Externalities
Today:
The fundamentals of externality theory
Externalities
Markets are well functioning for most private goods Many buyers and sellers Little or no market power by anybody Example: When demand shifts right for a good,
new equilibrium will have higher price and quantity Some markets do not have good
mechanisms to account for everything in a market Example: Talking on a cell phone in an airplane
Externalities
Externalities are effects that are not incorporated into market quantities and prices R/G (p.71) define an externality as “an activity of
one entity that affects the welfare of another entity in a way that is outside the market mechanism”
When markets have externalities, they are typically not efficient This is the topic of Chapter 5
Public good versus externality Although public goods are often looked at as
goods with externalities, we study the two topics separately Know which analysis applies when you solve a
problem
Negative externalities
Some examples of negative externalities Air pollution Water pollution
Sometimes you do not even think about polluting the water: Washing a car in your driveway
Noise pollution Highway congestion Standing at a concert or sporting event
Positive externalities
Some externalities are benefits Planting flowers in your front lawn Scientific research Vaccination
Prevents others from getting a disease from you Exercise?
Yes, if it leads to lower health care insurance premiums for others
More on the private health care market in Chapter 9
More externalities: Benefit or cost? Christmas decorations
Enjoyment or nuisance? A fan blowing in a warm office building
Cooling breeze or blowing your important papers? Use of perfume or cologne
Nice smell or allergen?
A simple example with externalities Suppose private MC equals quantity
MPC = Q Let demand be denoted by P = 100 – Q Let marginal damage be $10 per unit
A simple example with externalities
Translate equations and external cost to our graphical example
marginal damage per unit of $10
P = 100 – Q
MPC = Q
MSC = Q + 10
A simple example: Private equilibrium
Inefficient equilibrium w/o controls:
Set Q = 100 – Q Q = 50 (quantity F)
MPC = Q
P = 100 – Q
A simple example: Optimal equilibrium
Socially optimal quantity Q + 10 = 100 – Q Q = 45 (quantity E)
P = 100 – Q
MSC = Q + 10
An algebraic example: Price
Inefficient equilibrium, P = Q P = 50 Socially optimal quantity, P = Q + 10 P = 55
marginal damage per unit of $10
P = 100 – Q
MPC = Q
MSC = Q + 10
Price C = 50
Price B = 55
Recall E = 45 and F = 50
The externality problem
With externalities, quantity produced is typically not optimal
Finding optimal quantity when marginal damage is not constant
Deadweight loss of inefficient production
Next…
A more general analysis of externalities External cost per unit does not have to be
constant Graphical analysis of externalities
See Figure 5.1, p. 74 See Figure 5.2, p. 76
Graphical analysis of externalities
This is also the deadweight loss (or excess burden) when Q1 is produced
Pollution
Pollution is one of the biggest negative externalities around
Multiple steps needed to try to find optimal amount of pollution Which pollutants actually do damage? Are there pollutants that indirectly cause damage?
Example: CFCs on the ozone layer How do we value the damage done?
Very difficult to do, due to lack of markets
Pollution and empirical studies Empirical studies have been done to try to
determine the damages caused by pollution Remember from Chapter 2 that we need to
use events that prevent bias
Pollution and empirical studies Chay and Greenstone (2003, 2005)
Pollution on health 1 percent reduction in total suspended particulates
resulted in a 0.35 percent reduction in infant mortality rate
Pollution on housing prices Improved air quality between 1970 and 1980 in pollution-
regulated cities led to property value increases of $45 billion
The externalities of smoking
Increased health care costs Affects others through increased health care insurance
premiums Lower workplace productivity due to smoking
Lowers non-smoker wages also if firms cannot discriminate against smokers
Increased fires Additional fire fighting cost on society
The death benefit: A positive externality Secondhand smoke
The externalities of smoking
All together, the externalities due to smoking lead to a net cost on society Empirical estimates lead to a total cost that is
probably somewhere between $0.50-$1.50 per pack Estimates can vary depending on factors such as
discount rate, assumptions in a model, and value of life Current cigarette taxes in the US are about $1 per
pack
Why don’t we just negotiate?
Negotiation is typically costly Remember, time is worth something
Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring
Coase theorem
The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur People can negotiate costlessly The right can be purchased and sold
Property rights
Given the above conditions, efficient solutions can be negotiated
Ronald Coase
Coase theorem
Notice that the Coase theorem addresses efficiency
To get to efficiency, the quantity of most goods and services produced is still positive Example: It is not efficient to get rid of all pollution
If all pollution was gone, we could not live (since we exhale CO2)
Bargaining and the Coase Theorem See Figure 5.3, p. 80
MB exceeds MPC in this range Production will be Q1 without negotiation
MSC exceeds MB here With costless bargaining, consumers will pay to reduce production from Q1 to Q*
Other private responses to externalities Mergers
When negative externalities only affect other firms, two firms can merge to internalize the externalities
Social convention Social pressure to be nice can lower the amount
of certain negative externalities
Public responses to externalities Four public responses
Taxes Also known as emissions fee in markets with pollution
Subsidies Command-and-control
Government dictates standards without regard to cost Cap-and-trade policies
Also known as a permit system
Taxes: See Figure 5.4, p. 83
With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss Quantity is below the optimal amount with taxes
With negative externalities, taxes can improve efficiency The optimal tax is known as the Pigouvian tax
Pigouvian tax equals marginal damage at the efficient output Increased Pigouvian taxes can also lead to lower income
taxes without sacrificing overall tax revenue Double dividend hypothesis (More in Chapter 15)
Emissions fee
One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output This kind of tax is known as an emissions fee See Figure 5.6, p. 85
Subsidies: See Figure 5.5, p. 84 An alternative to taxes is providing a subsidy
to each firm for every unit that it abates Problems with subsidies:
Efficient outcome only with a fixed number of firms Increased profits of firms in the industry will encourage
new entrants into the industry Positive economic profits if new entry is not allowed
Revenue is needed to provide subsidies Taxing income reduces inefficiencies
Ethical issues: Who has the right to pollute?
Command-and-control pollution reduction Two firms
Each would pollute 90 units if there are no pollution controls
Suppose each firm was forced to reduce pollution by 50 units Known as uniform pollution reduction Usually not efficient
Inefficiencies of uniform reductions
Notice that MC of Homer’s last unit of abatement is higher than Bart’s
$ $
MC is for abatement on these graphs
Total abatement costs are in red for each firm
Inefficiencies of uniform reductionsOverall abatement costs
can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit
$ $
Command-and-control regulation Command-and-control regulations can take many
forms Uniform reductions Percentage reductions Technology standards
Each firm must use a certain type of technology This method may work best when emissions cannot be
monitored easily Performance standards
Government sets emissions goal for each polluter Firm can use any technology it wants Less expensive than technology standards
Lowering abatement costs
Going from command-and-control requirements to emissions fees can lower overall abatement costs
Marginal cost of abatement of the last unit is equal for each firm with an emissions fee
Emissions fee example See Figure 5.9, p. 88
Cap-and-trade policies
Policy in which a permit is needed for each unit of pollution emitted
Permits can be traded Policy is efficient if
Bargaining costs are negligible Competitive permit markets exist Number of permits matches efficient pollution level
Initial allocation of permits does not affect efficiency as long as the above criteria are met
Example: See Figure 5.10, p. 90
Emissions fee versus cap-and-trade Given certain conditions, we
notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency $50 fee for each unit polluted (implicit
fee under permits) Bart reduces pollution by 75 units Homer reduces pollution by 25 units
In what direction are we heading? Command-and-control policies often rely on
states to enforce States do not always comply with these measures Fees and permits can often be controlled on the
national level US policies have generally moved from
command-and-control to taxes and permits Exceptions do still apply: Emissions hot spots
In a perfect world…
…we would know everything with certainty The real world is not perfect
How does this complicate our analysis?
The real world is more complicated We do not live in a world with perfect
economic assumptions Complicating factors
Inflation Cost changes Uncertainty Distributional effects
Inflation
If emissions fees do not represent real prices, the amount of pollution will change as real price changes
Cap-and-trade policies do not need inflation factored in, since quantity limits are used
Cost changes
Suppose cost to abate decreases every year Optimal amount of abatement will increase each
year If a new abatement technology is just being
developed, future cost changes could be small or large Potential solution: Impose a hybrid system
Permit market Offer a high tax for pollution emitted without a permit
Uncertainty
Costs and benefits are typically not known with certainty With uncertainty, too much or too little pollution
can be produced (relative to the efficient outcome) Two situations analyzed, with MC curve
uncertain Inelastic MSB: See Figure 5.11, p. 92 Elastic MSB: See Figure 5.12, p. 93
Distributional effects
Firms… Lose when they pay a tax Win when they are given permits
Government can generate revenue… If a tax is imposed If permits are sold
Double dividend hypothesis supports taxes or selling permits
Political pressure may encourage permit giveaways
Distributional effects
Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods
Displacement concerns Job losses from environmental regulation: Does
this increase income inequity? Who bears the cost of pollution control?
Depends on who uses the good that has the pollution control Example: Cars that are 15 or more years old
Summary
Externalities lead to inefficient production of many goods and services
Costless negotiation can lead to efficient outcomes in the presence of externalities Not realistic in most markets
There are many ways to implement government policies to improve efficiency
Wednesday
Positive externalities An application of externalities
Highway travel Problems related to externalities