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Externalities and Policy Implications in Economic Decision-Making

Learn about the impact of externalities on various sectors, explore inefficiencies, and discover strategies to address market failures through government intervention, Coase theorem, and social norms.

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Externalities and Policy Implications in Economic Decision-Making

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  1. Section B • Managerial and individual decision problems • Externalities and regulation • Applications and case studies: pollution control, health care, education, sport and exercise, transport

  2. Suggested background reading • Allen et al. 2009. Managerial Economics. Norton. Chapters 14-16 • Kreps, D. M. 2004. Microeconomics for Managers. Norton Chapters 14 & 18-19 • Frank, R. H. 2008. Microeconomics and behaviour. McGraw Hill. Chapters 6 & 17 • Wall,S., Minocha, S. and Rees, B. 2010. International Business, Pearson. Chapter 6 • Grimes, P, Register, C. and Sharp, A. 2009. Economics of Social Issues, McGraw Hill. Chapters 4, 6 and 15 • Rasmusen, E. 2007. Games and Information, Blackwell. Chapters 7-9

  3. By the end of this section you should be able to: • Explain what is meant by the economic concept of an externality • Discuss efficiency and policy implications of externalities in relation to the following: • environmental issues (e.g. pollution and congestion) • health care • education • sport and exercise. • global labour markets

  4. Reintroduction to externalities(see e.g. Allen Chapter 16; Kreps chapter 14) • Externalities are usually associated with action by a firm or consumer that affects the welfare of others; positively or negatively e.g.: • Externalities in consumption • Smoking in an enclosed area, dumping your rubbish (wrapping), driving your car/motorbike in a street with many pedestrians, listening to loud music • Externalities in production • A firm polluting the air - affects health and environment • A firm polluting a river or lake – affects other firms and consumers of water • A beekeeper benefitting from nearby orchard – an orchard owner benefitting from the beekeeper’s bees

  5. Other types of externalities • Open access goods/services (the tragedy of the commons) • ocean fisheries- leads to over fishing, • wild animals - extinction • rain forests –over harvesting • Congestion externalities • e.g. driving at certain hours adds to the time others take to travel • Roads = open access facility

  6. More types of externalities • Public goods: non-excludable goods • non-rival, consumption by one person doesn’t affect the consumption of others • Non-excludable – no restrictions on access • e.g. national defence, clean air, polite behaviour • Network externalities e.g.: • Communications networks - the more users that join a communications network the better for the existing users/suppliers • benefits from being able to contact more users, economies of scale, • Locational (cluster) networks: IT firms locating together • Standards externalities • The more firms that use the same way of producing or servicing something (the standard) increases the market size for products built/serviced to this standard • E.g. use of a particular technology

  7. Inefficiency and externalities • When firms or consumers generate externalities, the free market outcome may not be efficient • It doesn’t maximise total surplus • Efficiency usually requires that: • Marginal consumer benefit (for all consumers) = marginal cost of production (for all firms) • This will be achieved in a competitive market equilibrium since consumer benefit is all private and production costs are all private • The free market outcome ensures that marginal private benefit (consumers) = marginal private cost (firms)

  8. Inefficiency and externalities • When there are externalities the free market outcome is not efficient as private benefits/costs are not equal to social benefits/costs • When there are consumption externalities, marginal private consumer benefit is not the same as marginal social (total) benefit • When there are production externalities firm’s private marginal costs of production are not the same as the marginal social (total) costs of production • The free market outcome doesn’t equate marginal social benefits and marginal social costs • Implies market failures - suggests a role for 3rd party (e.g. government) intervention

  9. Ways of dealing with externalities • Governments intervention and regulation e.g. supply of public goods, taxes/subsidies on externalities, standards • Establishing property rights and bargaining; the Coase theorem • e.g. establishing rights to clean water and air –not easy • Social norms: confirming to or internalisation of social pressures e.g. not dropping rubbish • Collective action through pressure groups

  10. Applications • Consumption externalities • Health and education, transport (roads) • Mix of production and consumption externalities • Sport and exercise, sports sector • Production externalities • Pollution

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