Externalities Chapter 10 Ratna K. Shrestha

Introduction/Background n Lets assume that your cigarette smoking in the classroom benefits you by $10 but harms the rest of the 150 students by $300 ($2 harm per head). In this case if there is no regulation, you will smoke in the classroom which will cause $300 – $10 = $290 harm to the class as a whole (total harm net of your benefits). n Then the question is how can the government prevent this $290 harm from occurring?

An externality arises when a person engages in an activity (production or consumption) that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. n Externality can be Negative or Positive depending upon whether the action of one party imposes a cost or benefit on another party. n Externality can also be production or consumption depending on whether the externality is caused by production or consumption activities.

Types of Externalities n Negative Externalities: Examples äSteel plant dumping waste in a river. äNoise in the neighborhood. ä Vehicle exhaust causing harm to the environment. äacid rain caused by coal burning production releasing SO 2. äglobal warming due to greenhouse gases (carbon particles from fossil fuel combustion, etc.).

ACID RAIN

Types of Externality n Positive Externality: Examples äresearch and innovation. äneighbor’s nice backyard. äImmunization. n Examples of production externality: äA paper factory dumping its waste to the river. n Example of consumption externality: äCigarette smoking in the classroom, Drinking and driving.

The Externality of SUVs n Consider a real-life example: the use of sport utility vehicles (SUVs). They create three sorts of externalities: äEnvironmental externalities: They consume a lot of gasoline and create more air pollution. äWear and tear on roads: SUV drivers do not bear the full costs of damage to the roads (other vehicles also share the costs) that result from their vehicles. äSafety externalities: When SUVs are in accidents, the other drivers are often more severely injured.

The Market for Aluminum... Quantity of AL 0 Price of Aluminum Q MARKE T Demand (private value) Supply (private MC) Equilibrium

Market for Aluminum n In the absence of any externality, the quantity produced and consumed in the market equilibrium is efficient in the sense that in this case the sum of producer and consumer surplus is maximized. n If the aluminum factory emits pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost of production to the factory.  MC to Society, MSC = MC of production of the factory + MC of pollution to the environment.  The MC of pollution to the environment is called marginal external cost (MEC).

Q Market Pollution and Dead Weight Loss Quantity of AL 0 Price of Aluminum Demand (private value) Supply (private MC) Social MC =Private MC +MEC Q Optimum Market Equilibrium Optimum P opt. P Market Dead Weight Loss

Socially Optimal Output  The government can internalize a negative externality by imposing a Pigovian tax (t = MEC at Q opt ) on the producer.  This tax induces the producer to reduce the equilibrium quantity to the socially desirable quantity, and thus eliminate the Dead Weight Loss.

Q no tax Pigouvian tax: as a solution to negative externality Quantity of AL 0 Price of Aluminum Demand (private value) Supply (private MC) Supply after tax (=Social MC) Q tax Market Equilibrium without tax P tax. P no tax t Market Eqlbm. with tax MC+t

Positive Externalities in Production When an externality benefits bystanders, a positive externality exists. A technology spillover is a type of positive externality because a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

Positive Externalities in Production... Quantity Of technology 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private MC) Social MC Q MARKET Marginal Value of technology spillover Market Equilibrium Optimum Deadweight Loss

Internalizing Externalities 1. Subsidy: Government usually uses subsidies (s = MEB at the optimum Q) as the primary method for attempting to internalize positive externalities. 2. Technology Policy: Government intervention in the economy that aims to promote technology- enhancing industries is called technology policy. Technology policy is also one way to internalize positive production externality

Technology Policy u Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. u The patent is then said to internalize the externality, in that it provides more incentives to invest in modern technology than that would occur otherwise.

Externalities in Consumption Externalities associated with consumption activities. Examples: u Alcohol: If people drive under the influence of alcohol, it imposes a negative externality. u Education: a positive externality because more education means a better society.

Consumption Externalities... Quantity of Education 0 Price of Education Demand (private value) Social value (b) Positive Consumption Externality Supply (private cost) Quantity of Alcohol 0 Price of Alcohol QMQM Demand (private value) Supply (private cost) Social value QoQo (a) (a)Negative Consumption Externality DWL DWL QoQo QMQM

Externalities and Market Inefficiency u Negative externalities in production or consumption lead markets to produce a larger quantity than is socially desirable. u Positive externalities in production or consumption lead markets to produce a smaller quantity than is socially desirable.

Private Solutions to Externalities Government action is not always needed to solve the problem of externalities. Sometimes private polluters themselves take care of it. Examples: 1. Moral codes and social sanctions. 2. Charitable organizations. 3. Integrating different types of businesses. 4. Bargaining between parties

The Coase Theorem The Coase Theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own regardless of who (i.e., polluter or victims) owns the property rights. Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

Bargaining: An Example  Suppose Jim owns a dog from which he gets benefits = $ 500.  The dog’s barking causes harm to Jerry = $ 800.  Since benefit < harm, getting rid of dog is good for Jim and Jerry combined (that is society as a whole).  How can they come to a negotiated solution?  If Jerry has the right to noise-free environment, then Jim cannot offer any amount that is acceptable to Jerry. Jim cannot keep the dog--the efficient solution.  If Jim has the right, then Jerry can offer Jim $501 to $799 to sell off the dog, which he will gladly accept—the efficient solution.

Coase Theorem at Work  Garbage spilling in NY harbor caused damage to New Jersey shore oftentimes littering its beaches.  New Jersey had right to clean beaches and could have sued NY city.  But by Sept of 1987, they came to a negotiated settlement. Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

Public Policy Toward Externalities When externalities are significant and private solutions are not found, government may attempt to solve the problem through...  command-and-control policies.  market-based policies.

Command-and-Control Policies u Usually take the form of regulations: u Forbid certain behaviors. u Require certain behaviors u Examples: u Requirements that all students be immunized. u Stipulations on pollution emission levels set by the Environment Canada. u Moratorium on cod fishing in the Atlantic Canada.

Command and Control: Examples Smoking Ban Emission Standard for Cars

Market-Based Policies u Government uses taxes and subsidies to align private incentives with social efficiency. u Pigovian taxes are taxes enacted to correct the effects of a negative externality. u Why gasoline is taxed so heavily?  Causes many negative externalities: congestion, accidents, pollution.

Examples of Regulation versus Pigovian tax If the Environment Canada (EC) decides to reduce the amount of pollution coming from a specific plant, it could…  tell the firm to reduce its pollution by a specific amount (i.e. regulation).  levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).

Market-Based Policies u Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. u How does it work? u The govt. creates the number of emission or pollution permits equal to the desired level of pollution and distribute them among the polluters. u Polluters can pollute only if they possess emission permits. u Polluters are allowed to trade the permits among themselves.

Market-Based Policies u A market clearing price for the permits will evolve in the market for pollution rights. u A polluting firm that can reduce pollution at a lower cost will find it beneficial to sell its permits (and control pollution). On the other hand, a high cost firm will find it beneficial to buy the permits and emit pollution. u The trade takes place until the MC of pollution control are equal across all polluters with the achievement of the desired level of pollution at the minimum costs.

The Equivalence of Pigovian Taxes and Pollution Permits... Quantity of Pollution Permits 0 Price of Pollution P Q Demand Pigovian Tax (a) Pigovian Tax Quantity of Permits 0 Q Demand Supply of Permits (b) Pollution Permits Price of Pollution P