G401 September 24, 1998 Professor Rasmusen NOTES ON EXTERNALITIES One reason for market failure is Externalities. Markets are efficient because people will engage in voluntary transactions if and only if the transaction will benefit both sides. The outcome is practically the same as our definition of Pareto Optimality-- if people make *all* those transactions, there is no way to make everybody better off by forcing an additional trade. A government restriction on trade will generally be inefficient, because it blocks two people from making a trade that would help both of them. That is the problem with price controls-- it prohibits mutually beneficial trades. Anything that breaks up the logic of the first paragraph creates market failure. If people have poor information, they might not know that a transaction hurt one or both of them, for example, or they might not know that a transaction would help them both. Externalities break up the logic of the first paragraph. An Externality, or Spillover, is an effect of an action on a third party who is not directly involved in an activity. If Smith makes tires for $30 each to sell to Jones at $40, and Jones values the tires at $55, then efficiency seems to require that Smith make a tire and sell it to Jones, for a total surplus of $25 ($10 for Smith and $15 for Jones). But suppose that when Smith makes tires, Johnson, his neighbor, suffers a loss of $35 from the air pollution that results. Then, the true social surplus is -$10, and the transaction ought not to occur. The problem is that Smith and Jones don't take Johnson into their calculations. That is a Real Negative Externality. A NEGATIVE externality is one which hurts the third party. A POSITIVE externality is one which helps the third party. If Smith smokes a pipe in class, that creates a negative externality for people in the class who hate smoke. That creates a positive externality for people who like the smell of pipe smoke. Positive externalities gives rise to inefficiency too. Suppose that Smith would get revenue of $10,000 per year from operating a tree farm next to Jones's house, and Jones would get a benefit of $2,000 per year from having such a pleasant neighbor, but Smith's cost for the farm would be $10,500 per year. Smith would go out of business, an inefficient outcome. A REAL externality is one which has a direct effect on the third party. A PECUNIARY externality is one which has an effect only via prices. So far these notes have discussed Real externalities. But suppose that Smith bids $500 for a chair in an auction, topping Jones's bid of $450. Jones now must bid $501 to get the chair, so Jones is hurt by Smith's action. It is not a direct hurt, but only because the price of the chair has gone up. So it is a negative pecuniary externality. Jones feels just as bad as if Smith had delivered a $51 blow to his face, but this kind of externality does *not* create inefficiency. That is because when prices change, there are winners as well as losers. When Smith bids up the price, the seller wins, even though Jones loses. When there are real externalities, either positive or negative, there is justification for government regulation. This is the standard justification for pollution regulation and for zoning laws. We still must, of course, be careful of government failure. Just because the market is flawed does not mean the government is capable of fixing it, or that the government cannot be manipulated by unscrupulous people.