1. Chapter 9 Externalities: When Prices Send the Wrong Signals

2. Externalities
Equilibrium in a free market yields a number of important results.
Goods must be produced at the lowest possible cost.
Goods must satisfy the highest valued demands.
Total surplus (consumer plus producer surplus) is maximized.
For most goods all the significant costs and benefits flow directly to the consumers and producers trading in the market creating the results above.
Instructor Notes:

3. Externalities Reviewing Gains from Trade Quantity Price Supply Demand
210
100
$13
$22
$10
Market Equilibrium
Instructor Notes: Figure 9.1: Reviewing Gains from Trade
The value of the 100th unit to buyers is $22. The cost of the 100th unit to sellers is $10. At the 100th unit there is a $12 gain from exchange. Gains from exchange are maximized when a total of 210 units are exchanged. Notice that the value of the 210th unit is just equal to the cost of the 210th unit.

4. Externalities
For some goods, however, the costs and benefits to consumers and producers are more complex.
A Private Cost is a cost paid by the consumer or producer.
A Private Benefit is a benefit received by the consumer or the producer.
An External Cost is a cost paid by people other than the consumers or the producers trading in the market.
An External Benefit is a benefit received by people other than the consumers or producers trading in the market.
Externalities are external costs or benefits.
Instructor Notes:

5. Externalities
In markets with externalities, consumers and producers focus on the wrong margin when making their decisions.
The Social Cost is the cost to everyone, the private cost plus the external cost.
The Social Benefit is the benefit to everyone, the private benefit plus the external benefit.
When making decisions, consumers and producers typically focus on private costs and benefits while ignoring external costs and benefits.
Instructor Notes:

6. Externalities
When consumers and producers ignore externalities, the market equilibrium can be less than optimal.
To evaluate market equilibrium in these cases, all costs and benefits must be accounted for.
Social Surplus is consumer surplus plus producer surplus plus everyone else’s surplus.
This is not maximized when externalities are present.
Instructor Notes:

7. External Costs
When consumers and producers ignore external costs, they base their decisions on private costs only.
As such, costs are underestimated, and the market quantity is greater than the socially efficient level.
At the higher market level of output, costs (all costs) exceed the private benefits to buyers.
A deadweight loss emerges reducing social surplus.
Instructor Notes:

8. External Costs When External Costs are Significant, Output is Too High
Price/Costs
Quantity
Qefficient
Social Cost
Pefficient
External Cost
overuse
Social Cost
Private Value
Deadweight Loss
Qmarket
Supply
Demand
Pmarket
Instructor Notes: Figure 9.2: When External Costs are Significant, Output is Too High
When consumers and producers focus only on private costs and benefits, the market equilibrium is Qmarket and Pmarket. The supply curve that consumers and producers use to make their decisions, however, does reflect all the costs in the market. The social cost which captures both private and external costs is reflected in a higher supply curve. The efficient equilibrium when accounting for the external cost is Qefficient and Pefficient. The market equilibrium, by ignoring the external costs, leads to a level of output that is too high (overuse) creating a deadweight loss. At the market quantity the social cost is greater than the private benefit to buyers (Private Value)

9. External Costs
When external costs are ignored, the market quantity is greater than the socially efficient level, and social surplus is reduced.
Reducing output below the market quantity increases social surplus when the social cost exceeds buyers’ private benefit.
Thus, to maximize social surplus output should be reduced to the socially efficient level.
Instructor Notes:

10. External Benefits
When consumers and producers ignore external benefits, they base their decisions on private benefits only.
As such, benefits are underestimated, and the market quantity is less than the socially efficient level.
At the lower market level of output, benefits (all benefits) exceed the private costs to sellers.
A deadweight loss emerges reducing social surplus.
Instructor Notes:

11. External Benefits
When External Benefits are Significant, Market Output is Too Low
Price
Quantity
Pmarket
Qmarket
Supply
Demand
External Benefit
Pefficient
Qefficient
Social Value
underuse
Private Cost
Deadweight Loss
Instructor Notes: Figure 9.3: When External Benefits are Significant, Market Output is Too Low
When consumers and producers focus only on private costs and benefits, the market equilibrium is Qmarket and Pmarket. The demand curve that consumers and producers use to make their decisions, however, does not reflect all the benefits in the market. The social value which captures both private and external benefits is reflected in a higher demand curve. The efficient equilibrium when accounting for the external benefit is Qefficient and Pefficient. The market equilibrium, by ignoring the external benefits, leads to a level of output that is too low (underuse) creating a deadweight loss. At the market quantity the social value is greater than the private costs.

12. External Benefits
When external benefits are ignored, the market quantity is less than the socially efficient level and social surplus is reduced.
Increasing output above the market quantity increases social surplus when the social value exceeds sellers’ private cost.
Thus, to maximize social surplus output should be expanded to the socially efficient level.
Instructor Notes:

13. Solving Problems Caused by Externalities
When externalities are significant, the market equilibrium is no longer efficient.
What can be done to resolve this problem?
Private Solutions
Government Solutions
Instructor Notes:

14. Private Solutions to Externalities
In certain situations the private sector can resolve externalities.
The Coase Theorem states that if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities.
Transaction Costs are all costs necessary to reach an agreement.
Instructor Notes:

15. Private Solutions to Externalities
The Coase Theorem suggests bargaining, with the right conditions, ensures that just the right amount of the externality is produced.
If there were either too little or too much of the externality, trading would push the quantity to the optimal level.
Thus, the free market equilibrium will maximize social surplus.
Instructor Notes:

16. Private Solutions to Externalities - Extra!
Suppose that a railroad runs along a wheat field.
Steam locomotives using the railroad emit hot cinders from their smokestacks that can burn the neighboring crops.
To avoid this danger, the wheat farmer does not plant crops within two hundred feet of the railroad incurring losses of $3,000 per harvest.
The railroad, thus, imposes an external cost on the farmer.
Instructor Notes: This example comes from Ronald Coase’s “The Problem of Social Cost” in the Journal of Law and Economics, 1960.

17. Private Solutions to Externalities - Extra!
If the farmer has a right to grow crops without them being burned, then the railroad must bear the costs to the farmer.
The railroad could pay the farmer $3,000 to cover the losses each harvest and continue to use the rail line.
Or, the railroad could prevent the fires by installing spark arresters that cost $2,000 to maintain each harvest.
In this situation all costs are now internalized, and the railroad will install the spark arresters (the least costly alternative).
Instructor Notes:

18. Private Solutions to Externalities - Extra!
If the railroad has a right to use the rail line, then the farmer must bear the costs of the losses.
The farmer would be willing to pay the railroad up to $3,000 per harvest to cease using the rail line.
Or, the farmer could purchase and maintain the spark arresters for the railroad at a cost of $2,000 per harvest.
In this situation all costs are now internalized, and the farmer will install the spark arresters (the least costly alternative) for the railroad.
Instructor Notes:

19. Private Solutions to Externalities - Extra!
If the railroad and the farmer can negotiate without incurring any additional costs, an efficient outcome will arise.
Note that regardless of who is initially assigned the property right, the same solution occurs – the spark arrester is installed.
Instructor Notes:

20. Private Solutions to Externalities
The conditions of the Coase Theorem, however, are unlikely to be met.
Transaction costs for many externalities are high, and property rights are often not clearly defined.
When these conditions do not hold, markets alone will not internalize all externalities.
The Coase Theorem does suggest that if these conditions exist, a new market for externalities might develop that maximizes social surplus.
Note that government can play a crucial role in defining property rights and reducing transaction costs.
Instructor Notes:

21. You want to hold a Saturday night party at your house but are worried that your elderly neighbors will complain to the police about the noise. Suggest a solution to this problem using what you know about the Coase Theorem.
Consider a factory near you that pollutes. What are the transaction costs involved in you and your neighbors negotiating with the factory to reduce the pollution? Is a private solution possible?
Instructor Notes:

22. Government Solutions to Externalities
When private solutions are not able to emerge, the government can play a role in resolving externalities.
Some options available to government are:
Taxes and Subsidies;
Command and Control;
Tradeable Allowances.
Instructor Notes:

23. Government Solutions to Externalities
Governments often use taxes and subsidies to resolve externalities.
When external costs are significant, governments impose taxes to reduce the market quantity to the efficient level where social costs equal buyers’ benefit.
When external benefits are significant, governments offer subsidies to increase the market quantity to the efficient level where social benefits equal sellers’ costs.
Instructor Notes:

24. Government Solutions to Externalities
A Pigouvian Tax is a tax on a good with external costs.
A Pigouvian Subsidy is a subsidy on a good with external benefits.
These policies allow markets to send proper signals when externalities are present thus maximizing social surplus.
Instructor Notes:

25. Government Solutions to Externalities
A Pigouvian Tax Reduces Output to the Efficient Quantity
Price
Quantity
Qefficient
Social Cost
Pefficient
Tax = External Cost
Deadweight Loss with No Tax
Qmarket
Supply
Demand
Pmarket
Instructor Notes: A Pigouvian Tax Reduces Output to the Efficient Quantity
A Pigouvian tax equal to the external cost shifts the supply curve reducing the market quantity to the socially efficient quantity. Note that the price with the tax now reflects all of the costs in the market.

26. Government Solutions to Externalities
A Pigouvian Subsidy Increases Output to the Efficient Quantity
Price
Quantity
External Benefit = Subsidy
Pefficient
Qefficient
Social Value
Deadweight Loss with No Subsidy
Pmarket
Qmarket
Supply
Demand
Instructor Notes: A Pigouvian Subsidy Increases Output to the Efficient Quantity
A subsidy equal to the external benefit shifts the demand curve increasing the market quantity to the socially efficient quantity. Note that the price with the subsidy now reflects all of the benefits in the market.

27. In our discussion of Pigouvian taxes, we assumed that the government set the correct tax to achieve efficient equilibrium. What if government overshoots and adds a tax that is too high? Will the equilibrium quantity be higher or lower than the efficient equilibrium?
In our discussion of Pigouvian subsidies, we assumed that government set the correct subsidy amount to achieve the efficient equilibrium. What if the government undershoots and provides a subsidy that is too low? Will the equilibrium quantity be higher or lower than the efficient equilibrium?
Instructor Notes:

28. Government Solutions to Externalities
The most direct approach for government to resolve externalities is to impose command and control regulation.
When external costs are significant, the government can mandate a lower quantity than the market level.
When external benefits are significant, the government can mandate a higher quantity than the market level.
Instructor Notes:

29. Government Solutions to Externalities
Command and control regulations do not always bring about an efficient solution.
Governments may not possess enough information to choose the least costly method to achieve the necessary reduction in quantity when external costs are present.
Command and control regulations do not provide consumers and producers the flexibility to choose the least costly method of reducing quantity in these instances.
Instructor Notes:

30. Government Solutions to Externalities
While command and control regulations fail to harness private information and individual preferences, there could exist some situations where such an approach would be preferable.
Command and control can be effective under the following conditions:
The best approach to the problem is well known;
Success requires very strong compliance.
Instructor Notes: The chapter refers to the World Health Organizations (WHO) in halting the spread of smallpox in the 1960s.

31. Government Solutions to Externalities
The government can address external costs by establishing a market for tradeable allowances.
Under this approach, the government sets a maximum quantity and rations a portion of that level to players in the market.
Consumers and producers individually choose the best (least costly) approach to limit their quantity.
Instructor Notes:

32. Government Solutions to Externalities
Tradeable allowances reduce external costs and avoid the problems of command and control regulation.
Consumers and producers have much more flexibility in implementing cost control measures.
Furthermore, the regime creates strong incentives for consumers and producers to reduce quantity since the allowances are tradeable.
Instructor Notes:

33. Government Solutions to Externalities
The Clean Air Act of 1990 created a system of tradeable allowances.
Under this reform the Environmental Protection Agency (EPA) distributes pollution allowances to generators of electricity, with each allowance giving the owner the right to emit one ton of sulfur dioxide (SO2).
Firms may trade allowances as they see fit, but no firm can emit more pollution than it has allowances.
SO2 emissions have been reduced 35% since 1990 while electricity generation has increased.
Instructor Notes: Students should note that the tradeable allowances system of the Clean Air Act of 1990 is really an example of the Coase Theorem in action where the market internalizes the externality. Through the legislation government established the necessary conditions for the Coase theorem to work - clear property rights and low transaction costs.

34. Government Solutions to Externalities
Instructor Notes:

35. Government Solutions to Externalities
There is a close relationship between using taxes and tradeable allowances to internalize externalities.
A tax set equal to the level of the external cost is equivalent to tradeable allowances when the number of allowances is set equal to the efficient quantity.
Instructor Notes: Note that tradeable allowances do not generate revenue like the tax unless they are sold.
From Greg Mankiw’s Blog Saturday, December 9, 2006:
“In fact, Pigovian taxes are not only least bad--they are good. They correct market failures when transactions costs are too high to expect the forces of the Coase theorem to fix the problem. Pigovian taxes allow truly distortionary taxes, either now or (through debt reduction) in the future, to be lower than they would otherwise be. And in the off-chance that we achieve libertarian utopia and reduce government spending below the level of revenue raised by optimal Pigovian taxation, the extra revenue can always be rebated lump-sum to the public. I am less fond of cap-and-trade programs than Pigovian taxes because they, in essence, give the revenue from a Pigovian tax lump-sum to a regulated entity. Why should an electric utility, for example, be given a valuable resource simply because it has for years polluted the environment? That does not strike me as equitable. A new firm entering the market should not have to pay for something that an incumbent gets for free. And the fact that the incumbent has for years been taking a valuable resource from the rest of society is no reason to think it deserves a free ride in the future. On equity grounds, one could just as easily argue that the incumbents should compensate society for their past misdeeds. Cap-and-trade systems are also relatively inefficient, for two reasons. First, they encourage utilities to pollute more before the cap-and-trade system is put into effect in order to "earn" pollution rights. Second, they waste the opportunity to use the Pigovian tax revenue to reduce distortionary taxes on labor and capital. Of course, cap-and-trade systems are better than heavy-handed regulatory systems. But they are not as desirable, in my view, as Pigovian taxes coupled with reductions in other taxes. One exception: If the pollution rights are auctioned off rather than handed out, then cap-and-trade systems are almost identical to Pigovian taxes, including all the desirable efficiency properties.”

36. Government sets a total quantity of tradable pollution allowances and auctions them off. After the auction, the price for an individual allowance is high. Over time, the price falls dramatically. What does this tell you?
The local government has decided to set and apportion tradable allowances for pollution in your neighborhood. Name three groups that would press for a large total quantity of allowances. Name three groups that would press for a smaller total quantity of allowances. Consider these groups, how likely is it that government would set a total quantity of allowances that would achieve an efficient equilibrium?
Instructor Notes:

37. Externalities are external costs or benefits.
An external cost is a cost paid by people other than the consumers or the producers trading in the market.
An external benefit is a benefit received by people other than the consumers or producers trading in the market.
When consumers and producers ignore externalities, the market equilibrium can be less than optimal.
Instructor Notes:

38. When external costs are ignored, the market quantity is greater than the socially efficient level, and social surplus is reduced.
When external benefits are ignored, the market quantity is less than the socially efficient level and social surplus is reduced.
Instructor Notes:

39. Some options available to government are:
Both private and government solutions exist to resolve problems of externalities.
The Coase Theorem states that if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities.
Some options available to government are:
Taxes and Subsidies;
Command and Control;
Tradeable Allowances.
Instructor Notes: