The economics of
externalities
Today: Graphical analysis
Private responses
Public responses
Today

More on the
externality problem


Marginal damage will
not be constant

Public responses



Private responses



The Coase Theorem
Mergers
Social conventions

Taxes
Subsidies
Command-andcontrol
Cap-and-trade
programs
The externality problem



With externalities, quantity produced is
typically not optimal
Finding optimal quantity when marginal
damage is not constant
Deadweight loss of inefficient production
Graphical analysis of externalities
MSC = MPC + MD
$
MPC
h
d
g
c
0
Socially efficient output
b
a
Q*
MD
f
e
MB
Q1
Q per year
Actual output
Graphical analysis of externalities
Producer surplus lost
going from Q1 to Q*
Graphical analysis of externalities
Consumer surplus gained
going from Q1 to Q*
Graphical analysis of externalities
Net social gain going
from Q1 to Q*
Pollution


Pollution is one of the biggest negative
externalities around
Multiple steps needed to try to find optimal
amount of pollution


Which pollutants actually do damage?
Are there pollutants that indirectly cause damage?


Example: CFCs on the ozone layer
How do we value the damage done?

Very difficult to do, due to lack of markets
Pollution and empirical studies


Empirical studies have been done to try to
determine the damages caused by pollution
Remember from Chapter 2 that we need to
use events that prevent bias
Pollution and empirical studies

Chay and Greenstone (2003, 2005)

Pollution on health


1 percent reduction in total suspended particulates
resulted in a 0.35 percent reduction in infant mortality
rate
Pollution on housing prices

Improved air quality between 1970 and 1980 in
pollution-regulated cities led to property value increases
of $45 billion
Costly negotiation

Negotiation is typically costly


Remember, time is worth something
Even if a resource is owned by someone,
costly negotiation can prevent better
outcomes from occurring
Coase theorem

The Coase theorem tells us the
conditions needed to guarantee that
efficient outcomes can occur


People can negotiate costlessly
The right can be purchased and sold


Property rights
Given the above conditions, efficient
solutions can be negotiated
Ronald Coase
Coase theorem


Notice that the Coase theorem addresses
efficiency
To get to efficiency, the quantity of most
goods and services produced is still positive

Example: It is not efficient to get rid of all pollution

If all pollution was gone, we could not live (since we
exhale CO2)
Bargaining and the Coase Theorem
$
MB exceeds MPC in this
range  Production will be
Q1 without negotiation
MSC = MPC + MD
MPC
h
d
g
c
MD
MB
0
Q*
Q1
Q per year
Bargaining and the Coase Theorem
$
MSC exceeds MB here 
With costless bargaining,
consumers will pay to reduce
production from Q1 to Q*
MSC = MPC + MD
MPC
h
d
g
c
MD
MB
0
Q*
Q1
Q per year
Other private responses to externalities

Mergers


When negative externalities only affect other
firms, two firms can merge to internalize the
externalities
Social convention

Social pressure to be nice can lower the amount
of certain negative externalities
Public responses to externalities

Four public responses

Taxes



Subsidies
Command-and-control


Also known as emissions fee in markets with pollution
Government dictates standards without regard to cost
Cap-and-trade policies

Also known as a permit system
Taxes

With no externalities, taxes on goods in complete
and competitive markets lead to deadweight loss


Quantity is below the optimal amount with taxes
With negative externalities, taxes can improve
efficiency

The optimal tax is known as the Pigouvian tax


Pigouvian tax equals marginal damage at the efficient output
Increased Pigouvian taxes can also lead to lower income
taxes without sacrificing overall tax revenue

Double dividend hypothesis (More in Chapter 15)
Pigouvian taxes in action
MSC = MPC + MD
(MPC + cd)
$
Pigouvian
tax revenues
i
j
MPC
d
c
MD
MB
0
Q*
Q1
Q per year
Emissions fee

One way to implement Pigouvian taxes is to
charge a tax on each unit of pollution, rather
than on each unit of output

This kind of tax is known as an emissions fee
Emissions fee in action
$
MC of abatement
f*
MSB of abatement
0
e*
Abatement quantity
Subsidies


An alternative to taxes is providing a subsidy
to each firm for every unit that it abates
Problems with subsidies:

Efficient outcome only with a fixed number of firms

Increased profits of firms in the industry will encourage
new entrants into the industry


Revenue is needed to provide subsidies


Positive economic profits if new entry is not allowed
Taxing income reduces inefficiencies
Ethical issues: Who has the right to pollute?
Subsidies in action
MSC = MPC + MD
(MPC + cd)
$
MPC
Pigouvian
subsidy
i
j
d
c
k
f
g
h
MD
MB
0
e
Q*
Q1
Q per year
Command-and-control pollution reduction

Two firms


Each would pollute 90 units if there are no
pollution controls
Suppose each firm was forced to reduce
pollution by 50 units


Known as uniform pollution reduction
Usually not efficient
Uniform pollution reductions
$
MC is for abatement
on these graphs
$
Total abatement
costs are in red for
each firm
MCH
MCB
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
Inefficiencies of uniform reductions
$
Notice that MC of
Homer’s last unit of
abatement is higher
than Bart’s  D’oh
$
Inefficiencies of uniform reductions
$
Overall abatement costs
can be reduced if Homer
reduces abatement by 1
unit and Bart increases
abatement by 1 unit
$
Command-and-control regulation

Command-and-control regulations can take many
forms



Uniform reductions
Percentage reductions
Technology standards



Each firm must use a certain type of technology
This method may work best when emissions cannot be
monitored easily
Performance standards



Government sets emissions goal for each polluter
Firm can use any technology it wants
Less expensive than technology standards
Lowering abatement costs


Going from command-and-control
requirements to emissions fees can lower
overall abatement costs
Marginal cost of abatement of the last unit is
equal for each firm with an emissions fee
Emissions fees
MC is for abatement
on these graphs
MCH
Bart’s Tax
Payment
Homer’s Tax
Payment
MCB
f=
$50
f=
$50
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
Cap-and-trade policies



Policy in which a permit is needed for each unit of
pollution emitted
Permits can be traded
Policy is efficient if




Bargaining costs are negligible
Competitive permit markets exist
Number of permits matches efficient pollution level
Initial allocation of permits does not affect efficiency
as long as the above criteria are met
Cap-and-trade
Bart and Homer will
negotiate until they
agree on a $50
price for permits
Suppose Bart starts with 80
permits and Homer starts with
none (see points a and b)
MCH
b
MCB
f=
$50
f=
$50
a
10
50
75 90
Bart sells 65 permits
Bart’s
pollution
reduction
50
75 90 Homer’s
25
Homer buys 65 permits pollution
reduction
Emissions fee versus cap-and-trade

Given certain conditions,
we notice that an emissions
fee and cap-and-trade
policies lead to the same
result for efficiency



$50 fee for each unit polluted
(implicit fee under permits)
Bart reduces pollution by 75
units
Homer reduces pollution by 25
units
The real world is more complicated


We do not live in a world with perfect
economic assumptions
Complicating factors




Inflation
Cost changes
Uncertainty
Distributional effects
Inflation


If emissions fees do not represent real prices,
the amount of pollution will change as real
price changes
Cap-and-trade policies do not need inflation
factored in, since quantity limits are used
Cost changes

Suppose cost to abate decreases every year


Optimal amount of abatement will increase each
year
If a new abatement technology is just being
developed, future cost changes could be
small or large

Potential solution: Impose a hybrid system


Permit market
Offer a high tax for pollution emitted without a permit
Uncertainty

Costs and benefits are typically not known
with certainty


With uncertainty, too much or too little pollution
can be produced (relative to the efficient outcome)
Two situations analyzed, with MC curve
uncertain


Inelastic MSB
Elastic MSB
Inelastic MSB curve
Marginal cost
schedule
could be as
high as MC’
$
MC’
MC*
Assume best
guess of
marginal cost
schedule is MC*
f*
Permits are
closer to
efficient than
fees in this case
MSB
0
ef
Too little pollution reduction with fees
e’ e*
Pollution reduction
Too much pollution reduction with permits
Elastic MSB curve
MC’
$
MC*
f*
Fees are closer to
efficient than
permits in this case
0
ef e’
e*
MSB
Pollution reduction
Too little pollution reduction with fees Too much pollution reduction with permits
Distributional effects

Firms…



Government can generate revenue…




Lose when they pay a tax
Win when they are given permits
If a tax is imposed
If permits are sold
Double dividend hypothesis supports taxes or selling
permits
Political pressure may encourage permit giveaways
Distributional effects


Since efficiency relates to willingness to pay,
poor neighborhoods should have more
pollution than rich neighborhoods
Displacement concerns


Job losses from environmental regulation: Does
this increase income inequity?
Who bears the cost of pollution control?

Depends on who uses the good that has the
pollution control

Example: Cars that are 15 or more years old
Externalities can be positive



Remember that not all externalities are
negative
Some consumption leads to external benefits
to others
Recall some examples



Planting flowers in your front lawn
Scientific research
Vaccination

Prevents others from getting a disease from you
Positive externalities and subsidies

Subsidies can be used to increase efficiency
in the presence of positive externalities


Note that this money must be generated from
somewhere, probably taxes
Recall that tax money used for subsidies has its
own deadweight loss

Compare DWL with efficiency gains from the subsidy
Positive externality example
$
MC
MSB = MPB + MEB
MPB
MEB
R1
R*
Research
per year
In what direction are we heading?

Command-and-control policies often rely on
states to enforce



States do not always comply with these measures
Fees and permits can often be controlled on the
national level
US policies have generally moved from
command-and-control to taxes and permits

Exceptions do still apply: Emissions hot spots
Summary

Many methods are used to try to increase
efficiency when externalities are present







Negotiation
Mergers between firms
Social conventions
Taxes, including emissions fees
Subsidies
Command-and-control policies
Cap-and-trade programs using marketable
permits
Summary

Distributional concerns are important for
someone that thinks that social welfare is
important

Who benefits and loses from taxes versus
permits?



Firms?
The government?
Who benefits most when pollution is abated

High-income more than low-income?