Externalities
Lecture 10 – academic year 2014/15
Introduction to Economics
Fabio Landini
What do we do today?
• The “external” effects of economic
activities
• How do we internalize externalities?
The KYOTO Protocol – since 1997
• The Kyoto Protocol, signed in December 1997 at
the UNFCCC COP3 (Conference Of Parties),
represents the executive instruments of the
Framework Convention
• The countries that are subject to the emission
constraint are 39 and they include the
European countries (including the East
countries), Japan, Russia, United States,
Canada, Australia and New Zealand
The KYOTO Protocol – since 1997
The European Directive 2003/87/CE “Emissions Trading”
regulate the exchange of quotas for the emission of
greenhouse gas. The final aim is to establish an European
market for the emission quotas.
During the first three years (2005-2007), the emissions of
large combustion plants, such as oil refineries, plants for
the production of ferrous metal, mineral goods (concrete,
lime, etc.) and the plants for the production of paper and
cartboard.
Market efficiency: A brief recap
• In a perfectly competitive market with no
externalities the total welfare of the economic
system is measured as the sum of consumer
surplus and producer surplus.
• “The invisible hand” (of the market) maximize
the total benefit of society
• Markets are usually good instruments to
organize the economic activity
• Sometimes, however: “market failures”
Externalities:
definition and effects
When the transaction between a buyer and a
seller has an effect on a third party, the effect
on the latter is called externality.
Whenever they do not take into account the
“third party”, the equilibrium prices and
quantities are not efficient.
Therefore the externalities cause an inefficient
allocation of resources, i.e. market failure.
The effects of externalities
on society
In the presence of externalities:
•Social welfare is not measured only by the welfare
of consumers and producers, but also by the welfare
of the third party (involuntary participant to the
market).
•The externalities can be negative or positive
•However, ALL externalities are sources of market
inefficiencies in the sense that the quantity
exchanged ≠ optimal quantity.
Negative externalities
Costs on other individuals (consumers or
producers) that are not directly involved in the
market exchange.
Example: smoke of cigarettes, cars’ exhaust
gas
Positive externalities
Direct benefits obtained by individuals
(consumers or producers) not directly involved
in the market exchange.
Example: Vaccines, restoration of a piece of
Art, investment in new technologies.
Externalities and market
inefficiency
• Negative externalities in production
Qmarket > Qoptimum (socially desirable quantity)
social costs > private costs
• Positive externalities in production
Qmarket < Qoptimum
social costs < private costs
Externalities and market
inefficiency
• Negative externalities in consumption
Qmarket > Qoptimum (socially desirable quantity)
Social benefit < private benefit
• Positive externalities in consumption
Qmarket < Qoptimum
Social benefit > private benefit
Negative externalities in
production
Price of
aluminium
Cost of
pollution
Social cost
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM
QMARKET
Quantity of
aluminium
Positive externalities in
production
Price of
Robot
Value of
technologica
l diffusion
Supply (private cost)
Social cost
Equilibrium
Optimum
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity
of Robot
Negative externalities in
consumption
Price of
alcoholic
drinks
Supply (private cost)
Equilibrium
Optimum
Demand
(private value)
Social value
0
QOPTIMUM QMARKET
Quantity of
alcoholic drinks
Positive externalities in
consumption
Price of
education
Supply (private cost)
Optimum
Equilibrium
Social value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
education
Positive externalities: the
diffusion of knowledge
A firm that starts a project (e.g., to produce
industrial robot) could develop a new technology
/ generate an innovation in production
techniques so as to improve the initial project.
Such an improvement could benefit the firm but
also the society as a whole, because such
knowledge will accumulate and becomes part of
the social knowledge stock.
Technology diffusion: positive externality
How to internalize externalities?
The Government can provide subsidies to produce
industrial robot.
Example: subsidy for each robot that is produced.
Increase of supply and therefore increase in the
equilibrium quantity (previous graph).
To obtain Qmarket= Qotpimum we need: subsidy = value
of technology diffusion.
Problem: how do we quantify this value?.
Problem of industrial policy
If the value of technological diffusion can be easily
quantified, then the Government should design
incentive (taxes, subsidies) that privilege high tech
sectors as opposed to more traditional ones
(INDUSTRAIL POLICY).
If the value of technological diffusion is difficult to
quantify, the risk is to end up helping sectors that
have stronger lobbying power and not those with
higher technological content.
The best is to enforce PROPERTY RIGHTS through
patents, which can then be licensed.
How to obtain Qoptimum?
1. Government intervention
• Government can internalize the externalities
by taxing the goods that causes negative
externalities and by subsidizing those with
positive externalities.
• “To internalize an externality” means to alter
market incentive with subsidies and taxes, so
as to induce individuals to take adequately
into account the external effects of their
actions.
Obtaining the optimal
production
If the externality is negative: internalization
through a tax – the tax reduces the quantity
that is exchanged in equilibrium until the social
optimum obtains
If the externality is positive: internalization
through a subsidy – the subsidy increase the
quantity that is exchanged in equilibrium until
the social optimum obtains
How to obtain Qoptimum?
2. Private solution
Public intervention is not always either
necessary or efficacious to deal with
externalities.
Example of private solutions:
•Ethical codes and social sanctions.
•NGOs (in the “no-profit” sector).
•Integration of different types of activities.
•System of contracts (Coase’s theorem).
Coase’s Theorem
The model developed by the
economist Ronald Coase is a
well-known proposal to solve the
externality problem without
government intervention
Coase’s Theorem: is the parties in
a transaction can negotiate over
the allocation of resources without
costs, then the market can solve
the externality problem.
What does Coase’s Theorem mean?
According to Coase externalities derive from the
absence of well-defined property rights.
If we assign exclusive property rights to some
subjects the problem can be solved.
Example: suppose we assign the exclusive rights to
pollute to a single firm.
The firm can decide to sell such rights, which will be
then bought by the one who evaluate it the most.
Consequences of Coase’s Theorem
Private subjects can internalize the effects of
externalities, negotiating among them.
In this way, an efficient allocation of property
rights can obtain.
If transaction costs = 0, then the parties can
always achieve the efficient allocation whatever
the initial distribution of property rights is.
Private solutions and
public intervention
Sometime private solutions do not work, because
transaction costs are high (= cost necessary to
achieve and enforce an agreement).
This is more likely the higher the number of subjects
involved in the transaction.
This make it impossible to rely on private
agreements.
Externalities and public intervention
When externalities are significant and private
solutions are not viable, the Public Authority can
react in one of two ways:
• By creating laws and enforcement devices
• By implementing market policies
1. Laws and enforcement devices
Usually: bans and duty
For instance:
• No entry ban for non-Euro-3 cars
• Vaccines
• Heater can be switched on after 15/10
2. Market policies
To align incentives and social optimum the Public
Authority can decide to rely on “market policies”:
•Regulation: determine a certain level of
environmental pollution that is allowed.
•Pigovian tax: create an incentive to reduce
pollution.
•Tradable permits: voluntary transfer of the rights
to pollute from one firm to the other.
Pigovian Tax
Economists tend to prefer Pigovian Tax because it
ensure a reduction of environmental pollution and
lower social costs compared to regulation.
Differently from regular taxation, it corrects the
system of incentives and induce an efficient
allocation of resources.
Tradable permits
They are used to fight environmental pollution.
They allow the voluntary transfer of the rights to
pollute from one firm to the other.
In fact: a market for pollution rights is created.
A firm that faces low cost to reduce her own
pollution will prefer to sell her rights to pollute to a
firm that faces high costs to reduce her own
pollution.
Price of pollution
Price of pollution
… together with
demand it determins the
price of pollution
The Pigovian tax
determines a price of
pollution…
Pigovian
tax
P
Supply of tradable
permits
P
Demand of
tradable
permits
Demand of
pollution rights
0
Q
Quantity of pollution
.
… together with
demand it determines
the quantity of polution
(a) Pigovian Tax
0
Q
Quantity of pollution
Tradable permits define
the quantity of
pollution…
(b) Tradable permits
Consumption tax on petrol
Petrol is mong the most taxed goods (nearly 50%
of final price in USA, nearly 75% in Italy).
Often such taxes are conceived as (distortive)
taxes on consumption (good with inelastic
demand, see previous lectures….)
Can consumption taxes on petrol (or cars)
be conceived also as Pigovian taxes?
In some respects the answer is YES.
The tax is aimed at correcting externalities that are
associated with the use of cars:
•Traffic congestion.
•Accidents (debate on SUV).
•Street wearing out
•Pollution.
Question: aren’t there more appropriate tools to
reduce pollution? A high price of petrol is paid by all
citizens, even those that live in the country side and
produce little pollution…
Conclusion
When the transaction between a buyer and a seller
has effects on a third party, there is an externality.
Negative (positive) externalities imply that the quantity
that is exchanged in equilibrium is higher (lower) than
the quantity that is socially desirable.
Solutions to externalities can derive both from private
parties and government intervention.