Market with an externality

Imagine a perfect market for (homogenous) oil

I Rank potential buyers willingness to pay for oil p1 > .. > pn
I Rank potential sellers reserve prices c1 < .. < cm (oil from
Saudi Arabia is cheaper to extract than Canadian oil).
I Imagine a remote island that is going to suffer from climate
change. The gvnmt of the remote island would be willing to
pay d in order to avoid each unit of oil.
I The competitive market would exactly lead to k sellers sell
their oil, k being defined by: pk Ø ck and pk+1 < ck+1 .
I Could we find a way, starting from the competitive
equilibrium, to make everyone better off ?
I What about the remote island ?
Market with an externality

I We can define the “right” amount of pollution such that the

k Õ sellers with the cheapest oil sell their oil, k Õ being defined
by: pk Õ Ø ck Õ + d and pk Õ +1 < ck Õ +1 + d.
I This new situation is Pareto efficient: starting from this
situation, it is not possible improve the welfare of one of the
agents without deteriorating the welfare of another (even
with transfers).
I It is straightforward that k Õ < k
Is it fair that the remote island pays for pollution
reduction ?

Is it fair that the remote island pays for pollution reduction ?

Imagine instead that nobody is allowed to pollute without the
authorization of the remote island. What is the right amount of
pollution ?
I The gvnmt of the remote island would be willing to accept
pollution is it gets a compensation of d̃ for each unit of
pollution.
I What is the number of trades that maximize the total gain ?
I The k̃ Õ sellers with the cheapest oil sell their oil, k̃ Õ being
defined by: pk̃ Õ Ø ck̃ Õ + d̃ and pk̃ Õ +1 Ø ck̃ Õ +1 + d̃
Coase theorem

If (1) property rights are complete (so here someone owns clean
air) and (2) parties can renegotiate costlessly, then the parties
will always negotiate an efficient solution to the externality. If, in
addition there is no income effect, the level of the externality is
invariant to the assignment of private property rights.
I If d̃ = d the two solutions yield to the same “right” amount
of pollution (but different sharing rule for the gains) !
I What are the right property rights of the environment?
I If there are future generations involved, how do design
transfers (and know WTP)?
Property rights ?

I Let’s move to a continuous world, p(Q) inverse demand,

c Õ (Q) marginal cost of production
I Call u the utility of the remote island. u depends on both
the wealth and the number of barrels sold u(w, Q).
I The island does not own the clean air, but to reduce oil by
dQ, the island would be ready to spend dD, defined as:

u(w ≠ dD, Q ≠ dQ) = u(w, Q)

uQ
dD = ≠ dQ
uw
Property rights ?

I To reduce oil by dQ, the island would be ready to spend dD,

defined as:

u(w ≠ dD, Q ≠ dQ) = u(w, Q)

uQ
dD = ≠ dQ
uw
dD
I The higher Q, the higher the WTP to decrease pollution dQ
(convex damages)
I Assumption: no income effect: uw = Cste, the WTP does
not depend on income.
I D Õ (Q) is the marginal willingness to pay to reduce pollution.
Property rights ?

I Starting from the competitive equilibrium Q c ,

p(Q c ) ≠ c Õ (Q c ) ≠ D Õ (Q c ) < 0

I As long as p(Q) ≠ c Õ (Q) ≠ D Õ (Q) < 0, the island can

compensate the seller and buyer to reduce pollution
I The island pays up to
⁄ Qc
D Õ (Q)dQ
Qú

where
p(Q ú ) ≠ c Õ (Q ú ) ≠ D Õ (Q ú ) = 0
I This situation (Q = Q ú ) is Pareto efficient
Property rights ?
I Starting from no trade, and nobody is allowed to pollute
without the authorization of the remote island.
I How much would the remote island accept to be paid in
order to authorize trade of one extra unit of oil?
I The island is ready to accept an increase oil by dQ, if it is
compensated:
u(w + dD, Q + dQ)
uQ
dD = ≠ dQ
uw
I Assumption: no income effect
I As long as p(Q) ≠ c Õ (Q) ≠ D Õ (Q) > 0, the island can be
compensated by the seller and buyer of oil to increase
pollution. s ú
I The island receives 0Q D Õ (Q)dQ to reduce pollution, with
p(Q ú ) ≠ c Õ (Q ú ) ≠ D Õ (Q ú ) = 0
I The amount of pollution is the same, but the surplus share
I We made the assumption of “no income effect”
I If the compensation spent or received by the island is small
compared to w, assuming constant marginal utility of
income is ok.
I The difference between the marginal WTP and the marginal
WTA a compensation of an agent is not large
A remedy ?

I We found a way to make a Pareto improvment with side

transfers
I Not feasible in a decentralized way
I If we agree on the property rights (money, environment), it
seems the solution gives us a “right” amount of pollution
and transfers.
I But what are the "right" property rights ?
Why could we think that this is not the “right” amount
of pollution ?

I In general, the WTP (and WTA a compensation) of an

agent to decrease pollution depends on its income level
I If the remote island is very poor while Donald (highest price
buyer) is very rich, the final outcome will not be the same as
if Donald is poor and the island is rich to begin with.
I The surplus is maximized, for a given allocation of oil,
money (and right to pollute) to begin with.
I We might perfer another allocation... which would give
another Pareto efficient amount of pollution
I Other social choices mechanism ?
Social Welfare Function

I Definition: Assume there are N people, each with utility

function ui (a). Let W (u1 , ..., uN ) be a function that
associates a single number with every distribution of utilities
in society.
I If, when comparing any two consumption bundles a and b,
W [u1 (a), ..., uN (a)] > W [u1 (b), ..., uN (b)] is equivalent to a
being socially preferred to b, then W is a Social Welfare
Function.
I Problems: In order to aggregate across individual utilities,
the individual utilities, not consumption bundles, must be
measured, it is a very difficult task.
Social Welfare Function
Some formal examples of Social Welfare Functions:
I Benthamite Utilitarianism:
ÿ
W (u1 , ..., uN ) = –i ui
i

where –i is the weight of i (the weights can, for example, be

equal across individuals, or be proportional to income)
I Egalitarian:
ÿ ÿ
W (u1 , ..., uN ) = ui ≠ ⁄ (ui ≠ min(ui ))
i
i i

Here, we care about both total utility and inequality (⁄

indicates the relative weight placed on equality)
I Rawlsian:
W (u1 , ..., uN ) = min(ui )
i
Criticism of the Utilitarian Perspective:

Whose utility functions should be included as arguments in W

(for example, future generations) ?
I Paternalism: What if people’s “revealed preferences” are not
their ‘hedonic preferences?”
I How to compare utility levels ?
I Economics likes to think of utility functions as immutable.
If they aren’t (for example, suppose education changes an
individual’s preferences about the environment), which
utility function should we use?
Voting

Potential problems with voting:

I Does not account for the intensity of preferences (no
compensation possible).
I Poorly informed voters?
Impossibility of Perfect Choice Mechanism: Arrow’s
Impossibility Theorem

I Is there a general way of aggregating individual ranked

preferences into a reasonable social preference ordering?
I Important: Ordinal, not cardinal, preferences
I Kenneth Arrow argued that any “reasonable” mechanism
should satisfy 6 basic axioms, and then proved that no such
mechanism exists.
Arrow’s Impossibility Theorem:
Axioms
I A1. Completeness: we can compare all social alternatives.
I A2. Unanimity: If everyone prefers a to b, then society
prefers a to b.
I A3. Non-dictatorship: the mechanism does not mirror any
single person’s preferences without consideration of the
other voters.
I A4. Transitivity: If a is socially preferred to b and b is
socially preferred to c, then a is socially preferred to c.
I A5. Independence of Irrelevant Alternatives (IIA): Society’s
choice between a and b should depend only on how
individuals rank a and b (and on no other information)
I A6. Universality: Any individual ranking over alternatives is
permissible.
Arrow’s Impossibility Theorem:

Theorem: There does not exist a Social choice Mechanism such

that A1-A6 are satisfied.
Jean Tirole (2016): Nous avons tous des réticences morales ou
éthiques à l’existence de certains marchés ou certaines formes
d’incitations. Nous pouvons citer le don d’organes, les mères
porteuses, la prostitution (...). Pourquoi en est-il ainsi? (...)
Gary Becker (...) remarquait que l’interdiction de vendre son
rein limitait les donations, (...) condamnant chaque année des
milliers de personnes (...) à mourir faute de donneurs. (...)
[N]ous éprouvons tous une gêne, vis à vis des marchés de dons
d’organes. Mais au vu des enjeux considérables, il conviendrait
de comprendre pourquoi. Est-ce parce que nous craignons que les
donneurs ne soient pas suffisamment informés des conséquences
de leur acte? (...) Ou bien est-ce parce que la vente d’organes, en
dévoilant que des individus sont prêts à vendre leur rein
pour quelques centaines d’euros, nous révélerait des
inégalités que nous voudrions bien oublier? Ou encore parce que
l’on veut protéger les gens contre leur préférence trop forte pour
le présent (...)?
Jean Tirole (2016): We all have moral or ethical reservations
about the existence of certain markets or certain forms of
incentives. We can mention organ donation, surrogacy,
prostitution (...). Why is this so? (...) Gary Becker (...) noted
that the ban on selling one’s kidney limited donations, (...)
condemning each year thousands of people (...) to die for lack of
donors. (...) We all feel uncomfortable with the organ markets.
But given the considerable stakes, it should be understood why.
Is it because we are concerned that donors are not sufficiently
informed about the consequences of their act? (...) Or is it
because the sale of organs, by revealing that individuals are
willing to sell their kidney for a few hundred euros,
would reveal inequalities that we would like to forget? Or
because we want to protect people against their preference too
strong for the present (...)?
Conclusions:
I Economics can admit a wide array of individual preferences
I Outcome depends on both individual preferences and social
choice mechanism.
I There is no perfect voting mechanism
Environmental Economics
Lecture 2

Fanny Henriet

September 27, 2019

Public Goods: a special case of an externality

I Excludability. A good is excludable if it is feasible and

practical to selectively allow consumers to consume the
good. A bad is excludable if it is feasible and practical to
selectively allow consumers to avoid consumption of the bad.
Examples of non excludable good: fishery
I Rivalry. A bad (good) is rival if one person’s consumption
of a unit of the bad (good) diminishes the amount of the
bad (good) available for others to consume, i.e., there is a
social opportunity benefit (cost) to others associated with
consumption. Examples of non rival good: clean air, street
light
Public Goods

Rival Nonrival
Excludable Private goods: Club goods:
- Hamburger - Local public beach
with access control
- Water pollution
in small lake
Nonexcludable Open access resources: Pure Public goods:
- Fishery - National defense
- Garbage disposal - Greenhouse gases
in middle ages
Excludability

Why is excludability important?

I To attach a price to the consumption of a good or bad, we
have to be able to deny that consumption if the price is not
paid. Assume a city park without entrance control. Thus no
one will pay admissions.
I Air pollution is not excludable: it is not possible to
selectively target who is to consume the air pollution. If it
were possible to exclude pollution, only tose people who
agreed to be compensated to breathe pollution would
consume it.
Rivalry

Why is rivalry important?

I No cost associated with incremental use
I Perfect competition: price equals marginal cost, price should
be zero.
I How can revenues balance costs?
Public goods

Public goods are goods or services that can be consumed by

several individuals simultaneously “ Pure ” public goods are
characterized by non-rivalry and non-excludability
I Non-rivalry: Multiple individuals can consume the same
good without diminishing its value
I Non-excludability: An individual cannot be prevented from
consuming the good
Examples: fresh air, a public park, a beautiful view, national
defense
Problem: in the absence of complete property rights, markets
cannot achieve an efficient allocation of public goods.
What does the marginal value from public goods
consumption look like?
Start with the demand for one individual...

MC

D1

Q1 Q
Add another individual with the same demand
If Q is a private good, what does the total demand look like?

P
MC

D2H

D1
Q1 Q2H Q
Aggregate demand for N (identical) individuals
Aggregate demand approaches infinitely elastic with large
number of individuals N and horizontal aggregation

P
MC

DNH

D2H

D1
Q1 Q2H QNH Q
Back to the demand of one individual
If Q is a public good, what does the individual demand look like?

MC

D1

Q1 Q
Add another individual with the same demand as the
first
If Q is a public good, what does the total demand look like?

D1 D2V

Q1 Q2V Q
Aggregate demand for N (identical) individuals
If Q is a public good, what does the total demand look like?

MC

DNV
D2V
D1

Q1 Q2V QNV Q
Aggregate demand for N (identical) individuals
Aggregate demand approaches infinitely inelastic with large
(identical) N and horizontal aggregation

MC

DNV
D2V
D1

Q1 Q2V QNV Q
How much of a public good will be provided, and at
what cost?
Aggregate demand approaches infinitely inelastic with large
(identical) N and horizontal aggregation

MC

DNV
D2V
D1

Q1 Q2V QNV Q
The problem with the provision of public goods

I Most people will wait for others to pay for the public good,
and then they will free ride æ Market under-provides public
goods
I When Mr.i contributes gi , it increases the utility of Mr j, by

uj (xj , Gú≠i + gi ) ≠ uj (xj , Gú≠i )

but Mr. i gets no compensation from Mr.j.

I There is a positive externality !
The problem with the provision of public goods

I Denote c the cost of providing an extra unit of the public

good (this is a marginal cost - assume it is constant)
I Contribution of Mr i with utility ui (x, G), initial wealth wi ?

max ui (wi ≠ cgi , Gú≠i + gi )

gi

ˆui ˆui
Optimal gi = 0 if (wi , Gú≠i ) < c (wi , Gú≠i )
ˆG ˆx
ˆui ˆui
Otherwise (wi ≠ cgi , Gú≠i + gi ) = c (wi ≠ cgi , Gú≠i + gi )
ˆG ˆx
The problem with the provision of public goods

I The quantity of public good provided is efficient as long as:

I We cannot find a set of transfers to any Mr i and from all
the other agents j such that all agents are better off by
having Mr i contributing more and receiving the sums of the
transfers.
I In equations, it must be the case that,

ÿ ˆuj
ˆG
ˆuj
=c
j ˆx
The problem with the provision of public goods

Why ?
I Call dtj the maximum transfer that Mr j is willing to pay to
Mr i in order that Mr i contributes an extra amount dgi .
I As long as ˆuˆx (≠dtj ) + ˆG dgi > 0, Mr j is better off by
j ˆuj

paying dtj in exchange of an extra contribution of Mr. i

than in the status quo. The maximum amount that he is
willing to pay is thus defined by: ˆxj (≠dtj ) + ˆGj = 0
ˆu ˆu

ˆuj
dtj =
ˆG
ˆuj
dgi
ˆx
The problem with the provision of public goods
I What is the minimal amount dTi that Mr i is willing to
accept in exchange for an extra contribution ? It is defined
by ˆu
ˆx (dTi ≠ pdgi ) + ˆG dgi = 0
i ˆuj
q
I A Pareto improvment is possible if dTi < j dtj , i.e if
Q R
ˆuj
ˆui aÿ ˆG
ˆuj
≠ cb > 0
ˆx j ˆx
q
I A Pareto improvment is also possible if dTi > j dtj
Q R
ÿ ˆuj
ˆui a ˆG
ˆu
≠ cb < 0
ˆx j
j
ˆx

(Why ? Because then everyone would be better off if Mr i

contributes dgi less and pays all Mr. j dtj )
The problem with the provision of public goods

I The situation is Pareto efficient whenever g1ú , g2ú ..gnú and the
repartition of (wj ) satisfy:
q ú
ˆG ( gi , wj ≠ cgjú )
ÿ ˆu j

ˆuj q ú
=c
j ˆx ( gi , wj ≠ cgj )
ú

I This is the Samuelson condition for efficient provision of

public good.
I Only one solution ?
The problem with the provision of public goods

With increasing marginal costs:

I Producing G units of public goods costs C(G).
I The situation is Pareto efficient whenever Gú and the
contributions (cú1 , cú2 , cún ) (and the repartition of (wj )) satisfy:

ˆG (G , wj ≠ cj )
ÿ ˆu j ú ú
= C Õ (Gú )
ˆx (G , wj ≠ cúj )
ˆuj ú
j

and ÿ
cúj = C(Gú )
j
The problem with the provision of public goods

I With n identical agents and n identical contributions, the

right contribution would be such that:
ˆui ˆui
n =c
ˆG ˆx
instead of

ˆui ˆui
=c
ˆG ˆx
I The last unit of public good I should provide has a very
small marginal utility np ˆu
ˆx
i

I Decreasing marginal utility (downward sloping demand)æ

underprovision of public goods
The problem with the provision of public goods

I What about Coase theorem?

I If there are property rights on the public good (you are not
allowed to breathe my clean air unless I sell you clean air)
ˆuj
I You are willing to pay me a price ˆG
ˆuj for a unit of clean air
ˆx
that I provide.
I Complicated to implement ! What is the difference with the
remote island example?
Can we set a price for public goods and obtain
efficiency?
If there is a tax · per unit of G, such that agent j chooses G ú ?

max uj (G, xj ≠ · G)
G

He chooses G such that

ˆG (G, xj ≠ · G)
ˆuj
=·
ˆx (G, xj ≠ · G)
ˆuj

· must be such that:

ˆG (G , xj ≠ · G ú)
ˆuj ú
=·
ˆx (G , xj ≠ · G ú)
ˆuj ú

The only way to get the Samuelson condition is to have

personalized price ! Ex: uj (G, xj ≠ · G) = xj ≠ · G + –j ln(G)
Personalized price?

MC

DNV
D2V
D1

Q1 Q2V QNV Q
Personalized price?

I Each individual has a different willingness to pay for the

public good
I The Lindhal tax imposes personalised prices that equal the
individual valuation of the public good
I But how do we get people to reveal their preferences for
public goods?
I Strong incentive to understate your preferences
Can we set a price for public goods and obtain
efficiency? On an example

Non rival good

I Suppose park with a fence.
I Access can be controlled
I Large park so that congestion is never a problem
I Suppose also cost of operating it is all fixed costs (no costs
depending on visitation)
I Tastes for the park are widely distributed within the
population.
I What should be the efficient admission price?
Can we set a price for public goods and obtain
efficiency?

What should be the efficient price?

I Since there is no cost associated with letting one more
person use the park, efficient use clearly calls for everyone
having access to the park.
I If we were to exclude anyone, then a Pareto improvment
could be attained by allowing whomever has been excluded
to use the park.
I What admission price would support this Pareto optimum?
Only a price of zero. For a nonrival exludable good, the
optimal price is zero.
Voting on the quantity of public good
I Can voting be efficient ?
I Assume I agents each endowed with 1 unit of revenue.
I Private good quantity consumed by i denoted xi , public
good x0 (cost c)
q
I Feasibility I = cx0 + xi
1
I Agent i has utility ui (x0 , xi , “i ) = xi + “i x0 )1/2
I Samuelson condition
ˆuj
ÿ ˆx ÿ “j
0
= 1/2
=c
2x0
ˆuj
j ˆxj j

Optimal level of public good

3 42
I “mean
x0ú =
4c
Voting on the quantity of public good
Which level of t is chosen ?
I Constitution: egalitarian financing of public good t per
capita, simple majority vote between any two possibilities.
I Consumption xi = 1 ≠ ti , public good x0 = f (It) = It/c

I Agent i has utility v i (t) = (1 ≠ t) + “i (It/c)1/2

I Single peaked preferences
I Preferred level of tax

“i2 I
ti =
4c
I Median voter theorem: with single peaked preferences, the
median voter choice will be preferred to any other tax.
I Outcome of the vote:
3 42
I “med
x0 =
4c
A game theory approach

Anil and Bala face the following problem:

I Pest insects that destroy the crops they cultivate in their
adjacent fields. Each has two feasible strategies:
I The first is to use an inexpensive chemical called Terminator.
It kills every insect for miles around. Terminator also leaks
into the water supply that they both use.
I The second is to use integrated pest control (IPC) instead of
a chemical. A farmer using IPC introduces beneficial insects
to the farm. The beneficial insects eat the pest insects.
I If just one of them chooses Terminator, the damage is quite
limited. If they both choose it, water contamination
becomes a serious problem, and they need to buy a costly
filtering system.
Payoffs

Both Anil and Bala are aware of these outcomes.

Anil’s best responses:
I If Bala chooses IPC: Terminator (cheap eradication of pests,
with little water contamination).
I If Bala chooses Terminator: Terminator (IPC costs more and
cannot work since Bala’s chemicals will kill beneficial pests).
So Terminator is Anil’s dominant strategy. You can check,
similarly, that Terminator is also a dominant strategy for Bala.
The pest control game is a particular example of a game called
the prisoners’ dilemma.
Why is it the outcome ?

I There was no way that either Anil or Bala (or anyone else)
could make whoever used the insecticide pay for the harm
that it caused.
I The problems of Anil and Bala are hypothetical, but they
capture the real dilemmas of free riding that many people
around the world face.
I For example, as in Spain, many farmers in southeast Asia
rely on a shared irrigation facility to produce their crops.
The system requires constant maintenance and new
investment. Each farmer faces the decision of how much to
contribute to these activities. These activities benefit the
entire community and if the farmer does not volunteer to
contribute, others may do the work anyway.
Public good game

I Imagine there are four farmers who are deciding whether to

contribute to the maintenance of an irrigation project.
I For each farmer, the cost of contributing to the project is
$10. But when one farmer contributes, all four of them will
benefit from an increase in their crop yields made possible
by irrigation, so they will each gain $8.
I Contributing to the irrigation project is called a public good:
when one individual bears a cost to provide the good,
everyone receives a benefit.
Public good game
Altruism

I Altruism could help to solve the free rider problem: if Kim

cared about the other farmers, she might be willing to
contribute to the irrigation project. But if large numbers of
people are involved in a public goods game, it is less likely
that altruism will be sufficient to sustain a mutually
beneficial outcome.
Altruism

I Yet around the world, real farmers and fishing people have
faced public goods situations in many cases with great
success.
I The evidence gathered by Elinor Ostrom, a political
scientist, and other researchers on common irrigation
projects in India, Nepal, and other countries, shows that the
degree of cooperation varies. In some communities a history
of trust encourages cooperation. In others, cooperation does
not happen. In south India, for example, villages with
extreme inequalities in land and caste status had more
conflicts over water usage. Less unequal villages maintained
irrigation systems better: it was easier to sustain
cooperation.
Repeated game

I Ongoing relationships are an important feature of social

interactions that was not captured in the models we have
used so far: life is not a one- shot game.
I Anil and Bala are more realistically portrayed as interacting
repeatedly.
I Imagine how differently things would work out if we
represented their interaction as a game to be repeated each
season. Suppose that Bala has adopted IPC. What is Anil’s
best response?
Repeated game

I If I play IPC, then maybe Bala will continue to do so, but if

I use Terminator—which would raise my profits this
season—Bala would use Terminator next year. So unless I
am extremely impatient for income now, I’d better stick
with IPC.
I Bala could reason in exactly the same way. The result might
be that they would then continue playing IPC forever.
Experimental evidence

Benedikt Herrmann, Christian Thoni, and Simon Gachter. 2008.

‘Antisocial Punishment Across Societies’. Science 319 (5868): pp.
1362–67.
Experimental evidence

I Many people are happy to contribute as long as others

reciprocate. A disappointed expectation of reciprocity is the
most convincing reason that contributions fell so regularly in
later rounds of this game.
I To test this, the experimenters took the public goods game
experiment and introduced a punishment option.
I After observing the contributions of their group, individual
players could pay to punish other players by making them
pay a $3 fine. The punisher remained anonymous, but had
to pay $1 per player punished.
Experimental evidence

Benedikt Herrmann, Christian Thoni, and Simon Gachter. 2008.

‘Antisocial Punishment Across Societies’. Science 319 (5868): pp.
1362–67.