1. Chapter 5: Externalities Problems and Solutions Outline Externality theory Private solutions Public solutions Focus on prices or focus on quantities? A couple problems

2. Introduction Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so. As we will see, this represents a market failure for which government action could be appropriate and improve welfare. Externalities can be negative or positive: Acid rain, bad. Asking good questions in class, good.

3. Introduction Global warming is likely the result of a negative externality. Most scientists who study the issue believe this warming trend is caused by human activity, namely the use of fossil fuels. These fuels, such as coal, oil, natural gas, and gasoline produce carbon dioxide that in turn traps heat from the sun in the earth’s atmosphere. Figure 1 Figure 1 shows the trend in warming over the last century.

4. Figure 1 This table shows the global temperature during the 20 th century. There has been a distinct trend upward in temperature

5. Introduction Although this warming trend has negative effects overall on society, the distributional consequences vary. In much of the United States, warmer temperatures may improve agricultural output and quality of life. In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea levels. If you’re wondering why you should care about Bangladesh, then you have identified the market failure that arises from externalities. From your private perspective, you shouldn’t! But this is the essence of an externality – your actions have consequences for others that you do not consider.

6. EXTERNALITY THEORY Externalities can either be negative or positive, and they can also arise on the supply side (production externalities) or the demand side (consumption externalities). A negative production externality is when a firm’s production reduces the well-being of others who are not compensated by the firm. A negative consumption externality is when an individual’s consumption reduces the well-being of others who are not compensated by the individual. Positive externalities are similar to negative externalities, except the actions have beneficial effects for others.

7. Economics of Negative Production Externalities To understand the case of negative production externalities, consider the following example: A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river. The fishermen downstream are harmed by this activity, as the fish die and their profits fall. This is a negative production externalities because: Fishermen downstream are adversely affected. And they are not compensated for this harm. Figure 2 Figure 2 illustrates each party’s incentives in this situation.

8. Price of steel p1p1 p2p2 0Q2Q2 Q1Q1 This framework does not capture the harm done to the fishery, however. The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q 1. Q STEEL D = PMB = SMB S=PMC SMC = PMC + MD MD Figure 2 Negative Production Externalities The socially optimal level of production is at Q 2, the intersection of SMC and SMB. The yellow triangle is the consumer and producer surplus at Q 1. The marginal damage curve (MD) represents the fishery’s harm per unit. The social marginal cost is the sum of PMC and MD, and represents the cost to society. The red triangle is the deadweight loss from the private production level. The steel firm overproduces from society’s viewpoint.

9. Negative Consumption Externalities We now move on to negative consumption externalities. Consider the following example: A person at a restaurant smokes cigarettes. That smoking has a negative effect on your enjoyment of the restaurant meal. In this case, the consumption of a good reduces the well-being of someone else. Figure 3 Figure 3 illustrates each party’s incentives in the presence of a negative consumption externality.

10. Q CIGARETTES Price of cigarettes 0Q2Q2 D=PMB Q1Q1 p1p1 S=PMC=SMC SMB=PMB-MD MD p2p2 The yellow triangle is the surplus to the smokers (and producers) at Q 1. This framework does not capture the harm done to non-smokers, however. The smoker sets PMB=PMC to find his privately optimal quantity of cigarettes, Q 1. The MD curve represents the nonsmoker’s harm per pack of cigarettes. The social marginal benefit is the difference between PMB and MD. The socially optimal level of smoking is at Q 2, the intersection of SMC and SMB. The smoker consumes too many cigarettes from society’s viewpoint. The red triangle is the deadweight loss from the private production level. Figure 3 Negative Consumption Externalities

11. Externalities Result in Underproduction or Overproduction The theory shows that when a negative externality is present, the private market will produce too much of the good, creating deadweight loss. When a positive externality is present, the private market produces too little of the good, again creating deadweight loss.

12. Graphing Externalities Determine whether the externality is associated with production (steel, donuts) or consumption (smoking, landscaping). Is the externality positive (donuts, landscaping) or negative (steel, smoking). Negative production externality, SMC is above PMC Positive production externality, SMC is below PMC Negative consumption externality, SMB is below PMB Positive consumption externality, SMB is above PMB

13. The Solution (Coase Theorem) The Coase Theorem: When there are well- defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level. Thus, the role of government intervention may be very limited—that of simply enforcing property rights.

14. Q STEEL Price of steel 0Q2Q2 D = PMB SMB Q1Q1 p1p1 S = PMC SMC = PMC + MD MD p2p2 But there is room to bargain. The steel firm gets a lot of surplus from the first unit. 12 This bargaining process will continue until the socially efficient level. There is still room to bargain. The steel firm gets a bit less surplus from the second unit. Thus, it is possible for the steel firm to “bribe” the fishery in order to produce the first unit. The reason is because any steel production makes the fishery worse off. Thus, it is possible for the steel firm to “bribe” the fishery in order to produce the next unit. If the fishery had property rights, it would initially impose zero steel production. While the fishery suffers only a modest amount of damage. While the fishery suffers the same damage as from the first unit. Figure 5 Negative Production Externalities and Bargaining: Giving the Fish People Property Rights The gain to society is this area, the difference between (PMB - PMC) and MD for the second unit. The gain to society is this area, the difference between (PMB - PMC) and MD for the first unit.

15. Figure 6 Negative Production Externalities and Bargaining: Steel Producers Have Property Rights Q STEEL Price of steel 0Q2Q2 D=PMB=SMB Q1Q1 p1p1 S = PMC SMC = PMC + MD MD p2p2 The fishery gets a lot of surplus from cutting back steel production by one unit. This level of production maximizes the consumer and producer surplus. If the steel firm had property rights, it would initially choose Q 1. While the steel firm suffers a larger loss in profits. The gain to society is this area, the difference between MD and (PMB-PMC) by cutting back 1 unit. While the steel firm suffers only a modest loss in profits. The gain to society is this area, the difference between MD and (PMB - PMC) by cutting another unit. This bargaining process will continue until the socially efficient level. Thus, it is possible for the fishery to “bribe” the steel firm to cut back another unit. Thus, it is possible for the fishery to “bribe” the steel firm to cut back. The fishery gets the same surplus as cutting back from the first unit.

16. Problems with Coasian Solutions There are several problems with the Coase Theorem, however. The assignment problem Hard to assign blame, hard to value marginal damages The holdout problem Each party has power, so it can be hard to negotiate settlements The free rider problem If investment is costly, but benefits are common, individuals will underinvest. Transaction costs and negotiating problems

17. PUBLIC-SECTOR REMEDIES FOR EXTERNALITIES Coasian solutions are insufficient to deal with large scale externalities. Public policy makes use of three types of remedies to address negative externalities: Corrective taxation Subsidies Regulation

18. Q STEEL Price of steel 0Q2Q2 D = PMB = SMB Q1Q1 p1p1 S=PMC SMC=PMC+MD p2p2 The steel firm initially produces at Q 1, the intersection of PMC and PMB. Imposing a tax shifts the PMC curve upward and reduces steel production. S=PMC+tax Imposing a tax equal to the MD shifts the PMC curve such that it equals SMC. The socially optimal level of production, Q 2, then maximizes profits. Figure 7 Pigouvian Tax

19. Subsidies The government can impose a “Pigouvian” subsidy on producers of positive externalities, which increases its output. If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point. Figure 8 Figure 8 illustrates such a subsidy.

20. Q DONUTS Price of donuts 0Q2Q2 D = PMB = SMB Q1Q1 p1p1 S = PMC SMC=PMC-EMB p2p2 The donut shop initially chooses Q 1, maximizing its profits. Providing a subsidy shifts the PMC curve downward. The socially optimal level of donuts, Q 2, is achieved by such a subsidy. Providing a subsidy equal to EMB shifts the PMC curve downward to SMC. Figure 8 Pigouvian Subsidy

21. Regulation Finally, the government can impose quantity regulation, rather than relying on the price mechanism. Figure 9 For example, return to the steel firm in Figure 9.

22. Q STEEL Price of steel 0Q2Q2 D = PMB = SMB Q1Q1 p1p1 S = PMC SMC = PMC + MD p2p2 The firm has an incentive to produce Q 1. Yet the government could simply require it to produce no more than Q 2. Figure 9 Quantity Regulation

23. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES The key goal is, for any reduction in pollution, to find the least-cost means of achieving that reduction. One approach could simply be to reduce output. Another approach would be to adopt pollution-reduction technology.

24. Figure 10 Model of Pollution Reduction On its own, the steel company would set Q R =0 and Q Steel =Q 1. QRQR PRPR 0 MD = SMB R*R* S=PMC=SMC D = PMB S=PMC While it faces increasing marginal costs from reducing its pollution level. While the benefit of pollution reduction is zero the firm, society benefits by MD. The good that is being created is “pollution reduction.” Since it pays for the pollution reduction, the SMC is the same as PMC. Pollution reduction has a price associated with it. The steel firm’s private marginal benefit from pollution reduction is zero. Such an action maximizes its profits. The optimal level of pollution reduction is therefore R *. R Full At some level of pollution reduction, the firm has achieved full pollution reduction. More pollution P*P* P Full 0 Thus, the x-axis also measures pollution levels as we move toward the origin.

25. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES Assume now there are two firms, with different technologies for reducing pollution. Assume firm “A” is more efficient than firm “B” at such reduction. Figure 11 Figure 11 illustrates the situation.

26. QRQR PRPR 0 MD=SMB R*R* S = PMC A + PMC B = SMC Firm B has relatively inefficient pollution reduction technology. PMC B PMC A PMC B PMC A For any given output level, PMC B >PMC A. While Firm A’s is more efficient. The SMB curve is the same as before. RA,RBRA,RB Quantity regulation in this way is clearly inefficient, since Firm B is “worse” at reducing pollution. If, instead, we got more reduction from Firm A, we could lower the total social cost. RARA RBRB The efficient level of pollution reduction is the same as before. To get the total marginal cost, we sum horizontally. Efficient regulation is where the marginal cost of pollution reduction for each firm equals SMB. Quantity regulation could involve equal reductions in pollution by both firms, such that R 1 + R 2 = R *. Imposing a Pigouvian tax equal to MD induces these levels of output. Figure 11 Two Firms Emit Pollution

27. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES Figure 11 Figure 11 shows that price regulation through taxes is more efficient than is quantity regulation. A final option is quantity regulation with tradable permits. Idea is to: Issue permits that allow firms to pollute And allow firms to trade the permits

28. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES As in the previous figure, initially the permits might be assigned as quantity regulation was assigned. This means that initially R A = R B. But now Firm B has an interest in buying some of Firm A’s permits, since reducing its emissions costs PMC B (>PMC A ). Both sides could be made better off by Firm A selling a permit to Firm B, and then Firm A simply reducing its pollution level. This trading process continue until PMC B =PMC A.

29. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES Finally, the government may not always know with certainty how costly it is for a firm to reduce its pollution levels. Figure 12 Figure 12 shows the case when the social marginal benefit is “locally flat.”

30. Figure 12 Model with Uncertainty and Locally Flat Benefits QRQR PRPR 0 MD = SMB R1R1 PMC 1 First, assume the SMB is downward sloping, but fairly flat. R Full More pollution P Full 0 This could be the case for global warming, for example. In addition, imagine that the government’s best guess of costs is PMC 1. But it is possible for the firm’s costs to be PMC 2. PMC 2 Regulation mandates R 1. If, instead, the government levied a tax, it would equal MD at Q R = R 1. Suppose the true costs are PMC 2. Then there is large deadweight loss. This results in a much smaller DWL, and much less pollution reduction. R3R3

31. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES Figure 13 Figure 13 shows the case when the social marginal benefit is “locally steep.”

32. Figure 13 Model with Uncertainty and Locally Steep Benefits QRQR PRPR 0 MD = SMB R1R1 PMC 1 R Full More pollution P Full 0 In addition, imagine that the government’s best guess of costs is PMC 1. But it is possible for the firm’s costs to be PMC 2. PMC 2 Regulation mandates R 1. If, instead, the government levied a tax, it would equal MD at Q R = R 1. This results in a larger DWL, and much less pollution reduction. R3R3 First, assume the SMB is downward sloping, and fairly steep. This could be the case for nuclear leakage, for example. Suppose the true costs are PMC 2. Then there is small deadweight loss.

33. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES These figures show the implications for choice of quantity regulation versus corrective taxes. The key issue is whether the government wants to get the amount of pollution reduction correct, or to minimize firm costs. Quantity regulation assures the desired level of pollution reduction. When it is important to get the right level (such as with nuclear leakage), this instrument works well. However, corrective taxation protects firms against large cost overruns.