered are homogeneous. They therefore base their decisions on same factors and it happens that there is no firm in the information set. Hence they change their prices simultaneously.