1. The economics of externalities
Today: Graphical analysis Private responses Public responses

2. Today More on the externality problem Private responses
Marginal damage will not be constant
Private responses
The Coase Theorem
Mergers
Social conventions
Public responses
Taxes
Subsidies
Command-and-control
Cap-and-trade programs

3. The externality problem
With externalities, quantity produced is typically not optimal
Finding optimal quantity when marginal damage is not constant
Deadweight loss of inefficient production

4. Graphical analysis of externalities
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. Graphical analysis of externalities
Producer surplus lost going from Q1 to Q*

6. Graphical analysis of externalities
Consumer surplus gained going from Q1 to Q*

7. Graphical analysis of externalities
Net social gain going from Q1 to Q*

8. Pollution
Pollution is one of the biggest negative externalities around
Multiple steps needed to try to find optimal amount of pollution
Which pollutants actually do damage?
Are there pollutants that indirectly cause damage?
Example: CFCs on the ozone layer
How do we value the damage done?
Very difficult to do, due to lack of markets

9. Pollution and empirical studies
Empirical studies have been done to try to determine the damages caused by pollution
Remember from Chapter 2 that we need to use events that prevent bias

10. Pollution and empirical studies
Chay and Greenstone (2003, 2005)
Pollution on health
1 percent reduction in total suspended particulates resulted in a 0.35 percent reduction in infant mortality rate
Pollution on housing prices
Improved air quality between 1970 and 1980 in pollution-regulated cities led to property value increases of $45 billion

11. Costly negotiation Negotiation is typically costly
Remember, time is worth something
Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

12. Coase theorem
The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur
People can negotiate costlessly
The right can be purchased and sold
Property rights
Given the above conditions, efficient solutions can be negotiated
Ronald Coase

13. Coase theorem Notice that the Coase theorem addresses efficiency
To get to efficiency, the quantity of most goods and services produced is still positive
Example: It is not efficient to get rid of all pollution
If all pollution was gone, we could not live (since we exhale CO2)

14. Bargaining and the Coase Theorem
MB exceeds MPC in this range  Production will be Q1 without negotiation
MSC = MPC + MD $
MPC h d g c MD MB Q* Q1
Q per year

15. Bargaining and the Coase Theorem
MSC exceeds MB here  With costless bargaining, consumers will pay to reduce production from Q1 to Q*
MSC = MPC + MD $
MPC h d g c MD MB Q* Q1
Q per year

16. Other private responses to externalities
Mergers
When negative externalities only affect other firms, two firms can merge to internalize the externalities
Social convention
Social pressure to be nice can lower the amount of certain negative externalities

17. Public responses to externalities
Four public responses
Taxes
Also known as emissions fee in markets with pollution
Subsidies
Command-and-control
Government dictates standards without regard to cost
Cap-and-trade policies
Also known as a permit system

18. Taxes
With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss
Quantity is below the optimal amount with taxes
With negative externalities, taxes can improve efficiency
The optimal tax is known as the Pigouvian tax
Pigouvian tax equals marginal damage at the efficient output
Increased Pigouvian taxes can also lead to lower income taxes without sacrificing overall tax revenue
Double dividend hypothesis (More in Chapter 15)

19. Pigouvian taxes in action
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

20. Emissions fee
One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output
This kind of tax is known as an emissions fee

21. Emissions fee in action$
MC of abatement f*
Axes and labels
1st click – MSB
2nd click – MC
3rd click – dashed line and e*
4th click – f* and brown horizontal line
MSB of abatement e*
Abatement quantity

22. Subsidies
An alternative to taxes is providing a subsidy to each firm for every unit that it abates
Problems with subsidies:
Efficient outcome only with a fixed number of firms
Increased profits of firms in the industry will encourage new entrants into the industry
Positive economic profits if new entry is not allowed
Revenue is needed to provide subsidies
Taxing income reduces inefficiencies
Ethical issues: Who has the right to pollute?

23. Subsidies in action MSC = MPC + MD $ (MPC + cd) MPC Pigouvian subsidyk 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

24. Command-and-control pollution reduction
Two firms
Each would pollute 90 units if there are no pollution controls
Suppose each firm was forced to reduce pollution by 50 units
Known as uniform pollution reduction
Usually not efficient

25. Uniform pollution reductions
MC is for abatement on these graphs
Total abatement costs are in red for each firm
MCH $ $
MCB
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 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction

26. Inefficiencies of uniform reductions
Notice that MC of Homer’s last unit of abatement is higher than Bart’s  D’oh $ $

27. Inefficiencies of uniform reductions
Overall abatement costs can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit $ $

28. Command-and-control regulation
Command-and-control regulations can take many forms
Uniform reductions
Percentage reductions
Technology standards
Each firm must use a certain type of technology
This method may work best when emissions cannot be monitored easily
Performance standards
Government sets emissions goal for each polluter
Firm can use any technology it wants
Less expensive than technology standards

29. Lowering abatement costs
Going from command-and-control requirements to emissions fees can lower overall abatement costs
Marginal cost of abatement of the last unit is equal for each firm with an emissions fee

30. Emissions fees MC is for abatement on these graphs 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

31. Cap-and-trade policies
Policy in which a permit is needed for each unit of pollution emitted
Permits can be traded
Policy is efficient if
Bargaining costs are negligible
Competitive permit markets exist
Number of permits matches efficient pollution level
Initial allocation of permits does not affect efficiency as long as the above criteria are met

32. Cap-and-trade
Bart and Homer will negotiate until they agree on a $50 price for permits
Suppose Bart starts with 80 permits and Homer starts with none (see points a and b)
MCH b
MCB
f = $50
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
Bart sells 65 permits
Homer buys 65 permits

33. Emissions fee versus cap-and-trade
Given certain conditions, we notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency
$50 fee for each unit polluted (implicit fee under permits)
Bart reduces pollution by 75 units
Homer reduces pollution by 25 units

34. The real world is more complicated
We do not live in a world with perfect economic assumptions
Complicating factors
Inflation
Cost changes
Uncertainty
Distributional effects

35. Inflation
If emissions fees do not represent real prices, the amount of pollution will change as real price changes
Cap-and-trade policies do not need inflation factored in, since quantity limits are used

36. Cost changes Suppose cost to abate decreases every year
Optimal amount of abatement will increase each year
If a new abatement technology is just being developed, future cost changes could be small or large
Potential solution: Impose a hybrid system
Permit market
Offer a high tax for pollution emitted without a permit

37. Uncertainty Costs and benefits are typically not known with certainty
With uncertainty, too much or too little pollution can be produced (relative to the efficient outcome)
Two situations analyzed, with MC curve uncertain
Inelastic MSB
Elastic MSB

38. Inelastic MSB curve Marginal cost schedule could be as high as MC’ MC’$
MC*
Assume best guess of marginal cost schedule is MC* f*
Permits are closer to efficient than fees in this case
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 with fees
Too much pollution reduction with permits

39. Elastic MSB curve MC’ $ MC* f*
Axes and labels
1st click – MSB
2nd click – MC*
3rd click – MC’
4th click – f*
Fees are closer to efficient than permits in this case
MSB ef e’ e*
Pollution reduction
Too little pollution reduction with fees
Too much pollution reduction with permits

40. Distributional effects
Firms…
Lose when they pay a tax
Win when they are given permits
Government can generate revenue…
If a tax is imposed
If permits are sold
Double dividend hypothesis supports taxes or selling permits
Political pressure may encourage permit giveaways

41. Distributional effects
Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods
Displacement concerns
Job losses from environmental regulation: Does this increase income inequity?
Who bears the cost of pollution control?
Depends on who uses the good that has the pollution control
Example: Cars that are 15 or more years old

42. Externalities can be positive
Remember that not all externalities are negative
Some consumption leads to external benefits to others
Recall some examples
Planting flowers in your front lawn
Scientific research
Vaccination
Prevents others from getting a disease from you

43. Positive externalities and subsidies
Subsidies can be used to increase efficiency in the presence of positive externalities
Note that this money must be generated from somewhere, probably taxes
Recall that tax money used for subsidies has its own deadweight loss
Compare DWL with efficiency gains from the subsidy

44. Positive externality example$ 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

45. In what direction are we heading?
Command-and-control policies often rely on states to enforce
States do not always comply with these measures
Fees and permits can often be controlled on the national level
US policies have generally moved from command-and-control to taxes and permits
Exceptions do still apply: Emissions hot spots

46. Summary
Many methods are used to try to increase efficiency when externalities are present
Negotiation
Mergers between firms
Social conventions
Taxes, including emissions fees
Subsidies
Command-and-control policies
Cap-and-trade programs using marketable permits

47. Summary
Distributional concerns are important for someone that thinks that social welfare is important
Who benefits and loses from taxes versus permits?
Firms?
The government?
Who benefits most when pollution is abated
High-income more than low-income?