Chapter_05_Students

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CHAPTER 5
Externalities
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Externalities

Externality

An activity on one entity that affects the welfare
of another entity in a way that is outside the
market mechanism


Increase in Social Costs
Pricing Effects

Suburban to Urban Migration

Rent on Condos Increase

Externality?
5-2
The Nature of Externalities

Privately vs. Public Ownership

Bart Operates a Polluting Factory on a Stream

Lisa Fishes on the Stream

Who owns the stream?

Does Bart have the right to operate a polluting factory
on the stream?
5-3
The Nature of Externalities

Can Consumers Produce Externalities?
5-4
The Nature of Externalities

Examples of Positive Externalities?
5-5
What Pollutants Do Harm?

Empirical Evidence: What is the Effect of Air
Pollution on Health?

How would you conduct a study?
5-6
What Pollutants Do Harm?

What Activities Produce Pollutants?


What is the Value of the Damage Done?


How Much?
Buy and Sell Pollution?
Empirical Evidence: The Effect of Air
Pollution on Housing Values
5-7
Implications for Income Distribution

Who Benefits?


Poor are Disproportionately Affected by Air
Pollution
Who Bears the Cost?
5-8
The Nature of Externalities-Graphical Analysis

Factory Pollutes Stream


Perfect Price Discriminator
Fisherman with Sick Fish

Marginal Damage or Social Cost
5-9
The Nature of Externalities-Graphical Analysis
$
MPC
Marginal
Private Cost
MB
0
Q1
Marginal
Benefit
Q per year
Actual output
5-10
The Nature of Externalities-Graphical Analysis

Suppose we have the following example:

MD= 25Q

MPC=50+40Q

Demand: P=400-5Q

Find Quantity of Widgets in Equilibrium

Find Social Efficient Quantity of Widgets


MSC
Find Gain to Society

Calculate Loss to Factory and Gain to Fisher
5-11
Pollution Reductions

We see postive effects of reducing negative
externalities such as pollution.

How do we get there?

Private Options

Public Options
5-12
The Coase Theorem

Coase Theorem

Provided that transaction costs are negligible, an efficient
solution to an externality problem is achieved as long as
someone is assigned property rights, independent of who
is assigned those rights
5-13
Bargaining and the Coase Theorem
MSC = MPC + MD
$
MPC
h
d
g
c
MD
MB
0
Q*
Q1
Q per year
5-14
The Coase Theorem

Coase Theorem



Provided that transaction costs are negligible, an efficient
solution to an externality problem is achieved as long as
someone is assigned property rights, independent of who
is assigned those rights
Assumptions:

Low Bargaining Costs

Ability to Identify the Source of Damage
US Air Pollution?
5-15
Other Private Solutions

Mergers

Social Conventions

Socially Acceptable
5-16
Public Response to Externalities

Taxes and Subsidies

Mandatory Pollution Reductions

Command and Control

Emissions Fees

Cap and Trade
5-17
Public Responses to Externalities – Taxes
MSC = MPC + MD
(MPC + cd)
$
MPC
d
MD
MB
0
Q*
Q1
Q per year
5-18
Public Responses to Externalities – Taxes

Calculate Tax Revenue

Calculate Producer Surplus

Calculate Producer’s Loss

Calculate Gain to Outside Firm
5-19
Pigouvian Tax Revenue

What should be done with this tax revenue?
5-20
Public Responses to Externalities - Subsidies
MSC = MPC + MD
$
MPC
d
c
MD
MB
0
Q*
Q1
Q per year
5-21
Public Responses to Externalities – Taxes

Calculate Subsidy

Calculate Producer Surplus

Calculate Producer’s Loss

Calculate Gain to Outside Firm
5-22
Pollution Reductions

We see postive effects of reducing pollution.

How do we get there?

Public Options

Private Options
5-23
Uniform Pollution Reductions


Consider Two Firms (B and H)

Each Starts Out Pollution 90 Units

Marginal Cost of Reducing Pollution

MCB = 2/3P

MCH = 2P
You Want to Reduce Pollution by 100 Units

Consider Uniform Pollution Reductions

Each Firm Reduces 50 Units

What would each firm pay to reduce these units?
5-24
Uniform Pollution Reductions
MCH
MCB
50
90
Bart’s
pollution
reduction
50
90 Homer’s
pollution
reduction
5-25
Command-and-Control Regulation

Incentive-based regulations

Command-and-Control Regulations
5-26
Command-and-Control Regulation

Technology Standard

Performance Standard

Costs

7% to 22 Times More Expensive (ERP 2003)

Corporate Average Fuel Economy (CAFE)

27.5 MPG Cars 20.7 MPG Light Trucks

Gas Tax

$700 Billion More for Raising CAFE (CBO
2004c)
5-27
The U.S. Response

Clean Air Act

1970 Amendments

Environmental Protection Agency (EPA)


Command-and-Control
All 6 Air Pollutants Fell

Causation?

Contrary Studies

Air Pollution on Decline Before 1970

Air Pollution Lower Due to EPA
5-28
Emissions Fee
$
MC
MSB
0
e*
Pollution reduction
5-29
Uniform Pollution Reductions
MCH
MCB
f=
$50
f=
$50
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
5-30
Uniform Pollution Reductions

Fair?
5-31
Uniform Pollution Reductions

Cost Effective

MC(P1)=MC(P2)

Suppose not. MC(P1)≠MC(P2)

Without Loss of Generality

Suppose: MC(P1)>MC(P2)

Cost of reducing firm 1’s last unit of pollution was
more expensive than firm 2’s.

There is a smaller cost to society if firm 2 reduces
one more unit and firm 1 reduces one less unit.
5-32
Cap-and-Trade

Goal: Decrease Pollution by 100 Units

80 Permits Issued

Suppose Bart Gets All 80
5-33
Cap-and-Trade

Bart’s Responsibility?

Homer’s?
5-34
Cap-and-Trade
MCH
MCB
10
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
5-35
Cap-and-Trade

Homer’s Cost?

Willingness to Pay for 1 Permit?

Willingness to Pay for 2 Permits?

For how many will he trade?

What would he be willing to pay?

What is Bart willing to accept?
5-36
Progress with Incentive-based Approaches

Policy Perspective: Cap-and-Trade for Sulfur
Dioxide

Policy Perspective: Cap-and-Trade to Protect
Fisheries and Wildlife

individual transferable quotas
5-37
Emissions Fee v Cap-and-Trade

Inflation


Emissions or Cap-and-Trade
Cost Changes

Emissions or Cap-and-Trade
5-38
Cap-and-Trade
MCH
b
MCB
$100
$100
$50
$50
a
10
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
5-39
Cap-and-Trade v Emissions Fee
MC’
$
MC*
f*
MSB
0
ef
Too little pollution reduction
e’ e*
Too much pollution reduction
Pollution reduction
5-40
Cap-and-Trade v Emissions Fee
MC’
$
MC*
f*
MSB
0
ef
Too little pollution reduction
e’
e*
Too much pollution reduction
Pollution reduction
5-41
Cap-and-Trade v Emissions Fee


Consider Lower Marginal Costs for an
Inelastic and Elastic MSB Line with a Partner

What Underperforms?

What Overperforms?
5 Minutes
5-42
Distributional Effects

Revenue?

Emissions fee

Cap-and-Trade
5-43
Positive Externalities
$
MC
MSB = MPB + MEB
MPB
MEB
R1
R*
Research
per year
5-44
Positive Externalities


Requests for subsidies

Resource extracted from taxpayers

Market does not always fail
Policy Perspective: Owner-Occupied Housing
5-45
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