Lecture Notes: Econ 203 Introductory Microeconomics
Lecture/Chapter 10: Externalities
M. Cary Leahey
Manhattan College
Fall 2012
Goals
• This is (yet) another applications chapter looking at international
trade.
• This chapter reviews many of the concepts introduced in earlier
classes, particularly the tradeoff between efficiency and equity.
• We look at externalities and why they can make market outcomes
inefficient (market “failures”).
• We look at why private solutions may solve or not solve the problem,
whether “internalizing the externality” can work.
• We examine the kinds of public policies to solve the problem of
externalities.
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Defining one kind of market failure-externalities
• The competitive market outcome is efficient and maximizes total
surplus, except when there are market failures.
• One kind of market failure is externalities, which is the
uncompensated impact of one person’s action on another’s wellbeing.
• Externalities need not be solely negative, a bystander’s well-being
could be enhanced by another's action.
• Some examples of externalities:
•
Pollution
•
Noise
•
Driving and texting
•
Flu shots (and the case for govt. subsidies)
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Example 1: negative externality, gasoline
The market for gasoline
P
$5
4
The market eq.
maximizes consumer
+ producer surplus.
Supply curve shows
private cost, the costs
directly incurred by sellers.
3
$2.50
2
Demand curve shows
private value, the value
to buyers (the prices they
are willing to pay).
1
0
0
10
20 25 30 Q
(gallons)
Example 1: negative externality, gasoline
The market for gasoline
P
$5
Social cost
= private + external cost
4
external
cost
Supply (private cost)
3
External cost
= value of the
negative impact
on bystanders
2
1
0
0
10
20
30 Q
(gallons)
= $1 per gallon
(value of harm
from smog,
greenhouse gases)
Example 1: negative externality, gasoline
The market for gasoline
P
$5
Social
cost
The socially
optimal quantity
is 20 gallons.
4
S
At any Q < 20,
value of additional gas
exceeds
At any Qsocial
> 20, cost.
3
2
D
1
0
0
10
20 25 30 Q
(gallons)
social cost of the
last gallon is
greater than its value
to society.
Example 1: negative externality, gasoline
The market for gasoline
P
$5
Social
cost
4
S
3
2
D
1
0
0
10
20 25 30 Q
(gallons)
Market eq.
(Q = 25)
is greater than
social optimum
(Q = 20).
One solution:
tax sellers
$1/gallon,
would shift
S curve up $1.
Internalizing the externality
• Internalizing the externality means changing incentives to make
people take accounts of the external effects of their actions. So not
just market costs but “all” costs of actions are incorporated.
• In the gasoline example, the tax makes the market cost equal the
social cost of gasoline consumption.
• The social optimum is when social costs are fully paid so
•
market equilibrium = social optimum
• The socially optimal Q quantity maximizes social welfare.
•
At a lower Q, the social value of additional units > social cost
•
At a higher Q, the social value of additional units < social cost.
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Example 2: positive externality, flu shots
P The market for flu shots
External benefit
= $10/shot
$50
Socially optimal Q
= 25 shots.
external
benefit
40
To internalize the
externality, use subsidy =
S
30
$10/shot.
Social value
= private value
+ $10 external benefit
20
10
D
0
Q
0
10
20 25 30
Summary of effects of externalities
• Negative externality: market Q larger than socially desirable Q
• Positive externality: market Q less than socially desirable Q
• To remedy the problem, internalize the externality
•
Tax goods with negative externalities
•
Subsidize goods with positive externalities.
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Public policies regarding externalities
• Two approaches have been adopted.
• Command and control
•
Relegate behavior directly to “guarantee” the desired outcome.
•
Limits on quantity of pollution
•
Require adoption of specific technologies to solve the problem
• Market based policies
•
Private sector solves problem on its own
•
Corrective taxes/subsidies
•
Tradable pollution permits
• Pay to pollute seems immoral to some.
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Public policies regarding externalities: corrective taxes
• Corrective tax also called Pigovian taxes
•
designed to make private decision makers take full account of the
social costs that arise from a negative externality.
• Ideal corrective tax equals the external cost
• A corrective subsidy deals with positive externalities
• Ideal corrective subsidy equals external benefit.
• While other taxes and subsidies distort incentives, thereby moving
outcomes away from the market ideal, corrective taxes and
subsidies move market outcomes closer.
• They align social interests and private incentives and move the
economy toward a more efficient allocation of resources.
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Corrective taxes versus regulations; which is better?
• Corrective taxes promote the most efficient outcome to dealing with
externalities of production.
• Different firms have different costs. The efficient outcome has firms
with the lowest abatement costs reducing pollution the most.
• In the case pollution, a tax is efficient.
•
Efficient firms (with low abatement costs) will reduce pollution to
reduce their tax burden.
•
Ineffecient firms (with high abatement costs) have a greater
willingess to pay tax.
• In contrast, a regulation may mandate the socially desirable
outcome but at a higher cost (ineffecient) since all firms are reuired
to cut emissions. So the inefficient firms have to devote more
resources to cleanup, which is inefficient.
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Corrective taxes versus regulations; which is better?
• Corrective taxes are better for the environment
• They gives firms incentives to continuer educing pollution as long as
the cost is less than the tax.
• Technological improvements are more likely to be adopted, since
the tax gives them an incentive to adopt them.
• In the regulatory world, firms have no incentives go beyond the
mandate.
• For example a gasoline tax attacks three negative externalities:
•
Congestion – reducing “unneeded” driving
•
Accidents – increasing demand for smaller vehicles (less damage)
•
Pollution – reducing emissions by reducing consumption
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Example 3: reducing greenhouse gases
• Acme and US Electric run coal-burning power plants. Each emits 40
tons of sulfur dioxide per month,
total emissions = 80 tons/month.
• Goal: Reduce SO2 emissions 25%, to 60 tons/month
• Cost of reducing emissions:
$100/ton for Acme, $200/ton for USE
Policy option 1: Regulation
Every firm must cut its emissions 25% (10 tons).
Cost to Acme: (10 tons) x ($100/ton) = $1000
Cost to USE: (10 tons) x ($200/ton) = $2000
Example 3: reducing greenhouse gases
• Policy option 2: Tradable pollution permits
• Issue 60 permits, each allows one ton SO2 emissions. Give 30
permits to each firm.
Establish market for trading permits.
• Each firm may use all its permits to emit 30 tons,
may emit < 30 tons and sell leftover permits,
or may purchase extra permits to emit > 30 tons.
Compute cost of achieving goal if Acme
uses 20 permits and sells 10 to USE for $150 each.
Acme
–
–
–
–
sells 10 permits to USE for $150 each, gets $1500
uses 20 permits, emits 20 tons SO2
spends $2000 to reduce emissions by 20 tons
net cost to Acme: $2000 − $1500 = $500
Example 3: reducing greenhouse gases
• Policy option 2: Tradable pollution permits
USE
–
–
–
–
buys 10 permits from Acme, spends $1500
uses these 10 plus original 30 permits, emits 40 tons
spends nothing on abatement
net cost to USE = $1500
Total cost of achieving goal = $500 + $1500 = $2000
Using tradable permits, goal is achieved at lower total cost and lower
cost to each firm than using regulation.
Pollution reduction is concentrated in the firms with the lowest
abatement costs, promoting an efficient outcome.
In the real world this has been going on since 1995 in the US.
Corrective taxes/tradable permits and morality
• In the pollution case, the demand for pollution has a downward
slope, as the price of polluting declines, Q polluted goes up.
• Corrective taxes raise the price of polluting to reduce emissions (Q).
• Tradable permits restricts the supply of pollution rights and has the
same effect as the tax.
• Tradable permits are to be preferred if policymakers do not know the
demand curve for polluting very precisely.
• The position argues that it is immoral to pay to pollute but life
involves tradeoffs-the value versus the cost of clean water.
• While moral solution can help internalize the externality, the Coase
theorem argues that if parties can “costlessly bargain,” then the
externality problem can be solved on its own.
• Example: cleaning dirty clothes-does the polluter or pollutee pay.
• In real life, transactions costs, stubbornness, and coordination
problem can stymie private solutions, making the Coase theorem a
nice academic discussion point but little more.
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