1. Lecture Notes: Econ 203 Introductory Microeconomics Lecture/Chapter 10: Externalities M. Cary Leahey Manhattan College Fall 2012

2. Goals
This is (yet) another applications chapter looking at international trade.
This chapter reviews many of the concepts introduced in earlier classes, particularly the tradeoff between efficiency and equity.
We look at externalities and why they can make market outcomes inefficient (market “failures”).
We look at why private solutions may solve or not solve the problem, whether “internalizing the externality” can work.
We examine the kinds of public policies to solve the problem of externalities.

3. Defining one kind of market failure-externalities
The competitive market outcome is efficient and maximizes total surplus, except when there are market failures.
One kind of market failure is externalities, which is the uncompensated impact of one person’s action on another’s well-being.
Externalities need not be solely negative, a bystander’s well-being could be enhanced by another's action.
Some examples of externalities:
Pollution
Noise
Driving and texting
Flu shots (and the case for govt. subsidies) 3

4. Example 1: negative externality, gasoline1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
The market eq. maximizes consumer + producer surplus.
Supply curve shows private cost, the costs directly incurred by sellers.
$2.50 25
Demand curve shows private value, the value to buyers (the prices they are willing to pay).
For many students, the concepts are easier to learn in the context of a specific example with numerical values.
Note that maximizing consumer + producer surplus is NOT the same as maximizing TOTAL surplus when the trades impose external costs (or benefits) on bystanders. 4 4

5. Example 1: negative externality, gasoline1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
Social cost = private + external cost
external cost
Supply (private cost)
External cost
= value of the negative impact on bystanders
= $1 per gallon (value of harm from smog, greenhouse gases) 5 5

6. Example 1: negative externality, gasoline1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
The socially optimal quantity is 20 gallons.
Social cost S
At any Q < 20,
value of additional gas exceeds social cost.
At any Q > 20,
social cost of the last gallon is greater than its value to society.
“At any Q < 20, value of additional gas exceeds social cost.”
For example, at Q = 10, the value to buyers of an additional gallon equals $4, while the social cost is only $2. Therefore, total surplus (society’s well-being) would increase with a larger quantity of gas.
“At any Q > 20, social cost of the last gallon is greater than its value.”
For example, at Q = 25 (the market equilibrium) the last gallon cost $3.50 (including the external cost) but the value of it to buyers was only $ Hence, total surplus would be higher if Q were lower.
Only at Q = 20 is society’s welfare maximized. D 25 6 6

7. Example 1: negative externality, gasoline1 2 3 4 5 10 20 30
Q (gallons) P $
The market for gasoline
Market eq. (Q = 25)
is greater than
social optimum (Q = 20).
Social cost S
One solution: tax sellers $1/gallon,
would shift S curve up $1. D 25 7 7

8. Internalizing the externality
Internalizing the externality means changing incentives to make people take accounts of the external effects of their actions. So not just market costs but “all” costs of actions are incorporated.
In the gasoline example, the tax makes the market cost equal the social cost of gasoline consumption.
The social optimum is when social costs are fully paid so
market equilibrium = social optimum
The socially optimal Q quantity maximizes social welfare.
At a lower Q, the social value of additional units > social cost
At a higher Q, the social value of additional units < social cost. 8

9. Example 2: positive externality, flu shots10 20 30 40 50 P Q $
The market for flu shots
External benefit = $10/shot
Socially optimal Q = 25 shots.
To internalize the externality, use subsidy = $10/shot.
external benefit S 25
Social value = private value + $10 external benefit D 9

10. Summary of effects of externalities
Negative externality: market Q larger than socially desirable Q
Positive externality: market Q less than socially desirable Q
To remedy the problem, internalize the externality
Tax goods with negative externalities
Subsidize goods with positive externalities. 10

11. Public policies regarding externalities
Two approaches have been adopted.
Command and control
Relegate behavior directly to “guarantee” the desired outcome.
Limits on quantity of pollution
Require adoption of specific technologies to solve the problem
Market based policies
Private sector solves problem on its own
Corrective taxes/subsidies
Tradable pollution permits
Pay to pollute seems immoral to some. 11

12. Public policies regarding externalities: corrective taxes
Corrective tax also called Pigovian taxes
designed to make private decision makers take full account of the social costs that arise from a negative externality.
Ideal corrective tax equals the external cost
A corrective subsidy deals with positive externalities
Ideal corrective subsidy equals external benefit.
While other taxes and subsidies distort incentives, thereby moving outcomes away from the market ideal, corrective taxes and subsidies move market outcomes closer.
They align social interests and private incentives and move the economy toward a more efficient allocation of resources. 12

13. Corrective taxes versus regulations; which is better?
Corrective taxes promote the most efficient outcome to dealing with externalities of production.
Different firms have different costs. The efficient outcome has firms with the lowest abatement costs reducing pollution the most.
In the case pollution, a tax is efficient.
Efficient firms (with low abatement costs) will reduce pollution to reduce their tax burden.
Ineffecient firms (with high abatement costs) have a greater willingess to pay tax.
In contrast, a regulation may mandate the socially desirable outcome but at a higher cost (ineffecient) since all firms are reuired to cut emissions. So the inefficient firms have to devote more resources to cleanup, which is inefficient. 13

14. Corrective taxes versus regulations; which is better?
Corrective taxes are better for the environment
They gives firms incentives to continuer educing pollution as long as the cost is less than the tax.
Technological improvements are more likely to be adopted, since the tax gives them an incentive to adopt them.
In the regulatory world, firms have no incentives go beyond the mandate.
For example a gasoline tax attacks three negative externalities:
Congestion – reducing “unneeded” driving
Accidents – increasing demand for smaller vehicles (less damage)
Pollution – reducing emissions by reducing consumption 14

15. Example 3: reducing greenhouse gases
Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month, total emissions = 80 tons/month.
Goal: Reduce SO2 emissions 25%, to 60 tons/month
Cost of reducing emissions: $100/ton for Acme, $200/ton for USE
Policy option 1: Regulation Every firm must cut its emissions 25% (10 tons).
Cost to Acme: (10 tons) x ($100/ton) = $1000
Cost to USE: (10 tons) x ($200/ton) = $2000
This first exercise is simple. 15

16. Example 3: reducing greenhouse gases
Policy option 2: Tradable pollution permits
Issue 60 permits, each allows one ton SO2 emissions. Give 30 permits to each firm. Establish market for trading permits.
Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons.
Compute cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each.
Acme
sells 10 permits to USE for $150 each, gets $1500
uses 20 permits, emits 20 tons SO2
spends $2000 to reduce emissions by 20 tons
net cost to Acme: $2000 − $1500 = $500 16

17. Example 3: reducing greenhouse gases
Policy option 2: Tradable pollution permits
USE
buys 10 permits from Acme, spends $1500
uses these 10 plus original 30 permits, emits 40 tons
spends nothing on abatement
net cost to USE = $1500
Total cost of achieving goal = $500 + $1500 = $2000
Using tradable permits, goal is achieved at lower total cost and lower cost to each firm than using regulation.
Pollution reduction is concentrated in the firms with the lowest abatement costs, promoting an efficient outcome.
In the real world this has been going on since 1995 in the US. 17

18. Corrective taxes/tradable permits and morality
In the pollution case, the demand for pollution has a downward slope, as the price of polluting declines, Q polluted goes up.
Corrective taxes raise the price of polluting to reduce emissions (Q).
Tradable permits restricts the supply of pollution rights and has the same effect as the tax.
Tradable permits are to be preferred if policymakers do not know the demand curve for polluting very precisely.
The position argues that it is immoral to pay to pollute but life involves tradeoffs-the value versus the cost of clean water.
While moral solution can help internalize the externality, the Coase theorem argues that if parties can “costlessly bargain,” then the externality problem can be solved on its own.
Example: cleaning dirty clothes-does the polluter or pollutee pay.
In real life, transactions costs, stubbornness, and coordination problem can stymie private solutions, making the Coase theorem a nice academic discussion point but little more. 18