McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 5 Externalities

5-2 Externalities  Externality An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism  Increase in Social Costs  Pricing Effects Suburban to Urban Migration  Rent on Condos Increase Externality?

5-3 The Nature of Externalities  Privately vs. Public Ownership Bart Operates a Polluting Factory on a Stream Lisa Fishes on the Stream Who owns the stream?  Does Bart have the right to operate a polluting factory on the stream?

5-4 The Nature of Externalities  Can Consumers Produce Externalities?

5-5 The Nature of Externalities  Examples of Positive Externalities?

5-6 What Pollutants Do Harm?  Empirical Evidence: What is the Effect of Air Pollution on Health? How would you conduct a study?

5-7 What Pollutants Do Harm?  What Activities Produce Pollutants? How Much?  What is the Value of the Damage Done? Buy and Sell Pollution?  Empirical Evidence: The Effect of Air Pollution on Housing Values

5-8 Implications for Income Distribution  Who Benefits? Poor are Disproportionately Affected by Air Pollution  Who Bears the Cost?

5-9 The Nature of Externalities-Graphical Analysis  Factory Pollutes Stream Perfect Price Discriminator  Fisherman with Sick Fish Marginal Damage or Social Cost

5-10 The Nature of Externalities-Graphical Analysis Q per year $ MB 0 MPC Q1Q1 Actual output Marginal Benefit Marginal Private Cost

5-11 The Nature of Externalities-Graphical Analysis  Suppose we have the following example: MD= 25Q MPC=50+40Q Demand: P=400-5Q Find Quantity of Widgets in Equilibrium Find Social Efficient Quantity of Widgets  MSC Find Gain to Society  Calculate Loss to Factory and Gain to Fisher

5-12 Pollution Reductions  We see postive effects of reducing negative externalities such as pollution.  How do we get there? Private Options Public Options

5-13 The Coase Theorem  Coase Theorem Provided that transaction costs are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights

5-14 Bargaining and the Coase Theorem Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d g h

5-15 The Coase Theorem  Coase Theorem Provided that transaction costs are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights  Assumptions: Low Bargaining Costs Ability to Identify the Source of Damage  US Air Pollution?

5-16 Other Private Solutions  Mergers  Social Conventions Socially Acceptable

5-17 Public Response to Externalities  Taxes and Subsidies  Mandatory Pollution Reductions Command and Control  Emissions Fees  Cap and Trade

5-18 Public Responses to Externalities – Taxes Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* d (MPC + cd)

5-19 Public Responses to Externalities – Taxes  Calculate Tax Revenue  Calculate Producer Surplus  Calculate Producer’s Loss  Calculate Gain to Outside Firm

5-20 Pigouvian Tax Revenue  What should be done with this tax revenue?

5-21 Public Responses to Externalities - Subsidies Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d

5-22 Public Responses to Externalities – Taxes  Calculate Subsidy  Calculate Producer Surplus  Calculate Producer’s Loss  Calculate Gain to Outside Firm

5-23 Pollution Reductions  We see postive effects of reducing pollution.  How do we get there? Public Options Private Options

5-24 Uniform Pollution Reductions  Consider Two Firms (B and H) Each Starts Out Pollution 90 Units Marginal Cost of Reducing Pollution  MC B = 2/3P  MC H = 2P  You Want to Reduce Pollution by 100 Units Consider Uniform Pollution Reductions  Each Firm Reduces 50 Units  What would each firm pay to reduce these units?

5-25 Uniform Pollution Reductions Bart’s pollution reduction Homer’s pollution reduction MC B MC H

5-26 Command-and-Control Regulation  Incentive-based regulations  Command-and-Control Regulations

5-27 Command-and-Control Regulation  Technology Standard  Performance Standard  Costs 7% to 22 Times More Expensive (ERP 2003) Corporate Average Fuel Economy (CAFE) 27.5 MPG Cars 20.7 MPG Light Trucks Gas Tax $700 Billion More for Raising CAFE (CBO 2004c)

5-28 The U.S. Response  Clean Air Act 1970 Amendments Environmental Protection Agency (EPA)  Command-and-Control All 6 Air Pollutants Fell  Causation? Contrary Studies  Air Pollution on Decline Before 1970  Air Pollution Lower Due to EPA

5-29 Emissions Fee 0 Pollution reduction MSB MC e* $

5-30 Uniform Pollution Reductions Bart’s pollution reduction Homer’s pollution reduction MC B MC H 25 f = $50

5-31 Uniform Pollution Reductions  Fair?

5-32 Uniform Pollution Reductions  Cost Effective MC(P 1 )=MC(P 2 )  Suppose not. MC(P 1 )≠MC(P 2 )  Without Loss of Generality Suppose: MC(P 1 )>MC(P 2 ) Cost of reducing firm 1’s last unit of pollution was more expensive than firm 2’s. There is a smaller cost to society if firm 2 reduces one more unit and firm 1 reduces one less unit.

5-33 Cap-and-Trade  Goal: Decrease Pollution by 100 Units  80 Permits Issued  Suppose Bart Gets All 80

5-34 Cap-and-Trade  Bart’s Responsibility?  Homer’s?

5-35 Cap-and-Trade Bart’s pollution reduction Homer’s pollution reduction MC B MC H 25 10

5-36 Cap-and-Trade  Homer’s Cost? Willingness to Pay for 1 Permit? Willingness to Pay for 2 Permits? For how many will he trade? What would he be willing to pay? What is Bart willing to accept?

5-37 Progress with Incentive-based Approaches  Policy Perspective: Cap-and-Trade for Sulfur Dioxide  Policy Perspective: Cap-and-Trade to Protect Fisheries and Wildlife individual transferable quotas

5-38 Emissions Fee v Cap-and-Trade  Inflation Emissions or Cap-and-Trade  Cost Changes Emissions or Cap-and-Trade

5-39 Cap-and-Trade Bart’s pollution reduction Homer’s pollution reduction MC B MC H 25 $50 10 a b $100

5-40 Cap-and-Trade v Emissions Fee 0 Pollution reduction MSB MC* e* f* $ MC’ efef e’ Too much pollution reduction Too little pollution reduction

5-41 Cap-and-Trade v Emissions Fee 0 Pollution reduction MSB MC* e* f* $ MC’ efef e’ Too much pollution reduction Too little pollution reduction

5-42 Cap-and-Trade v Emissions Fee  Consider Lower Marginal Costs for an Inelastic and Elastic MSB Line with a Partner What Underperforms? What Overperforms?  5 Minutes

5-43 Distributional Effects  Revenue? Emissions fee Cap-and-Trade

5-44 Positive Externalities Research per year $ MPB MC MEB MSB = MPB + MEB R*R1R1

5-45 Positive Externalities  Requests for subsidies Resource extracted from taxpayers Market does not always fail  Policy Perspective: Owner-Occupied Housing