CHAPTER 5 Externalities Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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 Not an Externality – suburban-urban migration example

5-3 The Nature of Externalities Privately-owned versus commonly-owned resources Externalities can be produced by consumers as well as firms Externalities are reciprocal in nature Externalities can be positive Public goods can be viewed as a special kind of externality

5-4 The Nature of Externalities-Graphical Analysis Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* Actual output Socially efficient output a b c d f e g h

5-5 What Pollutants Do Harm? Empirical Evidence: What is the Effect of Pollution on Health? What Activities Produce Pollutants? What is the Value of the Damage Done? Empirical Evidence: The Effect of Air Pollution on Housing Values

5-6 Bargaining and the Coase Theorem Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d g h

5-7 The Coase Theorem Coase Theorem – Provided that transaction casts 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 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

5-8 Other Private Solutions Mergers Social conventions

5-9 Public Responses to Externalities - Taxes Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d (MPC + cd) Pigouvian tax revenues i j

5-10 Public Responses to Externalities - Subsidies Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d (MPC + cd) i j g k h f e Pigouvian subsidy

5-11 Public Responses to Externalities- Emissions Fee 0 Pollution reduction MSB MC e* f* $

5-12 Emissions Fees Continued- Uniform Pollution Reductions Bart’s pollution reduction Homer’s pollution reduction MC B MC H 25 f = $50 Bart’s Tax Payment Homer’s Tax Payment

5-13 Public Responses to Externalities- Cap-and-Trade Bart’s pollution reduction Homer’s pollution reduction MC B MC H 25 f = $50 10 a b

5-14 Cap-and-Trade vs. Emissions Fee 0 Pollution reduction MSB MC* e* f* $ MC’ efef e’ Too much pollution reductionToo little pollution reduction

5-15 Cap-and-Trade v Emissions Fee 0 Pollution reduction MC* e* f* $ MC’ efef e’ MSB Too much pollution reductionToo little pollution reduction

5-16 Emissions Fee v Cap-and-Trade Responsiveness to Inflation Responsiveness to Cost Changes Responsiveness to Uncertainty Distributional Effects –Emissions fee –Cap-and-Trade Policy Perspective: Addressing Climate Change

5-17 Command-and-Control Regulation Incentive-based regulations Command-and-control regulations –Technology standard –Performance standard Is command-and-control ever better? –Hot spots

5-18 The U.S. Response Clean Air Act –1970 amendments –Command-and-control in the 70s –How well did it work?

5-19 Progress with Incentive-Based Approaches Policy Perspective: Cap-and-Trade for Sulfur Dioxide

5-20 Implications for Income Distribution Who Benefits? Who Bears the Cost?

5-21 Positive Externalities Research per year $ MPB MC MEB MSB = MPB + MEB R*R1R1

5-22 A Cautionary Note Requests for subsidies –Resource extracted from taxpayers –Market does not always fail Policy Perspective: Owner-Occupied Housing