Topic 4：Externalities
Definition of Externality
• An externality is an economic cost or benefit
that is the by-product of economic activity
but that is allacated outside of the market
system.
• Resources are likely to be misallocated
when there is an externality.
• There are two types of externalities:
negative externality and positive externality.
– Negative externalities occur when a cost is
generated by the producer of the externality, but
because there is no market for the externality,
the producer of the externality does not consider
the costs that the externality imposed on others.
– Positive externalities occur when a benefit is
generated by the producer of the externality, but
because there is no market for the externality,
the producer does not get compensated for the
benefit to others and has no incertive to take it
into account.
External Cost
• Scenario [si’neəri:əʊ]
– Steel plant dumping waste in a river
– The entire steel market effluent [‘eflu:ənt] can be
reduced by lowering output (fixed proportions
production function)
• Scenario
– Marginal External Cost (MEC) is the cost imposed
on fishermen downstream for each level of
production.
– Marginal Social Cost (MSC) is MC plus MEC.
Price
When there are negative
externalities, the marginal
social cost MSC is higher
than the marginal cost.
The differences is
the marginal external
cost MEC.
MSC
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
Price
MSCI
MC
S = MCI
The industry competitive
output is Q1 while the efficient
level is Q*.
Aggregate
social cost of
negative
externality
P*
P1
P1
MECI
MEC
D
q* q1
Firm output
Q* Q1
Industry output
• Negative Externalities encourage inefficient
firms to remain in the industry and create
excessive production in the long run.
• Positive Externalities and Inefficiency
– Externalities can result in too little production, as
can be shown in an example of home repair and
landscaping.
External Benefits
Value
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
MSB
D
P1
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MC
P*
Is research and development
discouraged by positive
externalities?
MEB
q1
q*
Repair Level
Public Policy toward Externalities
• When large numbers and high transactions
costs are invovled, government policy
becomes important to internalize an
externality.
• Internalizing an externality means changing
the incentives of the parites involved so that
they act as if there is a market for the
external cost or benefit.
Negative Externalities in a Supply and Demand
Framework
• The concept of the negative externality can
be depicted graphically in a supply and
demand framework as shown in figure 4.1.
• The externality generates additional
opportunity costs that are not included in
the supply curve. These costs can be
depicted as amount E in the diagram.
• The curve S+E includes the entire
opportunity cost of production, including the
cost of the externality.
• Private actions to correct an externality
– If only a few people are affected by the
externality, then private exchange might correct
the problem.
– The Coase Theorem states that in the absence of
transactions costs, the allocation of resources
will be independent of the assignment of property
rights.
• Ronald Coase. The Problem of Social Cost. 1960
• Corrective taxation of an extenality
– If the firms are charged a tax equal to the
external cost that they impose on others, then an
economically efficient level of output will result.
– But there are problems in measuring the cost of
the externality, so as to set the tax equal to the
marginal cost of the externality.
• The first problem is measuring the cost of the
externality.( One method might be to take a
poll to see how much people would be willing
to pay to reduce or eliminate the pollution.)
• The next problem is to decide who is
responsible for the cost.
• What should be taxed?
• The external cost is shown as a given amount per
unit of production. (figure 4.2, Panel A)
• In this case, the only way to reduce the
externality is to reduce the amount of production.
• But the external cost could be reduced in other
ways.
Placing a tax on each unit of output
would not quite give firms the right
incentives.
• In panel B, after the corrective tax is placed on
the cost of the externality, firms can take action
to reduce the amount of pollution they create per
unit of production, to lower their tax.
• The external cost per unit of production then
shifts down from E to E’.
Taxation v.s. Regulation
• Because it is so difficult to apply a
corrective tax on an externality in the real
world, governments are more likely to use
regulations requiring that certain steps be
taken to reduce the externality.
• In the short term, a quota might work, but in
the long run, the results from a quota and a
corrective tax will differ.
• taxation versus regulation of an externality(figure
4.3)
• The amount of the tax is shown by the entire
shaded area, and, as a result, the firm is
taking losses.
• If each firm is regulated by quotas Q*, they
will make above-normal profits, represented
by the heavily shaded area.
• In the long run, the regulation encourages
entry, whereas the optimal tax encourages
firms to leave the industry.
• the politics of quotas versus taxes
– industry representatives will lobby for regulatory
solutions
– taxpayers can benefit from the tax
– which one has more political influence?
• Incentive for pollution reduction with
regulation versus taxation
– incentives involved in regulating pollution are far
inferior to those involved in corrective taxation.
– however, it is often difficult to apply corrective
taxation, and there will be political pressures
against it.
– regulation may be the second-best solution.
Case Study:Standards and Fees
• Options for Reducing Emissions to E*
– Emission Standard
• Set a legal limit on emissions at E* (12)
• Enforced by monetary and criminal penalties
• Increases the cost of production and the
threshold price to enter the industry
MSC（marginal social cost,
边际社会成本，
是厂家不会主动考虑的）
Dollars
per unit
of Emissions
Standard
Fee
3
MCA(marginal cost
of abatement,
边际减排成本，
可视为边际排放收益）
E*
12
Level of Emissions
• Options for Reducing Emissions to E*
– Emissions Fee
• Charge levied on each unit of emission
Dollars
per unit
of Emissions
MSC
Cost is less than the
fee if emissions were
not reduced.
So the firm would
rather abate than
pay the fee.
Fee
3
Total Fee
of Abatement E*
Total
Abatement Cost
MCA
12
Level of Emissions
• Standards Versus Fees
– Assumptions
• Policymakers have asymmetric [,æsi’metrik ，
不对称]information
• Administrative costs require the same fee or
standard for all firms
Fee per
Unit of
Emissions
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
MCA1
MCA2
If a fee of $3 was imposed,
Firm 1 emissions would fall
by 6 . Firm 2 emissions
would fall by 8.
MCA1 = MCA2: efficient solution.
6
The cost minimizing solution
would be an abatement of 6
5
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
4
3.75
3
Firm 1’s Increased
Abatement Costs
2.50
2
Firm 2’s Reduced
Abatement
Costs
1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Level of
14 Emissions
• Advantages of Fees
– When equal standards must be used, fees
achieve the same emission abatement at lower
cost.
– Fees create an incentive to install equipment that
would reduce emissions further.
• Are fees always better than standards?
C
Fee per
Unit of 16
Emissions
Marginal
Social
Cost
14
12
Based on incomplete
information fee is $7
(12.5% reduction).
Emission increases to 11.
ABC is the increase
in social cost less the
decrease in abatement
cost.
E
10
A
D
8
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
B
6
Marginal Cost
of Abatement
4
2
0
2
4
6
8
10
12
14
16
Level of Emissions
• Conclusions about Fees vs. Standards
– Standards are preferred when MSC is steep and
MCA is flat.
– Standards (incomplete information) yield more
certainty on emission levels and less certainty on
the cost of abatement.
– Fees have certainty on cost and uncertainty on
emissions.
– Preferred policy depends on the nature of
uncertainty and the slopes of the cost curves.
Marketable Pollution Rights
• A system of marketable pollution rights
– give all existing polluters the right to continue
creating the amount of pollution that they
currently creat.
– firms would not be allowed to increase their level
of pollution without buying the right from
someone else.
– if a firm could find a way to reduce its pollution, it
could sell its right to pollute to others.
• Drawbacks of marketable pollution rights
– must be possible to monitor the amount of
pollution created by various contributors
– may creat new pollution
– need muture markets
Case: Emissions Trading and Clean Air
• Bubbles
– Firm can adjust pollution controls for individual
sources of pollutants as long as a total pollutant
limit is not exceeded.
• Offsets
– New emissions must be offset by reducing
existing emissions
• 2000 offsets since 1979
• Cost of achieving an 85% reduction in
hydrocarbon(烃)emissions for DuPont
– Three Options
• 85% reduction at each source plant (total cost = $105.7
million)
• 85% reduction at each plant with internal trading (total
cost = $42.6 million)
• 85% reduction at all plants with internal and external
trading
(total cost = $14.6
million)
• 1990 Clean Air Act
– Since 1990, the cost of the permits has fallen
from an expected $300 to below $100.
• Causes of the drop in permit prices
– More efficient abatement techniques
– Price of low sulfur coal has fallen
The Optimal Amount of Pollution
• Would it be optimal to eliminate all pollution?
– the costs of trying to reduce pollution might
outweigh the negative effects of the pollution
– if pollution is reduced to the point where the
marginal cost of doing so is just equal to the
marginal benefit of the reduced pollution, some
pollution will remain.
The Efficient Level of Emissions
Dollars
per unit
of Emissions
Assume:
1) Competitive market
2) Output and emissions decisions are independent
3) Profit maximizing output chosen
MSC
6
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost.
Why is this more efficient
than zero emissions?
4
At E1 the marginal
social cost is greater
than the marginal benefit.
The efficient level of
emissions is 12 (E*) where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
E*
12 14
16
E1
18 20
22
24
Level of Emissions
26
Positive Externalities
• Positive externalities produce a benefit to others,
but this benefit is not allocated within the
market(figure 4.4)
• Government subsidization
– the government compensates the producer for
the value of the positive externality
– the problem is how to calculate the optimal
subsidy, which should be equal to the external
benefit