Externalities

Plan Definition of externalities and examples Responses to externalities private mergers (Coase Theorem) social conventions public (government) regulation taxes creation of markets *All the rest of the details appear in the syllabus *Higher level course: 1. your responsibility to adequately allocate the time for studying (hw, etc.) 2. have to prepare for the job market articulate your ideas, be clear and precise; work in a team -> class presentations. *Before going into details, understand the title...

Externalities Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so. Examples: sea pollution, noise, etc. Externalities are reciprocal in nature.

SMC = PMC + MD Price of steel S=PMC The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q1. The yellow triangle is the consumer and producer surplus at Q1. The socially optimal level of production is at Q2, the intersection of SMC and SMB. The steel firm overproduces from society’s viewpoint. p2 This framework does not capture the harm done to the fishery, however. The marginal damage curve (MD) represents the fishery’s harm per unit. The red triangle is the deadweight loss from the private production level. The social marginal cost is the sum of PMC and MD, and represents the cost to society. p1 MD D = PMB = SMB Q2 Q1 QSTEEL Figure 2 Presence of Externalities May lead to Inefficiency Negative Production Externalities

Private Responses Role of social conventions to be stable, they must be efficiently enforced

Coase’s Insight: Private Response to Externalities Example. Doctor and Confectioner operate in the neighboring buildings. The machinery of the confectioner makes the noise that prevents the doctor to examine patients. The value of the damage from the noise to the doctor is 60. The value of continuing to operate the business for the Confectioner is 40.

Outcomes under two legal regimes

Coase’s Assumptions Low (no) bargaining costs There is a reliable estimate of the costs and benefits to each side and this is a common knowledge among the negotiating parties

Government Responses Regulation: simple, but may be inefficient Taxes and subsidies Creating a market

Pigouvian Taxes In the presence of externality a tax/subsidy can be imposed, so that the party generating the externality will “internalize” the effect he produces on the other party. Advantage: it does not require negotiation between the parties, so it is applicable in the cases, in which negotiation is impossible or is very expensive

The socially optimal level of production, Q2, then maximizes profits. SMC=PMC+MD Price of steel S=PMC+tax S=PMC The socially optimal level of production, Q2, then maximizes profits. p2 The steel firm initially produces at Q1, the intersection of PMC and PMB. Imposing a tax equal to the MD shifts the PMC curve such that it equals SMC. Imposing a tax shifts the PMC curve upward and reduces steel production. p1 D = PMB = SMB Q2 Q1 QSTEEL Figure 7 Pigouvian Tax

Pigouvian Tax may lead to inefficiency Recall the Example. Doctor and Confectioner operate in the neighboring buildings. The machinery of the confectioner makes the noise that prevents the doctor to examine patients. The value of the damage from the noise to the doctor is 60. Doctor can rearrange his office to eliminate the effect of the noise at a cost of 18. The value of continuing to operate the business for the Confectioner is 40. The two can not negotiate

Outcomes under two legal regimes

Pigouvian tax may enhance efficiency If, instead, the confectioner could install the soundproofing device at a low cost (say,10), the presence of tax would have enhanced efficiency. In general, if negotiation is impractical, taxing negative externality can lead to an efficient outcome, if the party generating the externality has a cheaper way to eliminate it than the “victim”.

Taxing pollution may be better than direct regulation Both firms use technological process A. City council wants to reduce the pollution by half. It can require each firm use C.

Taxing pollution may be better than direct regulation Alternatively, they can impose a tax T per ton of emitted smoke. What is the appropriate level of T?

Costs of regulation and taxation Regulation that requires to cut the pollution for both firms by 1/2 (use process C) costs 600-100=500 for firm X and 140-50=90 for firm Y, total cost being 590 Taxation will lead firm X to adopt process B, which increases the cost by 90 and firm Y to adopt process D, increasing its cost by 180. Total cost is 270<590.