Externalities
Externalities
a. What are externalities?
b. Pollution
November 21, 2006
c. Private solutions to externalities
Reading: Chapter 19
d. Policies toward pollution
This topic examines externalities, or side effects of
activities that are not paid for. We discuss how
externalities lead to market failures and how
government policy can make things better. We
devote some attention to a major externality,
pollution.
e. Production, consumption and
externalities
2
Pollution
What are externalities?
Costs and Benefits of Pollution
Externalities are costs and benefits that are side effects of
activities done by economic agents (individuals, firms) who do
not have an economic incentive to take these costs and
benefits into account.
External costs or external diseconomies result in costs to
others. Cost which an agent imposes on others without
compensating them for it.
External benefits or external economies result in benefits
to others. Benefit which an agent provides others without
being compensated for it.
Since agents do not take into account these external costs and
benefits, individual optimizing behavior, even under
conditions of perfect competition, results in market failure.
We will discuss two cases, those in which: (1) the side
effects can be directly measured and quantified, as in
the case of environmental pollution; and (2) only the
original activity, not the side effect, can be observed
and measured.
3
Pollution
Pollution: damage to the environment (clean air,
clean water, land) caused by economic activities
such production, consumption. Also refers to
deforestation, loss of biodiversity, damage to the
ozone layer, and global warming. Often measured
by amount of “bad” effluents released.
Marginal social cost of pollution: additional
cost imposed on society as a whole by an additional
unit of pollution. MSC increases with the amount of
pollution.
Marginal social benefit of pollution: additional benefit to society as a
whole from an additional unit of pollution. Reducing pollution requires scarce
resources which could have been used to produce goods and services. As
pollution falls, these additional resources are higher (think in terms of amount
of pollution reduction).
Socially optimal quantity of pollution: amount of pollution that maximizes
the difference between total social benefits and total social costs of pollution.
Amount of pollution society would choose if all costs and benefits of pollution
4
are fully accounted for. Where MSC = MSB for pollution. Not zero pollution.
Private Solutions to Externalities
Market failure
Coase theorem: even in the presence of externalities an
economy can always reach an efficient solution
provided that transaction costs (costs of making deals)
are sufficiently low.
Pollution, like other
externalities, results in
market failure.
Marginal benefits
(additional cost of
pollution control)
accrues to private firms
and individuals.
The theorem implies that externalities need not lead to
inefficiency because individuals have an incentive to
find a way to make mutually beneficial deals (usually
with payments) that lead them to take externalities into
account (that is, internalize the externality) when
making decisions.
Marginal costs accrue
to society as a whole in
the form of an
externality, not to
polluter.
In the absence of government intervention, polluters face no marginal costs,
only marginal benefits. So they will pollute up to where MSB=0; there will be
no pollution control. The free market results in QMKT level of pollution.
The socially efficient or optimal level of pollution is QOPT level of pollution.
Ronald Coase (b.
1910), American
economist and Novel
Prize winner
Problem: Individuals cannot always make such deals because of high
transaction costs due to:
1. High costs of communication if many people are involved
2. High legal expenses for legally binding agreements.
3. Delays in bargaining, with parties holding out to get better deals.
So the free market will not lead to a socially optimal outcome.
5
So government action is usually required.
6
1
Policies Toward Pollution
Policies Toward Pollution
Environmental Standards versus Emissions Taxes
1. Environmental standards: rules that protect the
environment by specifying actions by producers and
consumers. Generally such standards are inefficient
because they are inflexible, but historically reduce
pollution.
2. Emissions tax: a form of Pigouvian tax, a tax
designed to reduce external costs that depends on
the amount of pollution a firm produces. Efficient
because marginal cost of pollution control, or
marginal benefit of pollution equalized among all
polluters. Optimal tax is at the level MSB=MSC.
3. Tradable emissions permits: licenses to emit
limited quantities of pollutants that can be bought
and sold by polluters. Those who can reduce
pollution efficiently will do so, while others may
prefer to buy licenses.
Arthur Cecil Pigou
(1877-1959),
British economist
In some cases
taxes and
tradable permits
are not feasible,
and
environmental
standards must be
imposed.
Sometimes some
pollution may be
so destructive that
standards have to
be used. Catalytic
converters, no
7
smoking rules.
Production, Consumption, and Externalities
„
„
„
„
For some externalities, it is not possible to directly measure
and control the amount of an externality. In such cases, we
can focus directly on the activity, rather than its side
effect.
This is true for some kinds of pollution, eg. livestock rearing
results in air pollution and “muck”, and for smoking. But it is
common for external benefits – such as technology spillovers
and education.
Sometimes analysis in terms of units of externality (like
pollution) and in terms of units of production, can be
complementary.
For policy purposes, if it is possible to measure externality it
is usually better to deal with it directly – with taxes, for
instance, than taxing the output of the good. Doing the
latter will not create incentives to reduce pollution per unit of
output. But if it is not possible to measure the externality,
government policy may have to focus on the production and
consumption of goods and services that give rise to
externalities.
9
MBA shows marginal benefit of pollution to Plant A and MBB shows marginal benefit of
pollution to Plant B. Without government intervention, each plant emits 600 tons. Cost
of reducing emissions is lower for Plant A (MBA lies below MBB). Panel (a) shows the an
environmental standard that requires both plants to cut emissions in half is inefficient,
because it leaves the marginal benefit of pollution higher for Plant B than for Plant A.
Panel (b) shows how an emissions tax achieves the same quantity of overall pollution
efficiently: faced with an emissions tax of $200 per ton, both plants reduce pollution8 to
the point where its marginal benefit is $200. Least cost way of achieving 600.
Production, Consumption and Externalities
Negative Externalities and Production
Private versus Social Costs: When there are external costs, the marginal
social cost of a good or activity exceeds the firms’s private marginal cost of
producing the good. In the absence of government intervention, the industry
typically produces too much of the good.
The socially optimal quantity can be achieved by an optimal Pigouvian tax,
equal to the marginal external cost, or by a system of tradable production
permits.
Without government
action, the market
produces QMKT >QOPT,.
At QMKT, the market
price, PMKT, is less than
PMSC, the true marginal
cost to society of
production. An optimal
Pigouvian tax on
production, equal to its
marginal external cost,
moves the production
to QOPT, resulting in
lower output and a
higher price to
consumers.
10
Production, Consumption and Externalities
Positive Externalities and Production
Private versus social benefits: The most common examples of external benefits are
technology spillovers. When these occur, the marginal social benefit of a good or
activity exceeds the private marginal benefit to consumers, and too little of the
good is produced in the absence of government intervention.
The socially optimal quantity can be achieved by an optimal Pigouvan subsidy (a
payment designed to encourage activities that yield external benefits) equal to the
marginal external benefit.
Such a subsidy is an example of an industrial policy is a policy that supports industries
believed to yield positive externalities. Some economists don’t like these because
positive externalities are hard to measure and subsidies can become political in nature.
Without government
action, the market
produces QMKT < QOPT,. At
QMKT, the market price,
PMKT, is less than PMSB, the
true marginal benefit to
society. An optimal
Pigouvian subsidy to
producers, equal to its
marginal external benefit,
moves the production to
QOPT, resulting in higher
output and a higher price
to producers.
11
2