Externalities

Lecture 10 – academic year 2014/15Introduction to Economics

Fabio Landini

What do we do today?

• The “external” effects of economic activities

• How do we internalize externalities?

The KYOTO Protocol – since 1997

• The Kyoto Protocol, signed in December 1997 at the UNFCCC COP3 (Conference Of Parties), represents the executive instruments of the Framework Convention

• The countries that are subject to the emission constraint are 39 and they include the European countries (including the East countries), Japan, Russia, United States, Canada, Australia and New Zealand

The European Directive 2003/87/CE “Emissions Trading” regulate the exchange of quotas for the emission of greenhouse gas. The final aim is to establish an European market for the emission quotas.

During the first three years (2005-2007), the emissions of large combustion plants, such as oil refineries, plants for the production of ferrous metal, mineral goods (concrete, lime, etc.) and the plants for the production of paper and cartboard.

The KYOTO Protocol – since 1997

Market efficiency: A brief recap

• In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus.

• “The invisible hand” (of the market) maximize the total benefit of society

• Markets are usually good instruments to organize the economic activity

• Sometimes, however: “market failures”

Externalities: definition and effects

When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality.

Whenever they do not take into account the “third party”, the equilibrium prices and quantities are not efficient.

Therefore the externalities cause an inefficient allocation of resources, i.e. market failure.

The effects of externalities on society

In the presence of externalities:

•Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market).

•The externalities can be negative or positive

•However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged ≠ optimal quantity.

Negative externalities

Costs on other individuals (consumers or producers) that are not directly involved in the market exchange.

Example: smoke of cigarettes, cars’ exhaust gas

Positive externalities

Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange.

Example: Vaccines, restoration of a piece of Art, investment in new technologies.

Externalities and market inefficiency

• Negative externalities in productionQmarket > Qoptimum (socially desirable quantity)

social costs > private costs

• Positive externalities in productionQmarket < Qoptimum

social costs < private costs

• Negative externalities in consumptionQmarket > Qoptimum (socially desirable quantity)Social benefit < private benefit

• Positive externalities in consumptionQmarket < Qoptimum

Social benefit > private benefit

Externalities and market inefficiency

Negative externalities in production

EquilibriumEquilibrium

00

Price of Price of aluminiumaluminium

QQMARKETMARKET

DemandDemand(private value)(private value)

SupplySupply(private cost)(private cost)

Social costSocial costCost of Cost of pollutionpollution

QQOPTIMUMOPTIMUM

OptimumOptimum

Quantity of Quantity of aluminiumaluminium

Positive externalities in production

QuantityQuantity of Robotof Robot

00

Price of Price of RobotRobot

QQOPTIMUMOPTIMUM

DemandDemand(private value)(private value)

Supply (private cost)Supply (private cost)

QQMARKETMARKET

Value of Value of technologicatechnologica

l diffusionl diffusion

EquilibriumEquilibrium

Social costSocial cost

OptimumOptimum

Negative externalities in consumption

Quantity of Quantity of alcoholic drinksalcoholic drinks

00

Price of Price of alcoholic alcoholic

drinksdrinks

DemandDemand(private value)(private value)

Supply (private cost)Supply (private cost)

QQMARKETMARKET

EquilibriumEquilibrium

QQOPTIMUMOPTIMUM

OptimumOptimum

Social valueSocial value

Positive externalities in consumption

Quantity ofQuantity ofeducationeducation

00

Price of Price of educationeducation

DemandDemand(private value)(private value)

Supply (private cost)Supply (private cost)

QQMARKETMARKET

EquilibriumEquilibrium

QQOPTIMUMOPTIMUM

OptimumOptimum

Social valueSocial value

Positive externalities: the diffusion of knowledge

A firm that starts a project (e.g., to produce industrial robot) could develop a new technology / generate an innovation in production techniques so as to improve the initial project.

Such an improvement could benefit the firm but also the society as a whole, because such knowledge will accumulate and becomes part of the social knowledge stock.

Technology diffusion: positive externality

How to internalize externalities?

The Government can provide subsidies to produce industrial robot.

Example: subsidy for each robot that is produced.

Increase of supply and therefore increase in the equilibrium quantity (previous graph).

To obtain Qmarket= Qotpimum we need: subsidy = value of technology diffusion.

Problem: how do we quantify this value?.

Problem of industrial policy

If the value of technological diffusion can be easily quantified, then the Government should design incentive (taxes, subsidies) that privilege high tech sectors as opposed to more traditional ones (INDUSTRAIL POLICY).

If the value of technological diffusion is difficult to quantify, the risk is to end up helping sectors that have stronger lobbying power and not those with higher technological content.

The best is to enforce PROPERTY RIGHTS through patents, which can then be licensed.

How to obtain Qoptimum?1. Government intervention

• Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities.

• “To internalize an externality” means to alter market incentive with subsidies and taxes, so as to induce individuals to take adequately into account the external effects of their actions.

Obtaining the optimal production

If the externality is negative: internalization through a tax – the tax reduces the quantity that is exchanged in equilibrium until the social optimum obtains

If the externality is positive: internalization through a subsidy – the subsidy increase the quantity that is exchanged in equilibrium until the social optimum obtains

Public intervention is not always either necessary or efficacious to deal with externalities.

Example of private solutions:•Ethical codes and social sanctions.•NGOs (in the “no-profit” sector).•Integration of different types of activities.•System of contracts (Coase’s theorem).

How to obtain Qoptimum?2. Private solution

Coase’s Theorem

The model developed by the economist Ronald Coase is a well-known proposal to solve the externality problem without government intervention

Coase’s Theorem: is the parties in a transaction can negotiate over the allocation of resources without costs, then the market can solve the externality problem.

What does Coase’s Theorem mean?

According to Coase externalities derive from the absence of well-defined property rights.

If we assign exclusive property rights to some subjects the problem can be solved.

Example: suppose we assign the exclusive rights to pollute to a single firm.

The firm can decide to sell such rights, which will be then bought by the one who evaluate it the most.

Consequences of Coase’s Theorem

Private subjects can internalize the effects of externalities, negotiating among them.

In this way, an efficient allocation of property rights can obtain.

If transaction costs = 0, then the parties can always achieve the efficient allocation whatever the initial distribution of property rights is.

Private solutions and public intervention

Sometime private solutions do not work, because transaction costs are high (= cost necessary to achieve and enforce an agreement).

This is more likely the higher the number of subjects involved in the transaction.

This make it impossible to rely on private agreements.

Externalities and public intervention

When externalities are significant and private solutions are not viable, the Public Authority can react in one of two ways:

•By creating laws and enforcement devices

•By implementing market policies

1. Laws and enforcement devices

Usually: bans and duty

For instance:

•No entry ban for non-Euro-3 cars

•Vaccines

•Heater can be switched on after 15/10

2. Market policies

To align incentives and social optimum the Public Authority can decide to rely on “market policies”:

•Regulation: determine a certain level of environmental pollution that is allowed.

•Pigovian tax: create an incentive to reduce pollution.

•Tradable permits: voluntary transfer of the rights to pollute from one firm to the other.

Pigovian Tax

Economists tend to prefer Pigovian Tax because it ensure a reduction of environmental pollution and lower social costs compared to regulation.

Differently from regular taxation, it corrects the system of incentives and induce an efficient allocation of resources.

Tradable permits

They are used to fight environmental pollution.

They allow the voluntary transfer of the rights to pollute from one firm to the other.

In fact: a market for pollution rights is created.

A firm that faces low cost to reduce her own pollution will prefer to sell her rights to pollute to a firm that faces high costs to reduce her own pollution.

00

Price of pollutionPrice of pollution

PP

QQ

(a) Pigovian Tax(a) Pigovian Tax

Pigovian Pigovian taxtax

00 QQ

Demand of Demand of tradable tradable permitspermits

(b) Tradable permits(b) Tradable permits

Supply of tradable Supply of tradable permitspermits

PP

..

Price of pollutionPrice of pollution

Demand of Demand of pollution rightspollution rights

Quantity of pollutionQuantity of pollution Quantity of pollutionQuantity of pollution

The Pigovian tax determines a price of pollution…

… together with demand it determines the quantity of polution

Tradable permits define the quantity of pollution…

… together with demand it determins the price of pollution

Consumption tax on petrol

Petrol is mong the most taxed goods (nearly 50% of final price in USA, nearly 75% in Italy).

Often such taxes are conceived as (distortive) taxes on consumption (good with inelastic demand, see previous lectures….)

Can consumption taxes on petrol (or cars) be conceived also as Pigovian

taxes?In some respects the answer is YES.

The tax is aimed at correcting externalities that are associated with the use of cars:

•Traffic congestion.

•Accidents (debate on SUV).

•Street wearing out

•Pollution.

Question: aren’t there more appropriate tools to reduce pollution? A high price of petrol is paid by all citizens, even those that live in the country side and produce little pollution…

Conclusion

When the transaction between a buyer and a seller has effects on a third party, there is an externality.

Negative (positive) externalities imply that the quantity that is exchanged in equilibrium is higher (lower) than the quantity that is socially desirable.

Solutions to externalities can derive both from private parties and government intervention.