Today: The fundamentals of externality theory Externalities Today: The fundamentals of externality theory

Externalities Markets are well functioning for most private goods Many buyers and sellers Little or no market power by anybody Example: When demand shifts right for a good, new equilibrium will have higher price and quantity Some markets do not have good mechanisms to account for everything in a market Example: Talking on a cell phone in an airplane

Externalities Externalities are effects that are not incorporated into market quantities and prices R/G (p.73) define an externality as “an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism” When markets have externalities, they are typically not efficient This is the topic of Chapter 5

Public good versus externality Although public goods are often looked at as goods with externalities, we study the two topics separately Know which analysis applies when you solve a problem

Negative externalities Some examples of negative externalities Air pollution Water pollution Sometimes you do not even think about polluting the water: Washing a car in your driveway Noise pollution Highway congestion Standing at a concert or sporting event

Positive externalities Some externalities are benefits Planting flowers in your front lawn Scientific research Vaccination Prevents others from getting a disease from you Exercise? Yes, if it leads to lower health care insurance premiums for others More on the private health care market in Chapter 9

More externalities: Benefit or cost? Christmas decorations Enjoyment or nuisance? A fan blowing in a warm office building Cooling breeze or blowing your important papers? Use of perfume or cologne Nice smell or allergen?

A simple example with externalities Suppose private MC equals quantity MPC = Q Let demand be denoted by P = 100 – Q Let marginal damage be $10 per unit

A simple example with externalities MSC = Q + 10 MPC = Q marginal damage per unit of $10 P = 100 – Q Translate equations and external cost to our graphical example

A simple example: Private equilibrium MPC = Q P = 100 – Q Inefficient equilibrium w/o controls: Set Q = 100 – Q  Q = 50 (quantity F)

A simple example: Optimal equilibrium MSC = Q + 10 P = 100 – Q Socially optimal quantity Q + 10 = 100 – Q  Q = 45 (quantity E)

An algebraic example: Price MSC = Q + 10 MPC = Q Price B = 55 marginal damage per unit of $10 Price C = 50 P = 100 – Q Recall E = 45 and F = 50 Inefficient equilibrium, P = Q  P = 50 Socially optimal quantity, P = Q + 10  P = 55

The externality problem With externalities, quantity produced is typically not optimal Finding optimal quantity when marginal damage is not constant Deadweight loss of inefficient production

Next… A more general analysis of externalities External cost per unit does not have to be constant

Graphical analysis of externalities MSC = MPC + MD $ 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

Graphical analysis of externalities Producer surplus lost going from Q1 to Q*

Graphical analysis of externalities Consumer surplus gained going from Q1 to Q*

Graphical analysis of externalities Net social gain going from Q1 to Q*

Graphical analysis of externalities This is also the deadweight loss (or excess burden) when Q1 is produced

Pollution Pollution is one of the biggest negative externalities around Multiple steps needed to try to find optimal amount of pollution Which pollutants actually do damage? Are there pollutants that indirectly cause damage? Example: CFCs on the ozone layer How do we value the damage done? Very difficult to do, due to lack of markets

Pollution and empirical studies Empirical studies have been done to try to determine the damages caused by pollution Remember from Chapter 2 that we need to use events that prevent bias

Pollution and empirical studies Chay and Greenstone (2003, 2005) Pollution on health 1 percent reduction in total suspended particulates resulted in a 0.35 percent reduction in infant mortality rate Pollution on housing prices Improved air quality between 1970 and 1980 in pollution-regulated cities led to property value increases of $45 billion

The externalities of smoking Increased health care costs Affects others through increased health care insurance premiums Lower workplace productivity due to smoking Lowers non-smoker wages also if firms cannot discriminate against smokers Increased fires Additional fire fighting cost on society The death benefit: A positive externality Secondhand smoke

The externalities of smoking All together, the externalities due to smoking lead to a net cost on society Empirical estimates lead to a total cost that is probably somewhere between $0.50-$1.50 per pack Estimates can vary depending on factors such as discount rate, assumptions in a model, and value of life Current cigarette taxes in the US average about $2 per pack

Why don’t we just negotiate? Negotiation is typically costly Remember, time is worth something Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

Coase theorem The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur People can negotiate costlessly The right can be purchased and sold Property rights Given the above conditions, efficient solutions can be negotiated Ronald Coase

Coase theorem Notice that the Coase theorem addresses efficiency To get to efficiency, the quantity of most goods and services produced is still positive Example: It is not efficient to get rid of all pollution If all pollution was gone, we could not live (since we exhale CO2)

Bargaining and the Coase Theorem MB exceeds MPC in this range  Production will be Q1 without negotiation MSC = MPC + MD $ MPC h d g c MD MB Q* Q1 Q per year

Bargaining and the Coase Theorem MSC exceeds MB here  With costless bargaining, consumers will pay to reduce production from Q1 to Q* MSC = MPC + MD $ MPC h d g c MD MB Q* Q1 Q per year

Other private responses to externalities Mergers When negative externalities only affect other firms, two firms can merge to internalize the externalities Social convention Social pressure to be nice can lower the amount of certain negative externalities

Public responses to externalities Four public responses Taxes Also known as emissions fee in markets with pollution Subsidies Command-and-control Government dictates standards without regard to cost Cap-and-trade policies Also known as a permit system

Taxes With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss Quantity is below the optimal amount with taxes With negative externalities, taxes can improve efficiency The optimal tax is known as the Pigouvian tax Pigouvian tax equals marginal damage at the efficient output Increased Pigouvian taxes can also lead to lower income taxes without sacrificing overall tax revenue Double dividend hypothesis (More in Chapter 15)

Pigouvian taxes in action 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

Emissions fee One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output This kind of tax is known as an emissions fee

Emissions fee in action $ MC of abatement f* Axes and labels 1st click – MSB 2nd click – MC 3rd click – dashed line and e* 4th click – f* and brown horizontal line MSB of abatement e* Abatement quantity

Subsidies An alternative to taxes is providing a subsidy to each firm for every unit that it abates Problems with subsidies: Efficient outcome only with a fixed number of firms Increased profits of firms in the industry will encourage new entrants into the industry Positive economic profits if new entry is not allowed Revenue is needed to provide subsidies Taxing income reduces inefficiencies Ethical issues: Who has the right to pollute?

Subsidies in action MSC = MPC + MD $ (MPC + cd) MPC Pigouvian subsidy 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

Command-and-control pollution reduction Two firms Each would pollute 90 units if there are no pollution controls Suppose each firm was forced to reduce pollution by 50 units Known as uniform pollution reduction Usually not efficient

Uniform pollution reductions MC is for abatement on these graphs Total abatement costs are in red for each firm MCH $ $ MCB 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 50 75 90 Bart’s pollution reduction 25 50 75 90 Homer’s pollution reduction

Inefficiencies of uniform reductions Notice that MC of Homer’s last unit of abatement is higher than Bart’s $ $

Inefficiencies of uniform reductions Notice that MC of Homer’s last unit of abatement is higher than Bart’s  D’oh $ $

Inefficiencies of uniform reductions Overall abatement costs can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit $ $

Command-and-control regulation Command-and-control regulations can take many forms Uniform reductions Percentage reductions Technology standards Each firm must use a certain type of technology This method may work best when emissions cannot be monitored easily Performance standards Government sets emissions goal for each polluter Firm can use any technology it wants Less expensive than technology standards

Lowering abatement costs Going from command-and-control requirements to emissions fees can lower overall abatement costs Marginal cost of abatement of the last unit is equal for each firm with an emissions fee

Emissions fees MC is for abatement on these graphs 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

Cap-and-trade policies Policy in which a permit is needed for each unit of pollution emitted Permits can be traded Policy is efficient if Bargaining costs are negligible Competitive permit markets exist Number of permits matches efficient pollution level Initial allocation of permits does not affect efficiency as long as the above criteria are met

Cap-and-trade Bart and Homer will negotiate until they agree on a $50 price for permits Suppose Bart starts with 80 permits and Homer starts with none (see points a and b) 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 Bart sells 65 permits Homer buys 65 permits

Emissions fee versus cap-and-trade Given certain conditions, we notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency $50 fee for each unit polluted (implicit fee under permits) Bart reduces pollution by 75 units Homer reduces pollution by 25 units

In what direction are we heading? Command-and-control policies often rely on states to enforce States do not always comply with these measures Fees and permits can often be controlled on the national level US policies have generally moved from command-and-control to taxes and permits Exceptions do still apply: Emissions hot spots

In a perfect world… …we would know everything with certainty The real world is not perfect How does this complicate our analysis?

The real world is more complicated We do not live in a world with perfect economic assumptions Complicating factors Inflation Cost changes Uncertainty Distributional effects

Inflation If emissions fees do not represent real prices, the amount of pollution will change as real price changes Cap-and-trade policies do not need inflation factored in, since quantity limits are used

Cost changes Suppose cost to abate decreases every year Optimal amount of abatement will increase each year If a new abatement technology is just being developed, future cost changes could be small or large Potential solution: Impose a hybrid system Permit market Offer a high tax for pollution emitted without a permit

Uncertainty Costs and benefits are typically not known with certainty With uncertainty, too much or too little pollution can be produced (relative to the efficient outcome) Two situations analyzed, with MC curve uncertain Inelastic MSB Elastic MSB

Inelastic MSB curve Marginal cost schedule could be as high as MC’ MC’ $ MC* Assume best guess of marginal cost schedule is MC* f* Permits are closer to efficient than fees in this case 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 with fees Too much pollution reduction with permits

Elastic MSB curve MC’ $ MC* f* Axes and labels 1st click – MSB 2nd click – MC* 3rd click – MC’ 4th click – f* Fees are closer to efficient than permits in this case MSB ef e’ e* Pollution reduction Too little pollution reduction with fees Too much pollution reduction with permits

Distributional effects Firms… Lose when they pay a tax Win when they are given permits Government can generate revenue… If a tax is imposed If permits are sold Double dividend hypothesis supports taxes or selling permits Political pressure may encourage permit giveaways

Distributional effects Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods Displacement concerns Job losses from environmental regulation: Does this increase income inequity? Who bears the cost of pollution control? Depends on who uses the good that has the pollution control Example: Cars that are 15 or more years old

Summary Externalities lead to inefficient production of many goods and services Costless negotiation can lead to efficient outcomes in the presence of externalities Not realistic in most markets There are many ways to implement government policies to improve efficiency

Wednesday Positive externalities An application of externalities Highway travel Problems related to externalities

What’s in your scrubber?