Chapter 10: Externalities Econ 2100 EXTERNALITIES

What works in the public sector? Course Outline What; why; who? How markets work? Are markets good? How firms behave? Why are you hired? What works in the public sector? Chapters 10-12

Why Create Inefficiencies Chapter 10 Outline Externalities Definition Why Create Inefficiencies Public Solutions Private Solutions EXTERNALITIES

Introduction One of the principles from Chapter 1: Markets are usually a good way to organize economy activity. In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. One type of market failure: externality, the uncompensated impact of one person’s actions on the well-being of a bystander. Externalities can be negative or positive, depending on whether impact on bystander is adverse or beneficial. EXTERNALITIES 3

Introduction Self-interested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient. Another principle from Chapter 1: Governments can sometimes improve market outcomes. In presence of externalities, public policy can improve efficiency. EXTERNALITIES 4

Examples of Negative Externalities Air pollution from a factory The neighbor’s barking dog Late-night stereo blasting from the dorm room next to yours Noise pollution from construction projects Health risk to others from second-hand smoke Talking on cell phone while driving makes the roads less safe for others EXTERNALITIES 5

Why Create Inefficiencies Chapter 10 Outline Externalities Definition Why Create Inefficiencies Public Solutions Private Solutions EXTERNALITIES

Recap of Welfare Economics 1 2 3 4 5 10 20 30 Q (gallons) P $ The market for gasoline The market eq’m maximizes consumer + producer surplus. Supply curve shows private cost, the costs directly incurred by sellers. $2.50 25 Demand curve shows private value, the value to buyers (the prices they are willing to pay). For many students, the concepts are easier to learn in the context of a specific example with numerical values. Note that maximizing consumer + producer surplus is NOT the same as maximizing TOTAL surplus when the trades impose external costs (or benefits) on bystanders. EXTERNALITIES 7

Analysis of a Negative Externality 1 2 3 4 5 10 20 30 Q (gallons) P $ The market for gasoline Social cost = private + external cost external cost Supply (private cost) External cost = value of the negative impact on bystanders = $1 per gallon (value of harm from smog, greenhouse gases) EXTERNALITIES 8

Analysis of a Negative Externality 1 2 3 4 5 10 20 30 Q (gallons) P $ The market for gasoline The socially optimal quantity is 20 gallons. Social cost S At any Q < 20, value of additional gas exceeds social cost. At any Q > 20, social cost of the last gallon is greater than its value to society. D “At any Q < 20, value of additional gas exceeds social cost.” For example, at Q = 10, the value to buyers of an additional gallon equals $4, while the social cost is only $2. Therefore, total surplus (society’s well-being) would increase with a larger quantity of gas. “At any Q > 20, social cost of the last gallon is greater than its value.” For example, at Q = 25 - the market equilibrium - the last gallon cost $3.50 (including the external cost) but the value of it to buyers was only $2.50. Hence, total surplus would be higher if Q were lower. Only at Q = 20 is society’s welfare maximized. 25 EXTERNALITIES 9

Analysis of a Negative Externality 1 2 3 4 5 10 20 30 Q (gallons) P $ The market for gasoline Market eq’m (Q = 25) is greater than social optimum (Q = 20). Social cost S One solution: tax sellers $1/gallon, would shift S curve up $1. D 25 EXTERNALITIES 10

“Internalizing the Externality” Internalizing the externality: altering incentives so that people take account of the external effects of their actions In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs. When market participants must pay social costs, market eq’m = social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.) The parenthetical remark at the bottom of the slide follows from a lesson in Chapter 6: tax incidence and the allocation of resources is the same whether a tax is imposed on buyers or sellers. EXTERNALITIES 11

Examples of Positive Externalities Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you. R&D creates knowledge others can use. People going to college raise the population’s education level, which reduces crime and improves government. The textbook explains that a better educated population makes more informed voting decisions and elects higher quality lawmakers and leaders. Thank you for not contaminating the fruit supply! EXTERNALITIES 12

Positive Externalities In the presence of a positive externality, the social value of a good includes private value – the direct value to buyers external benefit – the value of the positive impact on bystanders The socially optimal Q maximizes welfare: At any lower Q, the social value of additional units exceeds their cost. At any higher Q, the cost of the last unit exceeds its social value. Since you have just walked students through the analysis of a negative externality, let’s see if they can do the analysis of a positive externality. This slide provides the introductory information they will need to do the analysis. The following slide provides the exercise. EXTERNALITIES 13

A C T I V E L E A R N I N G 1 Analysis of a positive externality 10 20 30 40 50 P Q $ The market for flu shots External benefit = $10/shot Draw the social value curve. Find the socially optimal Q. What policy would internalize this externality? S D 14

A C T I V E L E A R N I N G 1 Answers Socially optimal Q = 25 shots. To internalize the externality, use subsidy = $10/shot. 10 20 30 40 50 P Q $ The market for flu shots external benefit S 25 Social value = private value + $10 external benefit D 15

Effects of Externalities: Summary If negative externality market quantity larger than socially desirable If positive externality market quantity smaller than socially desirable To remedy the problem, “internalize the externality” tax goods with negative externalities subsidize goods with positive externalities Effects of Externalities: Summary EXTERNALITIES 16

Why Create Inefficiencies Chapter 10 Outline Externalities Definition Why Create Inefficiencies Public Solutions Private Solutions EXTERNALITIES

Public Policies Toward Externalities Two approaches: Command-and-control policies regulate behavior directly. Examples: limits on quantity of pollution emitted requirements that firms adopt a particular technology to reduce emissions Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own. Examples: corrective taxes and subsidies tradable pollution permits EXTERNALITIES 18

Corrective Taxes & Subsidies Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality Also called Pigouvian taxes after Arthur Pigou (1877-1959). The ideal corrective tax = external cost For activities with positive externalities, ideal corrective subsidy = external benefit Greg Mankiw’s blog (http://gregmankiw.blogspot.com) has semi-regular posts on Pigou taxes, some of which are worth using in class (either as assigned or recommended reading or fodder for class discussion). On the main page, look under “A Few Timeless Posts” for “the Pigou Club Manifesto.” In the textbook, a new “In the News” box includes Mankiw’s 2007 New York Times piece arguing for carbon taxes to fight global warming. The piece contrasts corrective taxes with regulations and with cap-and-trade systems. EXTERNALITIES 19

Corrective Taxes & Subsidies Other taxes and subsidies distort incentives and move economy away from the social optimum. Corrective taxes & subsidies align private incentives with society’s interests make private decision-makers take into account the external costs and benefits of their actions move economy toward a more efficient allocation of resources. EXTERNALITIES 20

Corrective Taxes vs. Regulations Different firms have different costs of pollution abatement. Efficient outcome: Firms with the lowest abatement costs reduce pollution the most. A pollution tax is efficient: Firms with low abatement costs will reduce pollution to reduce their tax burden. Firms with high abatement costs have greater willingness to pay tax. In contrast, a regulation requiring all firms to reduce pollution by a specific amount not efficient – costs higher. Some of your students may not know that pollution “abatement” simply means taking measures to cut pollution. Regarding the last bullet point: If all firms must reduce emissions by a fixed amount (or fixed percentage), then abatement is NOT concentrated among firms with the lowest abatement costs, and so the total cost of abatement will be higher. EXTERNALITIES 21

Corrective Taxes vs. Regulations Corrective taxes are better for the environment: The corrective tax gives firms incentive to continue reducing pollution as long as the cost of doing so is less than the tax. If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. In contrast, firms have no incentive for further reduction beyond the level specified in a regulation. EXTERNALITIES 22

A C T I V E L E A R N I N G 2 A. Regulating lower SO2 emissions Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month, total emissions = 80 tons/month. Goal: Reduce SO2 emissions 25%, to 60 tons/month Cost of reducing emissions: $100/ton for Acme, $200/ton for USE Policy option 1: Regulation Every firm must cut its emissions 25% (10 tons). Your task: Compute the cost to each firm and total cost of achieving goal using this policy. This first exercise is simple. 23

A C T I V E L E A R N I N G 2 A. Answers Each firm must reduce emissions by 10 tons. Cost of reducing emissions: $100/ton for Acme, $200/ton for USE. Compute cost of achieving goal with this policy: Cost to Acme: (10 tons) x ($100/ton) = $1000 Cost to USE: (10 tons) x ($200/ton) = $2000 Total cost of achieving goal = $3000 24

A C T I V E L E A R N I N G 2 B. Tradable pollution permits Initially, Acme and USE each emit 40 tons SO2/month. Goal: reduce SO2 emissions to 60 tons/month total. Policy option 2: Tradable pollution permits Issue 60 permits, each allows one ton SO2 emissions. Give 30 permits to each firm. Establish market for trading permits. Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons. Your task: Compute cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each. 25

A C T I V E L E A R N I N G 2 B. Answers Goal: reduce emissions from 80 to 60 tons Cost of reducing emissions: $100/ton for Acme, $200/ton for USE. Compute cost of achieving goal: Acme sells 10 permits to USE for $150 each, gets $1500 uses 20 permits, emits 20 tons SO2 spends $2000 to reduce emissions by 20 tons net cost to Acme: $2000 - $1500 = $500 continued… 26

A C T I V E L E A R N I N G 2 B. Answers, continued Goal: reduce emissions from 80 to 60 tons Cost of reducing emissions: $100/ton for Acme, $200/ton for USE. USE buys 10 permits from Acme, spends $1500 uses these 10 plus original 30 permits, emits 40 tons spends nothing on abatement net cost to USE = $1500 Total cost of achieving goal = $500 + $1500 = $2000 Using tradable permits, goal is achieved at lower total cost and lower cost to each firm than using regulation. 27

Tradable Pollution Permits A tradable pollution permits system reduces pollution at lower cost than regulation. Firms with low cost of reducing pollution sell whatever permits they can. Firms with high cost of reducing pollution buy permits. Result: Pollution reduction is concentrated among those firms with lowest costs. EXTERNALITIES 28

Objections to the Economic Analysis of Pollution Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment. However, people face tradeoffs. The value of clean air & water must be compared to their cost. The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment. EXTERNALITIES 29

Why Create Inefficiencies Chapter 10 Outline Externalities Definition Why Create Inefficiencies Public Solutions Private Solutions EXTERNALITIES

Private Solutions to Externalities Types of private solutions: Moral codes and social sanctions, e.g., the “Golden Rule” Charities, e.g., the Sierra Club Contracts between market participants and the affected bystanders The textbook gives a nice example of a contract in which a beekeeper and apple orchard manager each agree to boost production, as each producer’s activity confers an external benefit on the other. EXTERNALITIES 31

Private Solutions to Externalities The Coase theorem: If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own. See Spot bark. See Text for description of Dick, Jane and Spot as an illustration of the Coase theorem EXTERNALITIES 32

Why Private Solutions Do Not Always Work 1. Transaction costs: The costs parties incur in the process of agreeing to and following through on a bargain. These costs may make it impossible to reach a mutually beneficial agreement. 2. Stubbornness: Even if a beneficial agreement is possible, each party may hold out for a better deal. 3. Coordination problems: If # of parties is very large, coordinating them may be costly, difficult, or impossible. An example for each bullet point in the context of the brainstorming activity on the previous slide: 1. Transactions costs: Suppose lawyers charge $60,000 to represent the two parties and draw up a contract that is enforceable in a court. Then it will be impossible for both parties to come to a mutually beneficial agreement, and the factory will continue polluting the lake. 2. Stubbornness: Suppose the town offers $55,000 to the factory. The factory would be better off taking this offer than nothing at all, but the factory may counter with a $95,000 price. Both parties hold out in hopes that the other will cede, but neither does. The factory keeps polluting, and the residents of Green Valley continue to be denied the joy of swimming in the lake. 3. Coordination problems: Getting all 1000 residents to agree to a specific offer will be difficult. Moreover, each resident has an incentive to free-ride off his neighbors. EXTERNALITIES 33

Test Bank Questions EXTERNALITIES

Questions 6 & 10 6. An externality is the impact of 10. A cost imposed on someone who is neither the consumer nor the producer is called a a. society's decisions on the well-being of society. b. a person's actions on that person's well-being. c. one person's actions on the well-being of a bystander. d. society's decisions on the poorest person in the society. a. corrective tax. b. command and control policy. c. positive externality. d. negative externality. EXTERNALITIES

Questions 15 & 17 15. Which of the following statements about a well-maintained yard best conveys the general nature of the externality? 17. All externalities a. A well-maintained yard conveys a positive externality because it increases the home's market value. b. A well-maintained yard conveys a negative externality because it increases the property tax liability of the owner. c. A well-maintained yard conveys a positive externality because it increases the value of adjacent properties in the neighborhood. d. A well-maintained yard cannot provide any type of externality. a. cause markets to fail to allocate resources efficiently. b. cause equilibrium prices to be too high. c. benefit producers at the expense of consumers. d. cause equilibrium prices to be too low. EXTERNALITIES

Questions 15 & 16 15. Refer to Figure 10-1. This graph represents the tobacco industry. Without any government intervention, the equilibrium price and quantity are a. $1.90 and 38 units, respectively. b. $1.80 and 35 units, respectively. c. $1.60 and 42 units, respectively. d. $1.35 and 58 units, respectively. 16. Refer to Figure 10-1. This graph represents the tobacco industry. The socially optimal price and quantity are a. $1.90 and 38 units, respectively. b. $1.80 and 35 units, respectively. c. $1.60 and 42 units, respectively. d. $1.35 and 58 units, respectively. EXTERNALITIES

Question 3 3. Refer to Figure 10-5. Which of the following statements is correct? a. To induce firms to internalize the externality in this market, the government should impose a tax measured by P2 - P0. b. To induce firms to internalize the externality in this market, the government should offer a subsidy measured by P2 - P0. c. To induce firms to internalize the externality in this market, the government should impose a tax measured by P2 - P1. d. There is no externality in this market. EXTERNALITIES

Questions 10 & 16 10. A command-and-control policy is another term for a 16. If the government were to impose a fine of $1,000 for each unit of air-pollution released by a steel mill, the policy would be considered a. pollution permit. b. government regulation. c. corrective tax. d. Both a and b are correct. a. a subsidy. b. a regulation. c. a corrective tax. d. an application of the Coase theorem. EXTERNALITIES

Questions 67 & 71 67. Once tradable pollution permits have been allocated to firms, 71. Which of the following is an advantage of tradable pollution permits? a. the government controls the price of permits. b. firms that can reduce pollution only at high cost will be willing to pay the most for the pollution permits. c. the value of pollution-saving technology will be lower than the market value of a pollution permit. d. the Coase theorem is no longer applicable as a solution to reducing pollution. a. Each firm is allowed to pollute exactly the same amount. b. Revenue from the sale of permits is greater than revenue from a corrective tax. c. The initial allocation of permits to firms does not affect the efficiency of the market. d. Firms will engage in joint research efforts to reduce pollution. EXTERNALITIES

Questions 1 & 4 4. When externalities cause markets to be inefficient, 1. Externalities can be corrected by each of the following except 4. When externalities cause markets to be inefficient, a. government action is always needed to solve the problem. b. private solutions can be developed to solve the problem. c. given enough time, externalities can be solved through normal market adjustments. d. there is no way to eliminate the problem of externalities in a market. a. self-interest. b. moral codes and social sanctions. c. charity. d. normal market adjustments. EXTERNALITIES

Questions 8 & 16 8. Private contracts between parties with mutual interests 16. One reason that private solutions to externalities do not always work is that a. will reduce the well-being of society. b. will lead to market outcomes in which the public interest is sacrificed for personal gain. c. can solve some inefficiencies associated with positive externalities. d. will create negative externalities. a. government intervention negates the benefits of positive externalities. b. some people benefit from externalities. c. interested parties incur costs in the bargaining process. d. charities are not well organized. EXTERNALITIES