Remedies for Externalities Fees (Taxes) or Bonuses (Subsidies) Coase Approach (Private Solution) Command and Control Cap and Trade Yes  Is the state of affairs getting the most from the economy’s resources? No.  State of affairs inefficient. No Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else?  Is the state of affairs getting the most from the economy’s resources? Yes.  State of affairs efficient. Externalities cause inefficiency. Preview Externalities Definition: An externality exists whenever consumers or firms do not account fully for all the ramifications of their actions. The effect that is not accounted for is called the external effect. Negative externalities: Situations in which the external effect damages others; Positive externalities: Situations in which the external effect helps others.

Question: Does 399 units of chemicals maximize the chemical firm’s profit? Pollution and Efficiency 1, ,200 C* = 400 MC of Chemicals C Farmer’s Clean-up Costs = C  F whereC = Quantity of chemicals produced F = quantity of food produced Chemical Firm P C = 1,000P F = 800 MR C = 1,000 Both industries are perfectly competitive. MR C C = 399 MC C = C = ×399 = MC C = 998 Profit TR TC  = C = 399  C = 400 Up by $2 Up by $1,000 Up by $998 Question: Does 400 units of chemicals maximize the chemical firm’s profit? MC C = C = ×400 = MC C = 1,000 MC C First, focus on the chemical firm = P C = 1,000 Answer: Yes Answer: No.

Pollution and Efficiency Clean-up Costs = C  F whereC = Quantity of chemicals produced F = quantity of food produced P C = 1,000P F = 800 Both industries are perfectly competitive. MR F F* = 100 Farmer’s Clean-up Costs=C  F C* = 400 =400  100 Farmer’s Clean-up Costs=$40,000 The farmer must clean up the water before he can use it to irrigate his fields. Question: How much food will the farmer produce? 1, , MC of Food F C = 0 C = 400 Farm MR F = 800 C = 800 Next, focus on the farmer. = P F = 800

Chemical Firm: C* = 400 Profit C = 399  C = 400 Up by $2 Farm: F* = 100 Question: How would the farmer and the chemical firm be affected if the chemical firm produced 1 fewer unit of chemicals; that is, what if the chemical firm produced 399 units rather than 400? Claim: Chemical firm profit falls by $2. Question: Can you devise a special deal between the owner of the chemical firm and the farmer that would make both better off? State of Affairs: Each firm maximizes its individual profit: Claim: This state of affairs is inefficient. Claim: Farmer’s clean-up costs fall by $100. Review: Chemical firm profit rises by $2 when production rises from 399 to 400 Chemical firm profit falls by $2 when production falls from 400 to 399. Farmer’s Clean-up Costs=C  F =400  100 =$40,000 Farmer’s Clean-up Costs=399  100 =$39,900

Yes  Is the state of affairs getting the most from the economy’s resources? No.  State of affairs inefficient. No Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else?  Is the state of affairs getting the most from the economy’s resources? Yes.  State of affairs efficient. Special Deal: The farmer gives the owner of the chemical firm a “side payment” of $50 on the condition that the owner of the chemical firm reduces chemical production by 1 unit. Chemical Firm Farmer Chemical Production down by 1 unit Clean up costs down by $100  Profit down by $2 $50 ahead Each firm maximizes its profit: C=400 F=100 Farmer’s Clean-up Costs = 40,000 $50 $48 ahead Side payment Chemical firm profit falls by $2.Farmer’s clean-up costs fall by $100. When chemical production falls from 400 to 399. State of Affairs: Conclusion: The state of affairs in question results in an inefficient high level of chemical production.

Yes  Is the state of affairs getting the most does not from the economy’s resources? No.  State of affairs inefficient. No Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else?  Is the state of affairs getting the most does not from the economy’s resources? Yes.  State of affairs efficient. Intuition: When each firm maximizes its profit are decisions based on misleading or accurate information? Social Costs of Chemical Production > Private Costs of Chemical Production Difference: External Effect Misleading informationAccurate information  Inefficiency results  Efficiency results Question: Why does the market fail to operate efficiency in the presence of a negative externality?  Costs that the chemical firm incurs plus the costs the chemical firm imposes on others, the farmer.  Costs that the chemical firm incurs. Answer: The chemical firm does not fully account for all the costs it is imposing.

EPA Prohibits the Chemical Firm from Polluting 1, , MC of Food F C = 0 C = 400 Farm P C = 1,000P F = 800 MR F = 800 MR F = P F = 800 F** = 200 Farmer’s Clean-up Costs=C  F C** = 0 =0  200 Farmer’s Clean-up Costs=$0 Claim: This state of affairs is inefficient. Question: How would the chemical firm and the farmer be affected if the chemical firm were allowed to produce 1 unit of chemicals? MR C = P C = 1,000 C = 0 MC C = C = ×0 MC C = 200 Profit TR TC  = C = 0  C = 1 Up by $800 Up by $1,000 Up by $200 Chemical firm’s profit rises by $800 Farmer’s Clean-up Costs=C  F =1  200 =$200 Farmer’s clean-up costs rise by $200. Question: Can you devise a special deal to make both better off? C = 800

Yes  Is the state of affairs getting the most from the economy’s resources? No.  State of affairs inefficient. No Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else?  Is the state of affairs getting the most from the economy’s resources? Yes.  State of affairs efficient. Special Deal: The owner of the chemical firm gives the farmer a “side payment” of $400 on the condition that the owner of the chemical firm can increase chemical production by 1 unit. Chemical Firm Farmer Chemical Production up by 1 unit Clean up costs up by $200  Profit up by $800 $200 ahead State of Affairs: EPA prohibits pollution: C = 0 F = 200 Farmer’s Clean-up Costs = 0 $400 $400 ahead Side payment When chemical production rises from 0 to 1 Chemical firm’s profit rises by $800 Farmer’s clean-up costs rise by $200

Summary of Externalities An externality is present whenever consumers or firms do not account for the full ramifications of their actions. In such a situation, the markets fail because decisions are based on erroneous information. A market failure occurs. More specifically when one party does not account for all the costs of its actions, a negative externality exists. In such a case, An unfettered market when each firm independently maximizes its own profit results in an inefficiently high level of production. Complete elimination of the negative externality is typically inefficient also. The challenge: Efficiency calls for something in the middle. How can we get there? Remedies for Externalities Fees (Taxes) or Bonuses (Subsidies) Coase Approach (Private Solution) Command and Control Cap and Trade

Fees (Taxes) or Bonuses (Subsidies) Question: Consider the chemical firm and farm. What is the basic problem when each maximize profit? Answer: The chemical firm is not accounting for all the ramifications of its actions. It is not accounting for the fact that when it produces chemicals it is imposing a cost on the farmer. The government charges the owner of the chemical firm a fee for each unit of pollution the chemical firm dumps into the lake. Social Costs of Chemical Production Private Costs of Chemical Production Question: What should the pollution fee equal? 1, ,200 MC of Chemicals C Chemical Firm MC Private MC Social > External Effect: Costs the chemical firm imposes on the farmer. Answer: The cost of the external effect. Misleading Accurate  Inefficiency results  Efficiency results Intuition: Are decisions based on misleading or accurate information?

Coase Approach Bargaining and deal making are the central ideas behind the Coase approach. When it is possible to strike a deal be struck and when it would be impossible to strike a deal? make at least one individual better off. Question: What must be true if two (or more) individuals voluntarily agree to a deal? and make no individual worse off. Answer: The deal must make at least one individual better off Question: What must be true if it is IMPOSSIBLE for two (or more) individuals to AGREE voluntarily to a deal? and make no individual worse off. Answer: It must be impossible to find a way to Yes  Is the state of affairs getting the most does not from the economy’s resources? No.  State of affairs inefficient. No Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else?  Is the state of affairs getting the most does not from the economy’s resources? Yes.  State of affairs efficient.

Coase Theorem: When bargaining costs are negligible Furthermore, the assignment of property rights: Bargaining leads to efficiency. Ms. Jones is deciding how to heat her house and has narrowed the options to two: electricity or wood. Mr. Smith, who suffers from asthma, is getting a new neighbor; Ms. Jones is building a house near Mr. Smith. Electricity would cost her $5,000 per year and wood $2,000 a year. Ms. Jones does not suffer from any respiratory problems; consequently, the fact that wood burning will pollute the atmosphere does not concern her. Since Mr. Smith suffers from asthma, his lungs cannot tolerate the pollution produced by wood burning stoves. If the air were polluted by Ms. Jones’ wood smoke, he would have to install a climate control system in his home which would filter the air. Such a system costs $2,500 per year. Simple Illustration of the Coase Theorem: Mr. Smith, Ms. Jones, and a Wood Stove does not affect the allocation of resources. does affect the distribution of income. Coase Approach Encourage them to bargain and make deals. Get the affected parties together. Continue this bargaining and deal making process until it is impossible for the parties to make any more deals.

Scenario #1: Ms. Jones has the right to pollute the air. Heating Costs for Ms. Jones: Wood: $2,000Electricity: $5000 Would Ms. Jones choose, wood or electricity? Ms. Jones Heats with wood Spends $2,000 on heat Mr. Smith Installs climate control system Spends $2,500 on the climate control system A difference of $3,000 Question: Could Mr. Smith offer Ms. Jones a “side payment” to induce her to heat with electricity? What is the largest side payment Mr. Smith would be willing to offer? $2,500 What is the smallest side payment Ms. Jones would find acceptable? $3,000 No Outcome: Question: Does this outcome make economic sense from the perspective of society as a whole? There are two ways to achieve the goals: Ms. Jones heats with electricity Ms. Jones heats with wood and Mr. Smith installs the climate control system  Jones costs = $5,000 Smith costs = $0 Costs to Society = $5,000  Jones costs = $2,000 Smith costs = $2,500 Costs to Society = $4,500 Cost of Mr. Smith’s climate control system: $2,500 Ms. Jones Heats with wood Spends $2,000 on heat Mr. Smith Installs climate control system Spends $2,500 on the climate control system From society’s perspective there are two goals: Provide Ms. Jones with heat. Provide Mr. Smith with clean air.