1. CHAPTER 5
Externalities

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

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

4. The Nature of Externalities-Graphical Analysis
MSC = MPC + MD $
MPC h d g c
Axes and labels
1st click – MB
2nd click – MPC, Q1
3rd click – MD
4t click – MSC, Q* MD f b MB a e Q* Q1
Q per year
Socially efficient output
Actual output

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

6. Bargaining and the Coase Theorem
MSC = MPC + MD $
MPC h d g c
Axes and labels
1st click – MB
2nd click – MPC, Q1
3rd click – MD
4t click – MSC, Q* MD MB Q* Q1
Q per year

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

8. Other Private Solutions
Mergers
Social conventions

9. Public Responses to Externalities - Taxes
MSC = MPC + MD $
(MPC + cd)
Pigouvian tax revenues
MPC d i j c
Axes and labels
1st click – MP shifts up to MPC + cd
2nd click – Pigouvian tax revenues box MD MB Q* Q1
Q per year

10. Public Responses to Externalities - Subsidies
MSC = MPC + MD $
(MPC + cd)
MPC
Pigouvian subsidy d k i f g j c h
Axes and labels
1st click – MP shifts up to MPC + cd
2nd click – dashed lines fi, hj, and hf
3rd click = Pigouvian subsidy MD MB e Q* Q1
Q per year

11. Emissions Fee $ MC f* MSB e* Pollution reduction Axes and labels
1st click – MSB
2nd click – MC
3rd click – dashed line and e*
4th click – f* and brown horizontal line
MSB e*
Pollution reduction

12. Uniform Pollution Reductions
MCH
Bart’s Tax Payment
Homer’s Tax Payment
MCB
f = $50
axes and labels for both graphs
1st click – MCB and dashed vertical lines, MCH and dashed vertical black line
2nd click – horizontal dashed brown line and vertical dashed brown line
3rd click – dashed brown line and Bart’s dashed black line at 50 disappear
4th click – line at f = $50 wipes right
5th click – Bart’s tax payment
6th click – Homer’s tax payment
f = $50 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction

13. Cap-and-Trade MCH b MCB f = $50 f = $50 a 10 50 75 90
axes and labels for both graphs
1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line
2nd click –
3rd click – dashed brown line and Bart’s dashed black line at 50 disappear
4th click – line at f = $50 wipes right
5th click – Bart’s tax payment
6th click – Homer’s tax payment
f = $50 a 10 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction

14. Cap-and-Trade v Emissions Fee
MC’ $
MC* f*
Axes and labels
1st click – MSB
2nd click – MC*
3rd click – MC’
4th click – f*
MSB ef e’ e*
Pollution reduction
Too little pollution reduction
Too much pollution reduction

15. Cap-and-Trade v Emissions Fee
MC’ $
MC* f*
Axes and labels
1st click – MSB
2nd click – MC*
3rd click – MC’
4th click – f*
MSB ef e’ e*
Pollution reduction
Too little pollution reduction
Too much pollution reduction

16. Emissions Fee v Cap-and-Trade
Responsiveness to Inflation
Responsiveness to Cost Changes
Responsiveness to Uncertainty

17. Distributional Effects
Emissions fee
Cap-and-Trade

18. Command-and-Control Regulation
Incentive-based regulations
Command-and-control regulations
technology standard
performance standard
Is command-and-control ever better?
hot spots

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

20. 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

21. Implications for Income Distribution
Who Benefits?
Who Bears the Cost?

22. Positive Externalities$ MC
Axes and labels
1st click – MPB
2nd click – MC and R*
3rd click – MEB
4th click MSB and R1
MSB = MPB + MEB
MPB
MEB R1 R*
Research per year

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