Solutions to Negative Externalities Ap Micro 12/4

Warm Up Graph the following scenario: The private market will buy (and sell) 100,000 flu shots at a price of $20 each. The socially optimal quantity should be where D=MSC, which is 150,000 units at a price of $25. So what do we do? Subsidize the activity by the amount of the externality ($10 each). The bottom line: when positive externalities exist, the private market always produces too little at too low a price than what would be socially optimal. Remember, we want MSC = MSB, and in the case of positive externality, MC is MSC. The effect: The seller sells 150,000 units, the seller receives $25 per unit, but the people only pay $15 out of pocket (the other $10 per unit comes from the government.

Private Solutions to Externalities Can the private sector solve externalities without government intervention? The Coase theorem: An efficient solution can always be reached provided the costs of making a deal are sufficiently low (transaction costs) Property ownership is clearly defined The number of people involved is small Bargaining costs are negligible Example: My upstairs neighbor likes to play Wii at 11 PM, which annoys me to no end while I’m trying to sleep. An argument ensues. Who wins? Possible solution: I ask him nicely to stop (it might work!) or I pay him $10. The point: an efficient solution was reached because it was super easy to work it out (he lives nearby, it’s not a huge deal, etc). Coase theorem in action!

Internalizing the Externality Individuals have an incentive to make mutually beneficial deals and eliminate the inefficiency– internalizing the externality When might this not happen? Costs of communication might be high if many people are involved (ex: the whole apt complex having a party? Harder to pay them all off or have them cooperate). Cost of legal services might be too high (I could sue, but is it really worth thousands of dollars in fees? Guess I have to put up with it. That would be a silly lawsuit anyway.) Costly delays involved in bargaining might lead to increased effort/wasted time (I keep asking nicely, he keeps blowing me off, frustration mounts…)

Other Ways of Addressing Externalities Defined property rights and government liability laws help remedy some externality problems Directly and indirectly (fear of lawsuit) Government Intervention Direct Controls Specific Taxes Subsidies and government provisions Market Based Approaches Tragedy of commons

Government Intervention—Direct Controls Pass legislation limiting an activities Environmental standards: Rules that specify actions by producers and consumers. Ex: emissions standards for cars Force the offending firms to incur the actual costs of the activity Uniform emission standards. Ex. Clean Air Act of 1990 Direct controls raise the marginal cost of production For example, firms must operate and maintain pollution control equipment

Government Intervention—Specific Taxes Emissions taxes or charges specifically on the good generating externality Depends on amount of negative externality (pollution?) produced Pigouvian tax: tax designed to reduce external costs The problem: the process is very trial and error How much is the perfect tax? Hard to tell – just have to try an amount and see if that limits pollution enough. If not, increase the tax. Firms can either pay the tax or spend the funds to purchase or develop substitute products Marginal cost increases

Direct Control OR Taxation Graph

Quota Graph Companies A and B both are polluting, but are different: the cost of reducing emissions is less for company A than B (company B gets more marginal benefit in pollution than A gets). In other words, being able to pollute is more valuable to company B. Maybe A is a cleaner company to begin with? Both firms wants to pollute until MB = 0. Both will pollute 600 tons each if there was no regulation. Government regulation (quota) = both have to limit emissions to 300 tons each. This is inefficient: this rigid standard is much harder on company B than A Outcome = emissions limited to 600 total units.

Emissions Tax Graph Again, unregulated, both companies A and B would pollute 600 tons of emissions each. Instead of a rigid standard, the government says that each ton of emissions will be taxed $200. This is the marginal cost of each ton of emissions. Each company can now CHOOSE FOR ITSELF how many tons to pollute, and each will choose where MC = MB of pollution. Company A will choose to only pollute 200 units (because look – the marginal benefit of any units after 200 is worth less than $200). Company B, who values pollution more, will choose to pollute 400 units. Outcome = emissions limited to 600 tons total – the same outcome as if you did the rigid standard, but this method is much more efficient!