EXTERNALITIESChapter 5

Externalities

• Externality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism =>

unwanted effects– Paper production as by-product carcinogen dioxin =>

increases society’s health care costs => they are not included in the paper price

– Why not?– Production => positive– Consumption=> positive/negative

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The Nature of Externalities

• Privately-owned vs. commonly-owned resourcesA privately owned resource: its price reflects its value so used efficiently (Marg Social Cost= Marg Private Cost= Marg Social Benefit= Marginal Private Benefit = ??Remember: eq comp mkt => marg cost = marg utility=priceA commonly-owned resource (air, oceans): price ($0) does not

reflect its value so used inefficiently (MSC>MSB)Similar case with externalities:

• Production with negative externalities (pollution)• Marg private cost? Marg social cost? Difference?

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• Public goods as a special kind of externalityExternality itself is a public goodElectrocuting mosquitosR&D fall out from a private firm

The Nature of Externalities-Graphical Analysis

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*Actual outputSocially efficient output

ab

c

d

fe

g

h

Reduction from Q1 to Q* means dcg profit loss for Supplier and dchg welfare gain for Demander.

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What Pollutants Do Harm?

• Empirical Research on Pollution Effects on Health– Difficult to measure because of inability to perform randomized

studies on pollution effects– Must rely on cross-sectional or time-series analysis– Studies unable to measure lifetime exposure to air pollution

• Once pollutant identified:– Must identify the activities that produce the pollutant– Must identify the value of the damage done– Must identify the costs of remedying the damage

• Empirical Evidence: The Effect of Air Pollution on Housing Values

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Private ResponsesBargaining and the Coase Theorem

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

dg

h

Supplier will ↓ Q1 to Q* if paid by Demander, who is willing to do so. Bargain possible over $ transferred.

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The Coase Theorem

• Coase Theorem – Given:– Low transaction costs– Clear assignment of property rights An efficient solution to an externality problem can be

achieved: with or without Gov’t? Is it relevant to reach an equilibrium to whom property

right are assigned? Is it relevant for final distribution to whom property right

are assigned?

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• Assumptions necessary for Coase Theorem to work– The costs to the parties of bargaining are low– The owners of resources can identify the source of

damages to their property and legally prevent damages

Public Responses to Externalities - Taxes

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

Pigouviantax revenues

i

j

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Public Responses to Externalities – Subsidies that pay polluter not to pollute

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

i

jgk

h

f

e

Pigouviansubsidy

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Pros and cons P. T. on output

• Knowledge (graphic is known!)• Indirect effect (estimated)• No personalisation• No incentives

Public Responses to Externalities- Emissions Fee: tax on each pollution unit

0Pollution reduction

MSB

MC

e*

f*

$

Emissions fee

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• Pigouvian tax on each unit of emission instead of output

• Is f* a marginal tax?• Producer decide between paying MC and

paying f*• Incentive• Personalised (?)

Public Responses to Externalities- Uniform Pollution Reduction

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

10

bRequiring each company to reduce pollution by 50 units is not cost effective. Better to have Bart reduce pollution by 100 units because he can do so at a lower cost. But is it fair???

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Emissions Fees achieve fairness and efficiency

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

Bart’s TaxPayment Homer’s Tax

Payment

An Emissions Fee=$50 means Bart will reduce by 75 and Homer only by 25, but Homer pays larger tax.

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Marginal cost of reducing pollution across all polluters

Equal or different?Equal to what in equilibrium?

Is it cost effective? Why?

Public Responses to Externalities- Cap (80)-and-Trade: Polluters must have a permit

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

10

a

b

Bart: The cost of reducing pollution is less than market price of a permit, so sell permit. Homer: The cost of reducing pollution is greater than market price of a permit so buy permit.BOTH GAIN FROM TRADE

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• Total pollution 180• Total cap is 80• Permit issued by gov’t =80• To semplify the chart . 80 permits to Bart(tradable => do initial distribution matter?)

Emissions Fee v Cap-and-Trade

• Responsiveness to InflationNominal and realAdjustment• Responsiveness to Cost ChangesIncreasing marginal cost =>pollution ?

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Command-and-Control Regulation

• Command-and-control regulations require a given amount of pollution reduction:– Technology requirements– Performance requirementsFlexibility? Cost effective?

• Is command-and-control ever better? - Monitoring?

– Hot spots: Areas with relatively high concentrations of emissions

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Chapter 5 Summary• Externalities occurs when the activity of one person or firm

positively or negatively affects another person/group/firm outside the market mechanism

• An inefficient allocation of resources results because the market price does not reflect the external costs or benefits

• The Coase Theorem indicates that private solutions through bargaining can achieve the efficient outcome under certain circumstances

• Public solutions to externalities designed to achieve efficiency include taxes/subsidies; emissions fees; and command-and-control regulations

• A market-based, cost-effective, public solution is cap-and-trade where pollution permits – the right to pollute – are traded

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