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Presentation transcript:

©2016 by McGraw-Hill Education Limited. EXTERNALITIES Chapter 5 ©2016 by McGraw-Hill Education Limited.

Learning Objectives Describe how positive externalities differ from negative externalities. Demonstrate how the presence of an externality may lead to an inefficient allocation of resources. Explain how private responses could remedy the externality problem. Evaluate the advantages and limitations of various private responses that seek to remedy the externality problem. 5-2

Learning Objectives (cont) Explain how public responses (government policies) could remedy the externality problem. Evaluate the advantages and limitations of various public responses to the externality problem. Identify potential distributional implications of private and public responses to the externality problem. 5-3

The Nature of Externalities LO1 The Nature of Externalities Externality – when the activity of one entity (a person or a firm) directly affects the welfare of another in a way that is not transmitted by market prices Externalities can be produced by consumers and firms Externalities are reciprocal in nature Externalities can be positive or negative The distinction between public goods and externalities is a bit fuzzy 5-4

LO2 Negative Externalities and Economic Inefficiency A Negative Externality Problem SMC = PMC + MD $ PMC MD PMB Q* Q1 Q per year Socially efficient output Actual output Figure 5.1

Negative Externalities and Economic Inefficiency Gains and Losses from Moving to an Efficient Level of Output Reduction from 60 to 45 means dcg profit loss for Bart and cdhg welfare gain for Lisa. SMC = 20 + 2Q $ 200 PMC = 20 + Q h 140 MD d 110 g 80 c 60 45 f b 20 PMB a e 45 60 Q – output per year Figure 5.2

What Activities Produce Pollutants? Need to identify types and quantities of harmful pollution Transboundry problem Smog GHG 5-7

Which Pollutants Do Harm? Total suspended particles (TSPs) are widely considered to be he air pollutant most damaging to health Empirical research on correlation between TSPs and mortality rates 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 Chay and Greenstone (2003) and Currie and Neidell (2005): impact of air pollution on infant mortality 5-8

What is the Value of the Damage Done? Marginal damage schedule Willingness to pay Measurement problem GHG and Global warming 5-9

LO2 Positive Externalities and Economic Inefficiency A Positive Externality Example $ PMC b c a d SMB = PMB + EMB e PMB EMB g f R1 R* Research per year Figure 5.3

Private Responses to Externalities Bargaining and the Coase Theorem LO3, LO4 Private Responses to Externalities Bargaining and the Coase Theorem Coase Theorem If property rights are assigned and 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 Then An efficient solution to an externality problem can be achieved without government intervention 5-11

Private Responses to Externalities Other Private Solutions LO3, LO4 Private Responses to Externalities Other Private Solutions Mergers Way to internalize the externality The externality transmitter and recipient become one company Social conventions Littering is irresponsible and not “nice” “Do unto others as you would have others do unto you” 5-12

Public Responses to Externalities Taxes and Negative Externalities LO5, LO6 Public Responses to Externalities Taxes and Negative Externalities SMC = PMC + MD $ (PMC + cd) Pigouvian tax revenues PMC d i j c MD MB Q* Q1 Q per year Figure 5.4

Public Responses to Externalities Subsidies and Negative Externalities LO5, LO6 Public Responses to Externalities Subsidies and Negative Externalities SMC = PMC + MD $ (PMC + cd) PMC Pigouvian subsidy d k i f g j c h MD PMB e Q* Q1 Q per year Figure 5.5

LO5, LO6 Public Responses to Externalities Using an Emissions Fee to Reduce Pollution $ MD b a f* MAC d c E* E0 Emissions Figure 5.6

LO5, LO6 Public Responses to Externalities An Emissions Fee with Multiple Polluters $ $ The Outcome is Cost-Effective 225 180 MACB MACH Homer’s tax savings Bart’s tax savings 75 a d f*=50 30 c b f e 65 75 90 60 70 90 Bart’s Emissions Homer’s Emissions Figure 5.7

LO5, LO6 Public Responses to Externalities A tradable Permit Scheme and Negative Externalities $ $ A Cap and Trade Scheme is Cost-Effective 225 180 MACB MACH a 112.5 f*=50 c b 65 90 45 70 90 Bart’s Emissions Homer’s Emissions Figure 5.8

LO5, LO6 Public Responses to Externalities Regulation and Negative Externalities Command-and-control regulations require a given amount of pollution reduction and they are less flexible than incentive-based approaches Technology standard Performance standard Unlikely to be cost-effective 5-18

Public Responses to Externalities Positive Externalities LO5, LO6 Public Responses to Externalities Positive Externalities Subsidies Pigouvian subsidy Regulation For example: vaccinations Herd immunity 5-19

Implications for Income Distribution LO7 Implications for Income Distribution Who Benefits? Low- or High-Income Individuals? Who Bears the Cost? Workers of firms who must reduce output Buyers of firms’ output 5-20

Chapter 5 Summary An externality occurs when the activity of one person affects another person outside of the market mechanism. Externalities may generally be traced to the absence of property rights. Externalities cause market price to diverge from social cost, bringing about an inefficient allocation of resources. Negative externalities generally lead to too much of an activity while positive externalities typically result in too little. The Coase Theorem indicates that private parties may bargain toward the efficient output if property rights are established. However, bargaining costs must be low and the source of the externality easily identified. A Pigouvian tax is a tax levied on pollution in an amount equal to the marginal damage at the efficient level. Such a tax gives the producer a private incentive to pollute the efficient amount. 5-21

Chapter 5 Summary (cont) An emissions fee (a tax levied on each unit of pollution) achieves a given amount of pollution reduction at the lowest feasible cost (i.e., is cost-effective). The cost of emissions reductions is capped by the emissions fee but the level of pollution reduction can be uncertain. Pollution rights may be traded in markets; A cap and trade system grants permits to pollute, but allows the permits to be traded. Like the emissions fee, this approach is cost-effective. A cap and trade scheme is cost-effective and ensures a particular amount of pollution reduction, an advantage when administrators are uncertain how polluters will respond to Pigouvian taxes or emissions fees. However, the price of permits is uncertain. Command and control regulations are less flexible than incentive-based approaches, like emissions fees and permit schemes, and therefore tend to be more costly. 5-22