Public Finance - Introductory Externalities Public Finance - Introductory

Public Finance - Introductory Definition An externality occurs when the activity of an ind affects the utility of another ind in a way not accounted by the price system externality = external to the P mechanism E.g. pollution So called “pecuniary externalities” are reflected in the P mechanism → not an externality, no market inefficiency involved Very important concept, fundamental for economic analysis of the law, environmental economics etc. Public Finance - Introductory

Nature of externalities Firm A (paper producer) throws waste in a river upon which there are no property rights → negatively affects ind B (fisherman) → negative externality River water is input for firm A but has also alternative uses→ e.g. input for fisherman Input s are efficiently used if paid to owners on the basis of opportunity costs (e.g. wage is opportunity cost of leisure time of worker) P of water in example is 0 → nobody owns river→ no incentive to use it efficiently → Externality is consequence of lack of property rights Public Finance - Introductory

Features of externalities Produced by consumers and producers E. in consumption → affects utility E. in production → affects profits Reciprocal: firm A pollutes river, but also fisherman produces externalities → raises costs of polluting Negative and positive (e.g.. neighbor’s well tendered garden) PG are source of externalities Public Finance - Introductory

Picture of negative externality in consumption Public Finance - Introductory

The Nature of Externalities-Graphical Analysis MSC = MPC + MD Reduction from Q1 to Q* means dcg profit loss for Supplier and dchg welfare gain for Demander. $ MPC h d g c Axes and labels 1st click – MB 2nd click – MPC, Q1 3rd click – MD 4t click – MSC, Q* MD f b MB a e Q* Q1 Q per year Socially efficient output Actual output Public Finance - Introductory

Public Finance - Introductory Description Firm produces up to Q1 where πmax (Mπ=0) From the point of view of society → production must be up to MB=MSC (social costs, not firm’s private costs) → point Q* If there is an externality FTWE does not hold MB=MPC holds, not MB=MSC → if negative externality → excessive production wrt efficient quantity Public Finance - Introductory

Description of diagrams-2 Efficiency increases by moving from Q1 to Q* → Firm profits lowered (area dcg) → Fishermen’s welfare increases → every unit of output less increases fisherman welfare by MC of externality (abfe=cdgh because MSC=MPC+MD) If U functions of firm and of fisherman equivalent → society’s welfare increases by dgh 0 pollution is NOT socially desirable → both activity affect each other (“reciprocal externality”) → 0 pollution=0 production=0 profits Public Finance - Introductory

Public Finance - Introductory Limits of analysis 4 main limits → analysis assumes Knowledge of functional forms that generate curves Quite unlikely Identification of polluter Who’s responsible for acid rainfalls? Identification of pollutant agents Often disagreements about this (e.g.. ozone hole) Identification of damage What’s the cost of being polluted? Who decides it? Public Finance - Introductory

Remedies to externalities Mergers Social rules Pigouvian taxes Creation of markets Assignment of property rights Regulation Nothing Public Finance - Introductory

Mergers and social rules Mergers → externalities are internalized by merging the affected parties Agents coordinate to make joint π superior to sum of individual π → Damage (externality) eliminated e.g. Bank mergers where competition is externality → pooling of risks, as in financial crisis of 2008 Social rules → Education plays an important role in reduction of externalities Public Finance - Introductory

Public Finance - Introductory Pigouvian tax Externality inefficient because production costs do not reflect social costs → Pigouvian tax (by name of Arthur Pigou) aims at correcting such difference → increase P of underpriced inputs (e.g. P=0 in previous example) because of property rights not assigned Tax = externality = ij P=0j+ij New cost structure for firm is MPC+cd Firm produces Q* where MB=MPC+cd Revenue is cd*0Q* Public Finance - Introductory

Diagram of a Pigouvian tax MSC = MPC + MD $ (MPC + cd) Pigouvian tax revenues MPC d i j c Axes and labels 1st click – MP shifts up to MPC + cd 2nd click – Pigouvian tax revenues box MD MB Q* Q1 Q per year Public Finance - Introductory

Public Finance - Introductory Pigouvian tax - limits Pigouvian tax revenues must not go to people affected by externality Incentive to declare damage → Compensation of victims not needed to attain efficient production Identification of value of externality (MD function) Identification of who pollutes and how much Point is not whether Pigouvian tax is perfect, but whether it is better than the alternatives Public Finance - Introductory

Public Finance - Introductory Creation of markets - 1 Eternality due to lack of a market for it → state can create the market E.g. Trade of emission permits → market for non polluted air → air becomes economically valuable (=with a price) Aka “Cap and trade” State first sets (“caps”) the quantity of acceptable emissions (e.g. Z*), then auction off the right to pollute up to Z* (“trade”) P offered by best bidder is market equilibrium price P1 → efficient Those who do not want to pay P1 either reduce production or chooses cleaner technologies P1 = effluent fee Public Finance - Introductory

Diagram of market creation Public Finance - Introductory

Public Finance - Introductory Creation of markets - 2 Government can also distribute emission permits and let firm do the distribution in a secondary market Equilibrium not affected → firms sell rights only if value them less than P1 Distribution changes → gov. does not cash any revenues Main advantage is reduction of uncertainty about pollution level → this system works best when knowing the curves of the Pigouvian tax diagram is costly Markets for emission permits exist in USA and now in Europe as well Public Finance - Introductory

Attribution of property rights In certain conditions government can assign property rights on the resource that generates the externality → creating a market for externalities and then stay out of it → Coase Theorem (Coase, 1963): parties affected in an externality will always agree on a pareto-otpimal solution (Q*), regardless the prior attribution of property rights, provided that the transaction costs be 0 (or sufficiently low ) If firm owns river but MB of production is below MD (externality) → exchange opportunity → fishermen pay firm to produce up to Q* where MD=MB-MPC If fishermen own the river (opposite attribution of property rights) firms will pay to produce until MB=MPC, fishermen will demand MD → back to Q* Public Finance - Introductory

Public Finance - Introductory Coase theorem Public Finance - Introductory

Commentaries to Coase theorem No need for the state to intervene Within conditions where theorem applies, ind solve externalities through voluntary exchange Base for modern law and economics (e.g. extra trial negotiations and deals) 3 problems: Transaction costs 0 Identification of polluter and costs to enforce deal Few parties must be involved in externality and externality must be well defined (but experimental economics shows that range of deals is larger than expected; Mueller 2003) Government often increases transaction costs to be part of the deal (supply side) Public Finance - Introductory

Public Finance - Introductory Regulation Government establish rule not to pollute beyond a certain threshold → otherwise sanctions Kyoto protocol is regulation with weak sanctions Inefficient when involved firms are numerous and heterogeneous Firms X and Z have same fixed costs → their technology is potentially polluting → but face different demand curves Damage is d: with regulation, efficient production is where MB=MPC+d Firm with more elastic demand curve Z reduces Q more → made worse off by regulation to a larger degree than X → Not all firms that pollute in the same way pay the same amount e.g. Catalytic converters more useful in Paris traffic than in Rennes, but price is the same Firms use regulation strategically Public Finance - Introductory

Public Finance - Introductory Diagram of regulation Public Finance - Introductory

Public Finance - Introductory Which is best remedy? Choice of solution depends from circumstances Verify hypotheses that condition the efficiency of alternative solutions No best unique solution Economists generally prefer Pigouvian taxes, trade of emission permits and/or voluntary solutions Governments generally use taxes (revenues) or regulation to show that they are acting (visible action) Regulation has high costs → even if firm pollutes beyond thresholds sanctions are often not applied because if firms goes bankrupt unemployment is itself a cost → strategic use of regulation, which politicians use precisely because it is inefficient (e.g. Kyoto) Gradual move towards use of tradable emission permits Ideology makes finding solutions harder Public Finance - Introductory

Distributive consequences Who actually pays reduction of pollution? Evaluating distributional consequences is difficult Many parties involved, in different ways Empirical evidence Unemployment increases→ production costs increase, output goes down → environmental regulation responsible for lower growth rates of western economies since the 1970s (Mankiw, 2004) Prices go up→ consumers bear the costs of environmental friendly technologies (costs shifted onto final products) It seems that low income people face worst distributional consequences (e.g., having to buy a new car, with lower polluting emissions is a heavier financial sacrifice for low income families) Public Finance - Introductory

The impact of the Kyoto Protocol Other high income countries Eastern Europe Rest of the World Source William Nordhaus and Joseph Boyer, Warming the World: Economic Models of Global Warming, MIT Press, 2000 Public Finance - Introductory

Differences in polluting emissions Efficient policy: curve where costs and benefits of reduction of emissions are balanced Public Finance - Introductory

Differences in energy and primary inputs prices Public Finance - Introductory