©2014 by McGraw-Hill Education. All Rights Reserved. EXTERNALITIES Chapter 5 ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. Externalities Externality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism A paper mill’s production of the carcinogen dioxin increases society’s health care costs; these costs to society are not included in the paper mill’s paper price However, when large numbers of suburbanites relocate to a city, society is affected, although the effect is captured through higher prices of city housing ©2014 by McGraw-Hill Education. All Rights Reserved.

The Nature of Externalities Privately-owned vs. commonly-owned resources A privately owned resource: its price reflects its value so used efficiently (MSC=MSB) A commonly-owned resource (air, oceans): price ($0) does not reflect its value so used inefficiently (MSC>MSB) Externalities can be produced by consumers & firms Externalities are reciprocal in nature Externalities can be positive or negative Public goods can be viewed as a special kind of externality ©2014 by McGraw-Hill Education. All Rights Reserved.

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 ©2014 by McGraw-Hill Education. All Rights Reserved.

What Pollutants Do Harm? Empirical Research on Pollution Effects on Health 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 Once pollutant identified: Must identify the activities that produce the pollutant Must identify the value of the damage done Must identify the costs of remedying the damage Empirical Evidence: The Effect of Air Pollution on Housing Values ©2014 by McGraw-Hill Education. All Rights Reserved.

Private Responses Bargaining and the Coase Theorem MSC = MPC + MD Supplier will ↓ Q1 to Q* if paid by Demander, who is willing to do so. Bargain possible over $ transferred. $ MPC h d g c Axes and labels 1st click – MB 2nd click – MPC, Q1 3rd click – MD 4t click – MSC, Q* MD MB Q* Q1 Q per year ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. The Coase Theorem Coase Theorem – Given: Low transaction costs Clear assignment of property rights An efficient solution to an externality problem can be achieved Assumptions necessary for Coase Theorem to work 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 ©2014 by McGraw-Hill Education. All Rights Reserved.

Other Private Solutions Mergers – way to internalize the externality The externality transmitter and recipient become one company. Social conventions/Morals For example: “Littering” is wrong. ©2014 by McGraw-Hill Education. All Rights Reserved.

Public Responses to Externalities - Taxes 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 ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. Public Responses to Externalities – Subsidies that pay polluter not to pollute MSC = MPC + MD $ (MPC + cd) MPC Pigouvian subsidy d k i f g j c h Axes and labels 1st click – MP shifts up to MPC + cd 2nd click – dashed lines fi, hj, and hf 3rd click = Pigouvian subsidy MD MB e Q* Q1 Q per year ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. Public Responses to Externalities- Emissions Fee: tax on each pollution unit $ f1 results in only e1 reduction f* results in e* reduction: the efficient level MC f1 Emissions fee f* Emissions fee Axes and labels 1st click – MSB 2nd click – MC 3rd click – dashed line and e* 4th click – f* and brown horizontal line MSB e* e1 Pollution reduction ©2014 by McGraw-Hill Education. All Rights Reserved.

Public Responses to Externalities- Uniform Pollution Reduction MCH Requiring each company to reduce pollution by 50 units is not cost effective. Better to have Bart reduce pollution by 100 units because he can do so at a lower cost. But is it fair??? b MCB axes and labels for both graphs 1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line 2nd click – 3rd click – dashed brown line and Bart’s dashed black line at 50 disappear 4th click – line at f = $50 wipes right 5th click – Bart’s tax payment 6th click – Homer’s tax payment 10 50 75 90 Bart’s pollution reduction 25 50 75 90 Homer’s pollution reduction ©2014 by McGraw-Hill Education. All Rights Reserved.

Emissions Fees achieve fairness and efficiency An Emissions Fee=$50 means Bart will reduce by 75 and Homer only by 25, but Homer pays larger tax. MCH Bart’s Tax Payment Homer’s Tax Payment MCB f = $50 axes and labels for both graphs 1st click – MCB and dashed vertical lines, MCH and dashed vertical black line 2nd click – horizontal dashed brown line and vertical dashed brown line 3rd click – dashed brown line and Bart’s dashed black line at 50 disappear 4th click – line at f = $50 wipes right 5th click – Bart’s tax payment 6th click – Homer’s tax payment f = $50 50 75 90 Bart’s pollution reduction 25 50 75 90 Homer’s pollution reduction ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. Public Responses to Externalities- Cap-and-Trade: Polluters must have a permit Bart: The cost of reducing pollution is less than market price of a permit, so sell permit. Homer: The cost of reducing pollution is greater than market price of a permit so buy permit. BOTH GAIN FROM TRADE MCH b MCB f = $50 axes and labels for both graphs 1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line 2nd click – 3rd click – dashed brown line and Bart’s dashed black line at 50 disappear 4th click – line at f = $50 wipes right 5th click – Bart’s tax payment 6th click – Homer’s tax payment f = $50 a 10 50 75 90 Bart’s pollution reduction 25 50 75 90 Homer’s pollution reduction ©2014 by McGraw-Hill Education. All Rights Reserved.

Emissions Fee v Cap-and-Trade Responsiveness to Inflation Responsiveness to Cost Changes Distributional Effects Responsiveness to Uncertainty of Costs of reducing pollution (cont on next slides) ©2014 by McGraw-Hill Education. All Rights Reserved.

Cap-and-Trade vs. Emissions Fee Inelastic MSB of pollution reduction MC’ $ MC* Cap/trade allows too much pollution Emissions Fee allows too little pollution C&T more efficient than Emissions Fee f* Axes and labels 1st click – MSB 2nd click – MC* 3rd click – MC’ 4th click – f* MSB ef e’ e* Pollution reduction Too little pollution reduction Too much pollution reduction ©2014 by McGraw-Hill Education. All Rights Reserved.

Cap-and-Trade v Emissions Fee Elastic MSB of pollution reduction MC’ $ MC* Cap/trade allows too much pollution Emissions Fee allows too little pollution Emissions Fee more efficient than C&T f* Axes and labels 1st click – MSB 2nd click – MC* 3rd click – MC’ 4th click – f* MSB ef e’ e* Pollution reduction Too little pollution reduction Too much pollution reduction ©2014 by McGraw-Hill Education. All Rights Reserved.

Command-and-Control Regulation Command-and-control regulations require a given amount of pollution reduction with limited or no flexibility on how to achieve reduction Technology requirements Performance requirements Is command-and-control ever better? Hot spots: Areas with relatively high concentrations of emissions ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. The U.S. Response Clean Air Act 1970 amendments Command-and-control in the 70s How well did it work? Policy Perspective: Cap-and-Trade for Sulfur Dioxide ©2014 by McGraw-Hill Education. All Rights Reserved.

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 ©2014 by McGraw-Hill Education. All Rights Reserved.

Positive Externalities $ MC Axes and labels 1st click – MPB 2nd click – MC and R* 3rd click – MEB 4th click MSB and R1 MSB = MPB + MEB MPB MEB R1 R* Research per year ©2014 by McGraw-Hill Education. All Rights Reserved.

Positive Externalities: A Cautionary Note on Requests for Subsidies Subsidies must come from taxpayers Market does not always fail: the fact that an activity is beneficial does not always mean that a subsidy is required for efficiency Policy Perspective: Owner-Occupied Housing ©2014 by McGraw-Hill Education. All Rights Reserved.

©2014 by McGraw-Hill Education. All Rights Reserved. Chapter 5 Summary Externalities occurs when the activity of one person or firm positively or negatively affects another person/group/firm outside the market mechanism An inefficient allocation of resources results because the market price does not reflect the external costs or benefits The Coase Theorem indicates that private solutions through bargaining can achieve the efficient outcome under certain circumstances Public solutions to externalities designed to achieve efficiency include taxes/subsidies; emissions fees; and command-and-control regulations A market-based, cost-effective, public solution is cap-and-trade where pollution permits – the right to pollute – are traded ©2014 by McGraw-Hill Education. All Rights Reserved.