2. externalities and public goods.pdf

8/14/2019 2. externalities and public goods.pdf

1/53

Market Failures:

Externalties and Public Goods

Prof. Carlo Cambini

Politecnico di [email protected]


2/53

2

Externalities

Externalities arise between producers,

between consumers, or betweenproducers and consumers

Externalities are the effects of productionand consumption activities not directly

reflected in the market

They can be negative or positive


3/53

3

Externalities

Negative

Action by one party imposes a cost on anotherparty

Plant dumps waste in a river, affecting those

downstreamThe firm has no incentive to account for the external

costs that it imposes on those downstream

Production of electricity and emission of excessiveCO2


4/53

4

Externalities

Positive

Action by one party benefits another party

Homeowner plants a beautiful garden where all the

neighbors benefit from it

Homeowner did not take their benefits into accountwhen deciding to plant

Network externalities: mobile users benefits from abig installed base in order to obtain lower call prices

(for on net calls, but not for off net calls!)


5/53

5

Negative Externalities and

Inefficiency

Scenario plant dumping waste

Marginal External Cost (MEC) is the increase in costimposed on users downstream for each level ofproduction

Marginal Social Cost (MSC) is MC plus MEC

Equilibrium in a competitive market where marketdemand crosses supply curve

Assumption: the firm has a fixed proportions

production function and cannot alter its inputcombinationsThe only way to reduce waste is to reduce output


6/53

6

External Costs

MC

S = MCI

P1

q1

P1

Q1

MSC

MSCI

Firm output

Price

Industry output

Price

MEC

MECI

q*

P*

Q*

D

Firm will produce q1 at P1.

There is MEC of production from

the waste released. The MSC is

true cost of production.

The profit maximizing firm

produces at q1 while the

efficient output level is q*.


7/53

7

Negative Externalities and

Inefficiency

The MC curve for the firm is the marginal cost of

production Firm maximizes profit by producing where MC

equals price in a competitive firm

As firm output increases, external costs on usersalso increase, measured by the marginal

external cost curve

From a social point of view, the firm produces

too much output


8/53

8

External Costs

Aggregatesocial cost of

negative

externality

By not producing

at the efficient

level, there is a

social cost onsociety.MC

S = MCI

D

P1 P1

q1 Q1

MSC

MSCI

Firm output

Price

Industry output

Price

MEC

MECI

q*

P*

Q*


9/53

9

Positive (Network) Externalities Economists say that there is a network

externalitywhen the value of a good depends

on the number of other people who use it.

Examples are goods like the telephone

network, the fax machines network, the email

network, or the Internet itself.

Thus, the utility of a single agent i depends not

only on the quantity consumed (q) but also on

the numberN of agents in the market who use

it:),()( qNUqU ii =


10/53

10

Network externalities We face direct network externalities when the

utility of an agent of type A depends on the

number of agents belonging to the same group

(say network) A:

An additional agent that enter the network

generates a postive externality (positive feedback)

to the existing agents since connectionpossibilities are enlarged (ex. the evolution of

mobile adoption).

The Metcalfes law

),()(,,

qNUqUAAiAi

=


11/53

11

A simple model (Rohlfs, 1974)

Letp be the (fixed) price to be connected to a

telecom network; the utility function of aconsumers of type [0, 1] (= willingness to pay)

is:

Utility increases if the numbern [0, 1] of

users increases.

=connectnoif0

connectsif)1()(

pnU


12/53

12


Denote with the consumer indifferent

between being connected or not, for a given pricep and number of users n.

For the marginal consumer, the price limit is

given by:

In equilibrium, the number of potential users

should be equal to the number of existing users,

i.e. = n.

~

0)~

1( = pn

~


13/53

13


Thus, in equilibrium we have:

Two equilibria, one stable and one unstable.

is called the critical mass

)~

1(~

=pp

0

p

1/2n

1

0

0 0

L H

L0


14/53

14


What is the critical mass? The minimum level of

coverage/penetration that a network/technologyshould reach in order to remain in the market.

If you fail, you will exit the market.

Relevant concept in high-tech industries:compatible vs. incompatible products.

Relevant role of price and its impact on the

coverage level.

Important factors: switching costs and lock in

effect


15/53

15

Market analysis in presence of network

externalities

From social point of view, the optimal coverage is

the level that maximes welfare, given by the sum ofconsumer net surplus and firms profit, i.e.:

W= Gross Surplus P*Q(P) + P*Q(P) C(Q) == Gross Surplus C(Q)

where Gross Surplus =

and in equilibrium n =

=

2

~~

)1(

2~

0

ndn

~


16/53

16


externalities

From social point of view, it is easy to show that

a 100% coverage should be reached (almost for c< 0.5).

Costi,

Benefici

0

0,1

c = 0,5

0,2

0,3

0,4

0,5

0,2 0,4 0,6 0,8 1

c = 0,25

c = 0,1


17/53

17


externalities

Should a private firm choose to cover all the

marlet or not?In monopoly:

FOC:Costi,Ricavi

0

0,1

c = 0,5

0,2

0,3

0,4

0,5

0,2 0,4 0,6 0,8 1

c = 0,25

c = 0,1

~~

)~

1(~~~

)~

( ccp ==

0~

3~

2 2 = c


18/53

18


externalities

Using simulation we determine the optimal

coverage/penetration rate:

0,6710

0,6110,1

0,5410,2

0,510,25

010,5

MonopolyEfficiencyCost c


19/53


20/53

20

Network externalities

It is important to understand that if the value of the

network increases through interconnection (due toMetcalfe law), then there should be a way to divide

that increase in value so to make all participants

better off. If the pie gets bigger, everyone can get a larger

price. However, the increased size of the pie also

means that threats not to interconnect becomemore significant. And, of course, a larger pie is a

more tempting target for someone to try to snatch

than a smaller one.


21/53

21


If two networks of size n1 and n2 interconnect (with n1>> n2 ), what increase in value accrues to each one?

Applying Metcalfes law:

Each network gets equal value from interconnecting!!

This calculation, simple though it is, gives someinsight into why peering, or settlement-freeinterconnection, is common among large backboneproviders. The gains from interconnection are splitmore-or-less equally, even among somewhat differentsize networks.


22/53

22


But not all networks are willing to interconnect

on a payment-free basis.What happens if one network acquires the

other (say 1 acquires 2)?

Network 1 captures twice as much value by

buying out network 2 rather thaninterconnecting with it. Essentially the threat ofnon-connection increases the larger networksbargaining power.


23/53

23

Indirect network externalities

We face indirect network externalities when

the utility of an agent belonging to a group(say network) A depends on the number of

agents of the group B and viceversa:

Example: all the so called intermediation

market

==

)),(()(

)),(()(

,,

,,

qNNUqU

qNNUqU

ABBiBi

BAAiAi


24/53

24


Example (from Armstrong, 2004):


25/53

25




26/53

26




27/53

27




28/53

28

Indirect network externalities In all the examples, we have a (physical or virtual)

platform that intermediate between the two groups of

agent. When we have several groups of agents that interact

via one or more platform, we say that we face a two-sided market

Surplus is created or destroyed only when groupsinteract, but this interaction should be mediated insome way.

In these cases, the surplus enjoyed by a member ofone group depends on the number of the agent of theother group that join the same platform


29/53

29

Two-side markets


30/53

30

Two-side markets

Business strategy for the platform: getting both

side on board. Only maximizing the number ofagent in both side of the market permit to createhigher surplus in the market

Pricing issues: prices are related to: a) relativeimpact of the positive externality; b) level of priceelasticity.

Tariff level and tariff structure


31/53

31

Two-side markets: a simple model

Two-sided market. Price competition.

with eij 0 and e12e21 < 1

Note:

ifD(p2) increases (due to a decrease ofp2), positive

effect also on the market demand 1, raising by e21D(p2).


32/53

32


Benchmark model. Independent platform:

suppose each market served by one platform:

We obtain:


33/53

33


Now suppose only one platform serves all

markets:

Price equilibrium:


34/53

34


Case I: intermediate level of indirect

externalities


35/53

35


Case II: high externality from 2 to 1 (i.e. e21 >

e12)


36/53

36


Case III: high externality from 1 to 2 (i.e. e21

2. externalities and public goods.pdf

Documents