EXTERNALITIES Chapter 5

Externalities Externality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism => unwanted effects Paper production as by-product carcinogen dioxin => increases society’s health care costs => they are not included in the paper price Why not? Production => positive Consumption=> positive/negative

The Nature of Externalities Privately-owned vs. commonly-owned resources A privately owned resource: its price reflects its value so used efficiently (Marg Social Cost= Marg Private Cost= Marg Social Benefit= Marginal Private Benefit = ?? Remember: eq comp mkt => marg cost = marg utility=price A commonly-owned resource (air, oceans): price ($0) does not reflect its value so used inefficiently (MSC>MSB) Similar case with externalities: Production with negative externalities (pollution) Marg private cost? Marg social cost? Difference?

Public goods as a special kind of externality Externality itself is a public good Electrocuting mosquitos R&D fall out from a private firm

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

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

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

The Coase Theorem Coase Theorem – Given: Low transaction costs Clear assignment of property rights An efficient solution to an externality problem can be achieved: with or without Gov’t? Is it relevant to reach an equilibrium to whom property right are assigned? Is it relevant for final distribution to whom property right are assigned?

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

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

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

Pros and cons P. T. on output Knowledge (graphic is known!) Indirect effect (estimated) No personalisation No incentives

Public Responses to Externalities- Emissions Fee: tax on each pollution unit $ MC 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* Pollution reduction

Pigouvian tax on each unit of emission instead of output Is f* a marginal tax? Producer decide between paying MC and paying f* Incentive Personalised (?)

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

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

Marginal cost of reducing pollution across all polluters Equal or different? Equal to what in equilibrium? Is it cost effective? Why?

Public Responses to Externalities- Cap (80)-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

Total pollution 180 Total cap is 80 Permit issued by gov’t =80 To semplify the chart . 80 permits to Bart (tradable => do initial distribution matter?)

Emissions Fee v Cap-and-Trade Responsiveness to Inflation Nominal and real Adjustment Responsiveness to Cost Changes Increasing marginal cost =>pollution ?

Command-and-Control Regulation Command-and-control regulations require a given amount of pollution reduction: Technology requirements Performance requirements Flexibility? Cost effective? Is command-and-control ever better? - Monitoring? Hot spots: Areas with relatively high concentrations of emissions

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