Externalities & Transaction Costs

Lecture 9

Markets generally lead to efficient outcomes.

When individuals can voluntarily bargain with one another, all mutually beneficial exchanges can be identified and carried out.

Markets generally lead to efficient outcomes.

When individuals can voluntarily bargain with one another, all mutually beneficial exchanges can be identified and carried out.

Total surplus (consumer plus producer) is maximized.

There are no deadweight losses associated with mutually beneficial exchanges failing to occur.

At equilibrium, sellers bring exactly the amount buyers are willing to purchase at that price.

No wasteful production, no willing buyer unable to obtain the good.

The sum of consumer surplus and producer surplus (total surplus) is maximized. All mutually beneficial exchanges are identified and executed.

Markets generally lead to efficient outcomes, under two key assumptions.

1. The absence of spillover effects.

When individuals exchange, there are no effects on third parties not part of the transaction.

2. Zero costs of identifying exchanges and carrying them out.

Individuals can costlessly identify mutually beneficial exchanges and carry them out.

Externalities

The technical term for spillovers is externalities.

Externalities

The technical term for spillovers is externalities.

Externalities (also external effects): costs or benefits generated by one individual’s actions that are borne or enjoyed by others.

Externalities

The technical term for spillovers is externalities.

Externalities (also external effects): costs or benefits generated by one individual’s actions that are borne or enjoyed by others.

Each party to an exchange expects a benefit greater than the cost he/she incurs.

When all benefits/costs are internalized, all are taken into account.

Externalities

Externalities: costs or benefits generated by one individual’s actions that are borne or enjoyed by others.

Each party internalizes own costs/benefits, but not spillovers.

Consequence:

Exchanges will occur that do not take into account costs imposed on others. (Overproduction.)
Exchanges will fail to occur because they do not take into account benefits enjoyed by others. (Underproduction.)

Externalities

Positive externalities (external benefits):

An individual’s action generates benefits for third parties who do not pay for them.
Example: Vaccines.
When you get vaccinated, you protect not just yourself but others around you (herd immunity).
That benefit is not reflected in your personal willingness to pay.

Consider a market in equilibrium where there is a positive externality. The demand curve reflects only private willingness to pay.

Social demand (including third-party benefits) lies above private demand. Market produces too little.

The shaded triangle is additional surplus not created due to the positive externality (underproduction).

Externalities

Negative externalities (external costs):

An individual’s action imposes costs on third parties who are not compensated.
Example: Environmental pollution.
Producers do not bear the full social cost of their output.
Supply (private marginal cost) understates the true social marginal cost.

Consider a market in equilibrium where there is a negative externality. The supply curve reflects only private production costs.

Social supply (including external costs) lies above private supply. Market produces too much — overproduction.

The shaded triangle represents losses from overproduction in excess of consumers’ willingness to pay.

The second assumption: zero coordination costs.

Markets are efficient when individuals can costlessly identify mutually beneficial exchanges and carry them out.

But how do hundreds of millions of people coordinate across billions of goods?

Individuals have very limited information.
Each has knowledge of his/her own particular circumstances of time and place.
Individuals need to effectively make use of others’ knowledge.

Hayek’s answer: the price system

“We must look at the price system as […] a mechanism for communicating information[.]”

“The most significant fact about this system is the economy of knowledge with which it operates, or how little individual participants need to know in order to be able to take the right action.” F. A. Hayek, “The Use of Knowledge in Society” (1945)

The price system aggregates and transmits dispersed knowledge efficientlyno central planner needs to know everything.

Why do firms exist?

“Firms are ‘islands of conscious power in an ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk.’” D. H. Robertson

The plans of firms and individuals are coordinated across the economy by the price system: decentralized, communicates and economizes on dispersed knowledge, identifies mutually beneficial exchanges. Yet within a firm, something very different operates.

Why do firms exist? (Coase 1937)

“[T]he distinguishing mark of the firm is the suppression of the price mechanism.” Ronald Coase, “The Nature of the Firm” (1937)

Within a firm, market transactions are replaced by a centralized entrepreneur who directs production. Why does this happen? Why is the price mechanism suppressed in some cases?

Why do firms exist? (Coase 1937)

There are always costs associated with using the price system.

These are specific types of transaction costs:

Transaction costs: the time, money, and other resources used to make exchanges occur.
Associated with both market and non-market exchanges.
Assumed (unrealistically) to be zero in textbook supply & demand analysis.

The real world is full of transaction costs.

Search and information costs:

Shopping for the best goods at the best terms is costly.

Negotiation and contracting costs:

Negotiating and then contracting terms is costly.

Enforcement costs:

Enforcing the terms of contracts is costly.

Monitoring costs:

Monitoring/measuring the performance of services or provision of goods is costly.

Why do firms exist? (Coase 1937)

Using the price system involves transaction costs of:

Discovering what the relevant prices are.
Negotiating contracts.
Specifying contingency plans for an uncertain future.

Using non-market mechanisms involves (different) transaction costs too.

Exchanges will be internal to a firm when the transaction costs are lower than they would be via markets.

How do we mitigate transaction costs?

It is costly to identify and carry out mutually beneficial transactions.

There are innumerable institutions that arise and/or are designed to mitigate transaction costs.

Markets and the price system.
Firms (internal organization).
Regulations, legal codes, and contracts.

Institutions

“Humanly devised constraints that structure political, economic, and social interaction.”

“The rules of the game in society.” Douglass North

Institutions reduce transaction costs by providing a stable framework within which individuals can plan and exchange. Without them, even simple market transactions would be prohibitively costly.

Examples of Institutions

Formal institutions:

Legal codes, regulations, and contracts.

Informal institutions:

Norms of behavior, religions, customs, “corporate culture.”

Many are mixed:

E.g., markets have both formal (contract law) and informal (trust, reputation) elements.

Formal institutions are consciously established and explicitly stated.

They are written down, codified, and enforced by identifiable authorities.

Constitutions and statutes.
Property rights and legal codes.
Regulatory agencies and their rules.
Corporate charters and bylaws.

Informal institutions are unplanned, emergent“spontaneous orders.”

They arise from repeated interactions and shared experience, not deliberate design.

Say “God bless you!” when someone sneezes.
Walk on the right side of the sidewalk.
Shake hands when you meet someone new.
Say “please” and “thank you” when asking for something.
“Corporate culture.”

Formal institutions matter: days needed to legally start a business.

Source: World Bank “Doing Business” project. GDP per capita shown in parentheses.

Country (GDP per capita)	Days to start a business
High-burden countries
Venezuela ($16.1k)	230
Haiti ($1.3k)	97
Cambodia ($1.6k)	99
Brazil ($8.7k)	79.5
Suriname ($6.4k)	84
Low-burden countries
New Zealand ($42.1k)	0.5
Canada ($46.2k)	1.5
Hong Kong ($48.7k)	1.5
Denmark ($60.2k)	3
United States ($65.3k)	5.6

Fraser Institute’s Economic Freedom of the World Index

Countries scored according to five areas:

Size of government.
Legal system and property rights.
Soundness of money.
Regulation of business, credit, and labor markets.
Freedom to trade internationally.

Better institutions ︎→︎ lower transaction costs ︎→︎ more exchange ︎→︎ higher incomes.

Economic Freedom & Prosperity: Selected Countries

Source: Fraser Institute, Economic Freedom of the World. Score 0–10 (higher = freer).

Country	EFW Score	Quartile
Most economically free (top quartile)
Hong Kong	8.9	1st
Singapore	8.7	1st
New Zealand	8.5	1st
Switzerland	8.4	1st
United States	8.1	1st
Least economically free (bottom quartile)
Venezuela	2.9	4th
Sudan	4.2	4th
Zimbabwe	4.5	4th
Congo (Rep.)	4.8	4th

Pattern: Countries in the top quartile of economic freedom have average incomes roughly 7× those in the bottom quartile.

Institutions shape the cost of transactingand therefore the extent of the market.

Where formal institutions protect property rights, enforce contracts, and limit regulatory burdens, transaction costs are low and markets flourish.

Where formal institutions are weak, predatory, or arbitrary, transaction costs are high and mutually beneficial exchanges do not occur.

Managerial implication: When doing business internationally or entering new markets, the institutional environment is not a background conditionit is a fundamental determinant of costs, risk, and feasibility.

Two conditions for market efficiency

1. No externalities (no uncompensated spillovers).

Positive externalities ︎→︎ underproduction.
Negative externalities ︎→︎ overproduction.

2. Zero (or low) transaction costs.

High TC ︎→︎ mutually beneficial exchanges fail to occur.
Firms exist to internalize exchanges when internal TC < market TC.
Institutions exist to lower TC across the whole economy.

Interactive: Externalities and Efficiency

Externality Size

Key Terms

Practice Questions

Question 1 of 5

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