6.

Externalities and Public Goods

1

Externalities

In the presence of an externality, the Walrasian equilibrium allocation fails to

be Pareto optimal. This is an example of market failure, a situation in which
some of the assumptions of the welfare theorems or of perfectly competitive
markets do not hold and in which market equilibria do not necessarily yield
Pareto optimal outcomes. Consumption externalities arise when an agents
consumption affects other agents utility. Production externalities are effects of
a firms production on other firms production frontiers.
For instance, in a case with two agents, two goods, and externalities in the
consumption of good x, the presence of (negative) externalities shows in the fact
2 u1
that u
x1 , x2 < 0. Recall that Pareto optimal allocations maximize a weighted
average of the utility of the two agents. Thus , these Pareto optimal allocations
are characterized by:
maxu1 (x1 , (
x x1 ), y1 ) + (1 )u2 ((
x x1 ), x1 , (
y y1 )),
xi ,yi

whose FOCs, at an interior solution are:

h
i
h
u2
u1
1
u
x1 x2 + (1 ) x1

u2
x2

=0

u2
1
u
y1 (1 ) y2 = 0

By rearranging the conditions, we obtain the following:

u1
x1
u1
y1

u1
x2
u1
y1

u2
x2
u2
y2

u2
x1
u2
y2

However, at a market equilibrium, the condition that defines the equilibrium

allocation is
u1
x1
u1
y1

px
=
py

u2
x2
u2
y2

and thus, the Walrasian equilibrium allocation is not Pareto efficient, since at a
Walrasian equilibrium, M RSs are equated across agents, which does not happen
at a Pareto optimal allocation due to the externalities.
Externalities arise because there are missing markets. If there were two extra
goods, namely, the right to bother agent 1 and the right to bother agent 2,
and well-functioning markets for them, with prices p1 and p2 respectively, then
we would have a market equilibrium in which agent 1 would
max u1 (x1 , x2 , y1 )

x1 ,y1 ,x2

s.t. px x1 + py y1 + p2 x1 px x1 + py y1 + p1 x2
1

whose FOCs are

u1
x1

= 1 (px + p2 )
u1
y1 = 1 py
u1
x2 = 1 p1

On the other hand, agent 2 would

max u2 (x2 , x1 , y2 )

x2 ,y2 ,x1

s.t. px x2 + py y2 + p2 x1 px x2 + py y2 + p2 x1
whose FOCs are

u2
x2

= 2 (px + p1 )
u2
y2 = 2 py
u2
x1 = 2 p2

Now, combining both agents conditions, we obtain

and

u1
x1
u1
y1

px + p2
, p1 = py
py

u1
x2
u1
y1

u2
x2
u2
y2

px + p1
, p2 = py
py

u2
x1
u2
y2

which yield:
u1
x1
u1
y1

u2
x1
u2
y2

u1
x2
u1
y1

u2
x2
u2
y2

which turns out to be the same condition that characterized Pareto optimal
allocations.
If property rights are well defined, then the outcome is Pareto efficient.
Suppose we have two persons in one room. Person A likes to smoke, but person
B doesnt. Both consumers must consume the same amount of smoke. Then, if
there are two goods, consumption of the composite good and smoke, property
rights determine who owns the initial endowments. For instance, if both agents
start with 100 units of consumption of the composite good, and A has the right
to pollute, the initial endowment is one point. However, if B has the right to
breath clean air, the initial endowment is another point instead. In any case, if
the parties can bargain, the solution is Pareto efficient. Notice that both agents
are constrained to consuming the same amount of smoke.
Regarding the case of a production externality, suppose that we have two
firms. Firm 1 produces x, that imposes a cost e(x) on firm 2. This firm produces
some output, but we ignore that for simplicity. Then,

maxpx c(x)

e(x)

and the first-order condition of firm 1s problem is p = c0 (x), i.e. firm 1

equalizes private marginal revenue to private marginal cost.
The efficient amount of output comes from explictly considering the externality:
= maxpx c(x) e(x)
x

whose first-order condition is

p = c0 (xe ) + e0 (xe )
price now equals social marginal cost.
One way to internalize the externality is to introduce a Pigouvian tax: t =
e0 (xe ), inducing the firm to choose x = xe . Another way is to introduce markets
for the missing goods: right to impose a negative externality or right not to
suffer the externality.

1.1

The Coase Theorem

If property rights are not well defined, we are at a Pareto inefficient situation.
As long as property rights are well defined, trade between agents results in
an efficient allocation of the externality. Generally speaking, the amount of
the externality in the efficient solution depends on the assignment of property
rights. However, if preferences are quasilinear, then the efficient amount of the
good involved in the externality is independent of the distribution of property
rights since quasilinear preferences exhibit no wealth effects.

Public goods

Public goods are nonrival and nonexclusive. In this case, consumption of these
goods involves a multilateral externality, affecting everybody in the economy.
In order to determine the efficient provision of public goods, denoted by x,
suppose that a central planner solves
max u1 (x, y1 ) + (1 )u2 (x, y2 )

x,y1 ,y2

s.t. T (x, y1 + y2 ) = 0
where the constraint is the economys production possibilities frontier. Thus,
the FOCs of this problem are:
u2
T
1
u
x + (1 ) x = x
u1

u2

y1
y2
u2
T
1
u
y1 = y = (1 ) y2 = T = (1 ) T

Therefore,
u1
x
u1
y1

u2
x
u2
y2

T
x
T
y

= M RT

P
Also, i M RSi = M RT, which is known as Samuelsons condition. This
is different from the market equilibrium condition. Graphically, the efficient
provision of a public good is determined by the intersection of the marginal cost
curve and the vertical summation of individual demand curves.
The problem with public goods is that individuals have an incentive to take
everybody elses purchases as given and enjoy them without paying at all. This
is the free-rider problem which usually causes an underprovision of the public
good using a market mechanism. Indeed, in some cases, the provision could be
zero, if no agent finds it optimal to contribute to the public good, conditional
on the rest of the agents not contributing.
A theoretical solution to this problem is to make use of Lindahl prices, i.e., to
charge each consumer a personalized price per unit of the public good. However,
we are assuming here that consumers can be excluded from consumption of the
public good.
Each consumer i solves
maxui (G, xi )
G,xi

s.t. xi + pi G wi
thus yielding
ui
ui
= pi
pi = M RSi .
G
xi
Now, the provider of the public good would charge pi to each consumer. If
the cost of producing the public good is c(G), then the firm
X
X
pi = c0 (G)
max pi G c(G)
G

thus the firm chooses

the level of provision of the public good which is efficient,
P
i.e. such that i M RSi = M RT. We can also interpret these prices, known as
Lindahl prices, as tax rates. If G units of the public good are provided, then
agent i must pay a tax pi G. Of course, in order for this to work, we must assume
that the firm is able to exclude consumers from consumption of the good and
that consumer honestly reveal their valuation of the public good.