1. …………….And thus achieve ALLOCATIVE EFFICIENCY
Policies to correct for existence of EXTERNALITIES ….. (Policies can be extended to the issues of merit and demerit goods, public goods, over-use of common access resources, and asymmetric information)
…………….And thus achieve
ALLOCATIVE EFFICIENCY

2. B) Market-based (or internalising the externality)
Two main methods
A) Command and Control
(Non-market based government REGULATIONS or provision by govt etc)
B) Market-based (or internalising the externality)

3. Correcting Negative production externalities (or over-use of common access resources or asymmetric information)
A) Government regulations
Totally forbid and ban the use and dumping of certain toxic substances or in certain places (e.g. river, ocean, etc.)
Limit the amount of pollution
Limit the quantity of output (QUOTAS)
Require installation of technologies
Regulate for product safety/financial markets/insurance
Provide information
B) Market-based policies
Impose taxation on output
Impose taxation on the amount of pollution
Introduce tradable permits (“cap and trade”)
Assign PROPERTY RIGHTS

4. Taxing Negative Production Externalities:
Tax per unit of output is an indirect tax on the total amount of output causing pollution
It shifts the supply (MPC) curve upwards (decreases supply) to the MSC curve  P increases and Q falls to Qopt
Tax per unit of pollutants e.g. carbon tax is a tax per unit of carbon emissions of fossil fuels (eg oil, coal, or natural gas). As not all fossil fuels emit the same amounts of carbon when burned, carbon tax is calculated on the basis of how much carbon the fuel emits
As in the tax per unit of output, this entails higher cost of production for the firms and the MPC will shift upwards to MSC  P rises and Q falls to optimum

5. Additional Effects of Carbon Tax
Unlike the tax per unit of output, carbon or emission tax has further implications
Since there are other substitute energy sources with lower carbon emissions or zero emissions, there is an incentive for firms to switch to less polluting or non-polluting energy sources (e.g. solar)

6. Graphical Analysis
The S curve shifts upwards toward MSC. Qopt is produced and price of the good is raised. Overallocation of resources and WL is corrected. (For (b) the firm finds a substitute with less emissions MSC 2 )

7. IN REALITY
A 2013 study estimated that the damages (ie agric losses, rising sea levels, health costs) from each metric ton of carbon dioxide emitted=$50. But existing taxes average only about $10 per metric ton
At the December 2015 Paris conference on climate change, Japan pledged that it would reduce emissions by 26% of 2013 levels by the year 2030

8. Other Market-Based Solutions
Tradable permits also known as cap and trade /emissions trading schemes, are a relatively new policy involving permits (permission, rights) to pollute which are issued to firms by a government or an international body
These permits to pollute can be traded (bought and sold) in a market just like stocks
Promoted by the Global Warming and Climate Change movement of 2008

9. Tradable Permits
Permits to pollute can be bought and sold and the price is determined by D and S as in any other market
If a firm can produce its product by emitting a lower level of pollutants than the level set by its permits, it can sell its extra permits in the market and make a profit
Provide incentives to producers to switch to less polluting resources for which it is not necessary to buy permits or if a firm finds a way to reduce its emissions, it can sell its permits
Permits are therefore intended to reduce the quantity of pollutants emitted, thus reducing the size of the negative externality without compromising the level of output

10. Graphically… with room for innovation similar to the case of tax per unit emissions
There is a time series effect: as the MSC1 shifts to MSC2

11. Evaluation of the Policies
A) COMMAND and CONTROL
Advantages of Government Regulations:
Simple to design and implement with less technical difficulties
Disadvantages of Government Regulations:
Externality is not internalized by those who pollute
Unable to provide incentives for firms to use less polluting resources. Thus the regulations restrain the size of pollution but do not reduce it with new innovative methods
Problems of enforcement of the policy

12. (continued) B) Market Based Policies Advantages Disadvantages
Have the effect of internalizing the externality by the firm who produces it (meaning the costs that were previously external are now made internal). “The polluter pays” principle.
Provide incentives for firms to reduce the use of polluting resources (e.g. oil and fossil fuels), innovate and use new technologies, etc.
Lead to increase in output and decrease in pollution
Disadvantages
In practice, very hard to implement with lots of technical difficulties
eg Which and how pollutants should be taxed or provided permits? What is the monetary value of the external cost? How many permits should be provided or what should the cap (maximum amount of pollution) be? How to distribute the permits?

13. 2) Correcting Negative Consumption Externalities………Command and control
Advertising Ads and campaigns
by government can be used to try
to persuade consumers to buy
fewer goods e.g. anti-smoking
Government regulations
Laws can be used to prevent or limit consumption
of the good (e.g. age limits to drink and smoke)
BOTH have the effect of shifting the demand curve downwards toward the MSB curve

14. Graphically …

15. Market-based policies
Indirect taxes on the consumption of the good that causes external costs (eg on cars or on gasoline). It forces the consumers of such goods to internalize (take into account) the external costs
An extra PRICE (eg congestion charge in London for those who drive into the city or a CARBON price) for the activity
A SUBSIDY on alternative goods (eg on solar power or on trains)

16. Market-based policies (taxes)
The tax shifts the supply curve of the good upward ideally until the point where
MPC + tax curve intersects MPB at Qopt

17. Evaluation of the Policies (1) Group VI Thurs 9th Freb
Similar in principle to the previous ones…
Advantage of advertising and persuasion:
Simpler to implement
Disadvantage of advertising and persuasion :
Costly to government and tax revenue is used; possibility that the ads are not effective
Advantage of regulations:
Simpler and easy to implement e.g. no alcohol until 20 years old
Disadvantage of regulations:
Cannot be implemented for all goods with negative externalities e.g. oil, gas, fossil fuels, etc. are all necessities
People will break the law (eg informal markets)

18. Evaluation of the Policies (2)
Advantage of market based policies:
Economists prefer the market based solutions, such as an indirect tax, as it internalizes the externality to those who create them. Indirect tax becomes part of the decision making process of the consumers and creates incentives for them to change their consumption patterns by changing their preferences and relative prices (the price signal and mechanism is altered): the good that is taxed is relatively more expensive and consumption is reduced accordingly
“Polluter pays” principle

19. Disadvantages of market based policies:
Difficulties of measuring the value of the external cost for which the tax or charge is designed
e.g. how do you measure costs of second hand smoke?
A lot of technical difficulties in accurately assessing and measuring “who” and “what” is affected
Some of the goods we would like to tax have inelastic demand (e.g due to addiction –tobacco). Thus, tax will only increase the tax revenue and not decrease the consumption level significanly.
A very high tax that raises the price a lot (elastic portion of the demand curve) is necessary but the lower-income consumers are most affected (inequitable)

20. 3) Correcting Market Failure due to Positive Production Externalities
Two main methods:
A) Direct provision of the goods and services that are creating external benefits
E.g. government often engages in R&D through various public think tanks and research center such as Institute of National Sciences, Center of Disease Control, American Institute of Progress, National Academy of Educational Science, Institute of Medical Research
Educational and vocational training for the unemployed, immigrant workers, etc.

21. (continued)
Direct government provision has the effect of shifting the supply curve (MPC curve) rightwards toward the MSC (which has …………… the marginal external benefit) curve so that the optimum output is produced

22. Market-based method B) Subsidies
If the government provides a subsidy to a firm per unit of the good produced that is equal to the external benefit, the firm’s costs are effectively reduced and the MPC curve will shift downward until it coincides with the MSC curve
Qopt is produced and the problem of underallocation of resources and underprovision of the good are corrected allocative efficiency
e.g. Hybrid cars; subsidies for research into “clean technologies”

23. Graphically…

24. Evaluation of the Policies
Direct Provision and Subsidies:
Advantages
Both methods are very effective in increasing the quantity of the good produced and consumed
Both have the advantage of lowering the price of the good to consumers
Disadvantages
Both need government funds that rely on tax revenues. Both therefore have an opportunity cost
In practice it is very difficult (sometimes impossible) to measure the size of the external benefits. It is difficult to precisely calculate which goods and by how much they should be supported.
If provided at a very low or zero price, may lead to OVERALLOCATION of resources and another welfare loss.

25. 4. Correcting Market Failure due to Positive Consumption Externalities
Positive consumption externalities refer to external benefits created by consumers
Examples
Consumption of education benefits the person who receives it but also give rise to external benefits involving more productive workforce, lower unemployment rates, higher economic growth, lower crime rates, better collaboration among colleagues, etc.
Consumption of health care, immunization, HIV tests, etc., also benefits the society at large as healthier economy is more productive, safe and healthier society e.g. no epidemic such as Ebola, higher standard of living and better quality of life, etc.

26. SUBSIDIES (as for positive prod. Externalities)
POLICIES
Government regulations and legislation
Legislation to promote greater consumption of the good e.g. making education compulsory up to certain age
This has the effect of shifting the demand curve upward to the right towards the MSB curve
Provision at LOW or ZERO price (also of PUBLIC GOODS)
Advertising
Ads and campaigns by government to try to persuade consumers to buy more goods e.g., CMs with basketball stars on eating right, “milk does the body good”,
This has the same effect as gov regulation by shifting the demand curve upwards toward the MSB curve
SUBSIDIES (as for positive prod. Externalities)

27. Evaluation of the Policies (similar to those for External Benefits of Production Slide 23)
Legislation and Advertisements
Advantages:
Easy to implement
Not costly in terms of tax revenue compared to the case of subsidy and direct provision. Tax revenues can be used for other purposes
Disadvantages:
Also subject to the limitation concerning calculating the size of the external benefits. It is too difficult to measure its size and design the appropriate legislation.
In case of advertisements, there is no guarantee that it has the effect of shifting the MPB by the right the amount to the point where Qopt is achieved e.g. ads on good nutrition, HIV tests, and education.
May be OVERALLOCATION if provided at price = zero
->May need another RATIONING method (eg queues/waiting lists in the British Health Service)

28. Disadvantages (continued)
The effectiveness of the policy can vary from case to case e.g. legislation on the minimum age of schooling can be effective but not all people can afford health care services or higher level of education without further assistance
As the demand for the good increases, it has the effect of increasing the price which can make the good unaffordable to some consumers (eg university education in US)
 To sum, as shown in reality, legislation and ads can be more effective if implemented together with direct provision and subsidies e.g. compulsory education and at the same time scholarships/grants for school uniforms are provided

29. Policies to deal with the problem of common access resources
Handout: Page 6
Notice—AIR is a common-access resource and therefore the issue of GLOBAL WARMING is a typical problem of overuse/negative externalities (both of consumption and production)

30. Carbon emissions= Negative production externalities
Negative production externalities because over and above the firm’s private costs to produce, there are additional costs that spill over onto society
The market overallocates (too much of it is produced relative to the social optimum) resources to the production of the good that has carbon emissions This is shown by Qm > Qopt and MSC > MSB at the point of production Qm
 allocative inefficiency and welfare loss …

31. Other Government responses to threats to sustainability
Legislation
Emission standards, quotas, licenses, permits, outright regulation (e.g. on car use, factory operation, chemical ban, restricting hunting season and areas, quotas on fishing, national parks)
Advantage: easy to implement; Disadvantage: no incentive to reduce emissions or innovate as those who pollute do not internalize the external cost
Carbon tax and tradeable permits
Advantage: those who pollute pay and the cost is internalized, incentive to change to pollution- decreasing innovative technologies. Can make profit for selling extra permits (UN Convention  if help other countries reduce pollution get more permits)
Disadvantage: hard to measure and implement
Funding clean technologies and energy sources e.g. wind power, solar energy, biofuels, geothermal energy, energy storage technology, fuel efficiency technology, recycling and more (as in Japan and Germany)
Advantage: can reduce emissions and increase output at the same time
Disadvantage: still a growing and new industry, far from being able to replace fossil fuels which emit carbon dioxide
Promote more international cooperation and treaties e.g United Nations Climate Change Conference, COP 21 and better development activities/aid

32. The issue of GLOBAL WARMING
The Stern Review: Economics of Climate Change
2015 United Nations Climate Change Conference, COP 21 or CMP 11 was held in Paris in December 2015

34. The Stern Review
CO2 is one of the biggest negative production externalities for all producers (eg oil and fossil fuel related production such as making steel, aluminum, metal, rubber, etc.)
Therefore, imposing regulations on CO2 emissions has huge effects worth billions of dollars per year