Externalities

Negative
 Action by one party imposes a cost on another party

Scenario
 Steel plant dumping waste in a river
 The entire steel market effluent can be reduced by
lowering output (fixed proportions production function)
 Marginal External Cost (MEC) is the cost imposed on
fishermen downstream for each level of production.
 Marginal Social Cost (MSC) is MC plus MEC.

Negative Externalities encourage inefficient firms to remain
in the industry and create excessive production in the long
run.
Chapter 18
Slide 1
External Costs
Price
When there are negative
externalities, the marginal
social cost MSC is higher
than the marginal cost.
The difference 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
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 cost of abatement.
The efficient level of
emissions is 12 (E*) where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
Chapter 18
E*
12 14
16
E1
18 20
22
24
Level of Emissions
26
Slide 3
Ways of Correcting Market Failure

Options for Reducing Emissions to E*

Emission Standard: Set a legal limit on
emissions at E* (12) which increases the cost
of production and the threshold price to enter
the industry. Enforced by monetary and criminal
penalties.

Emissions Fee: Charge levied on each unit of
emission.

Assumptions:
 Policymakers have asymmetric information

Chapter 18
Administrative costs require the same fee or
standard for all firms
Slide 4
The Case for Fees
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
From 14 to 8. Firm 2 emissions
would fall from 14 to 6.
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
Chapter 18
1
2
3
4
5
6
7
8
9
10
11
12
13
Level of
14 Emissions
Slide 5
The Case for 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
Chapter 18
2
4
6
8
10
12
14
16
Level of Emissions
Slide 6
Ways of Correcting Market Failure

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.

Summary: 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.
Chapter 18
Slide 7
Ways of Correcting Market Failure

Transferable Emissions Permits

Permits help develop a competitive
market for externalities.
Chapter 18

Agency determines the level of
emissions and number of permits

Permits are marketable

High cost firm will purchase permits
from low cost firms
Slide 8
Externalities and Property Rights

Property Rights



Bargaining and Economic Efficiency


Legal rules describing what people or firms may do with their
property
For example: If residents downstream owned the river (clean
water) they control upstream emissions.
Economic efficiency can be achieved without government
intervention when the externality affects relatively few parties
and when property rights are well specified.
Coase Theorem

When parties can bargain without cost and to their mutual
advantage, the resulting outcome will be efficient, regardless of
how the property rights are specified.
Chapter 18
Slide 9
Example: Bargaining with Alternative Property
Rights: Fishermen and a Factory!
Right to Dump Right to Clean Water
No Cooperation
Profit of factory
Profit of fishermen
$500
$200
$300
$500
$550
$250
$300
$500
Cooperation
Profit of factory
Profit of fishermen
Chapter 18
Slide 10
Externalities and Property Rights

Costly Bargaining - The Role of Strategic Behavior


Bargaining requires clearly defined rules and property
rights.
A Legal Solution - Suing for Damages

Fishermen have the right to clean water

Factory has two options
 No filter, pay damages


Filter, no damages

Chapter 18
Profit = $100 ($500 - $400)
Profit = $300 ($500 - $200)
Slide 11
Externalities and Property Rights

A Legal Solution - Suing for Damages


Factory has the right to emit effluent
Fishermen have three options
 Put in treatment plant


Filter and pay damages


Profit = $200
Profit = $300 ($500 - $200)
No plant, no filter

Profit = $100

Conclusion: A suit for damages results in an efficient
outcome.

Question: How would imperfect information impact the
outcome?
Chapter 18
Slide 12
Common Property Resources

Common Property Resource

Everyone has free access.

Likely to be overutilized

Examples: Air and water; Fish and animal
populations

Solution: Private ownership

Question: When would private ownership be
impractical?
Chapter 18
Slide 13
Common Property Resources
Without control the number
of fish/month is FC where
PC = MB.
Benefits,
Costs
($ per
fish)
Marginal Social Cost
However, private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Private Cost
Demand
F*
Chapter 18
FC
Fish per Month
Slide 14
Public Goods


Public Good Characteristics

Nonrival: For any given level of
production the marginal cost of providing
it to an additional consumer is zero.

Nonexclusive: People cannot be
excluded from consuming the good.
Free Riders: enjoy the benefit of a good or
service without paying for it.
Chapter 18
Slide 15