EXTERNALITIES
Chapter 5
Externalities
• Externality – An activity of one entity that affects
the welfare of another entity in a way that is
outside the market mechanism =>
unwanted effects
– Paper production as by-product carcinogen dioxin =>
increases society’s health care costs => they are not
included in the paper price
– Why not?
– Production => positive
– Consumption=> positive/negative
5-2
The Nature of Externalities
• Privately-owned vs. commonly-owned resources
A privately owned resource: its price reflects its value so used
efficiently (Marg Social Cost= Marg Private Cost= Marg Social
Benefit= Marginal Private Benefit = ??
Remember: eq comp mkt => marg cost = marg utility=price
A commonly-owned resource (air, oceans): price ($0) does not
reflect its value so used inefficiently (MSC>MSB)
Similar case with externalities:
• Production with negative externalities (pollution)
• Marg private cost? Marg social cost? Difference?
5-3
• Public goods as a special kind of externality
Externality itself is a public good
Electrocuting mosquitos
R&D fall out from a private firm
The Nature of Externalities-Graphical Analysis
$
MSC = MPC + MD
Reduction from Q1 to Q* means dcg
profit loss for Supplier and dchg
welfare gain for Demander.
MPC
h
d
g
c
0
Socially efficient output
b
a
Q*
MD
f
e
Q1
MB
Actual output
Q per year
5-5
What Pollutants Do Harm?
• Empirical Research on Pollution Effects on Health
– Difficult to measure because of inability to perform randomized
studies on pollution effects
– Must rely on cross-sectional or time-series analysis
– Studies unable to measure lifetime exposure to air pollution
• Once pollutant identified:
– Must identify the activities that produce the pollutant
– Must identify the value of the damage done
– Must identify the costs of remedying the damage
• Empirical Evidence: The Effect of Air Pollution on
Housing Values
5-6
Private Responses
Bargaining and the Coase Theorem
$
MSC = MPC + MD
Supplier will ↓ Q1 to Q* if
paid by Demander, who is
willing to do so. Bargain
possible over $ transferred.
MPC
h
d
g
c
MD
MB
0
Q*
Q1
Q per year
5-7
The Coase Theorem
• Coase Theorem – Given:
– Low transaction costs
– Clear assignment of property rights
An efficient solution to an externality problem can be
achieved: with or without Gov’t?
Is it relevant to reach an equilibrium to whom property
right are assigned?
Is it relevant for final distribution to whom property right
are assigned?
5-8
• Assumptions necessary for Coase Theorem to work
– The costs to the parties of bargaining are low
– The owners of resources can identify the source of
damages to their property and legally prevent
damages
Public Responses to Externalities Taxes
MSC = MPC + MD
(MPC + cd)
$
Pigouvian
tax revenues
i
j
MPC
d
c
MD
MB
0
Q*
Q1
Q per year
5-10
Public Responses to Externalities –
Subsidies that pay polluter not to pollute
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
5-11
Pros and cons P. T. on output
•
•
•
•
Knowledge (graphic is known!)
Indirect effect (estimated)
No personalisation
No incentives
Public Responses to ExternalitiesEmissions Fee: tax on each pollution unit
$
MC
Emissions fee
f*
MSB
0
e*
Pollution reduction
5-13
• Pigouvian tax on each unit of emission
instead of output
• Is f* a marginal tax?
• Producer decide between paying MC and
paying f*
• Incentive
• Personalised (?)
Public Responses to ExternalitiesUniform Pollution Reduction
MCH
Requiring each company to
reduce pollution by 50 units is
not cost effective. Better to
have Bart reduce pollution by
100 units because he can do so
at a lower cost. But is it fair???
b
MCB
10
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
5-15
Emissions Fees achieve fairness and
efficiency
An Emissions Fee=$50 means
Bart will reduce by 75 and
Homer only by 25, but Homer
pays larger tax.
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
5-16
Marginal cost of reducing pollution across all
polluters
Equal or different?
Equal to what in equilibrium?
Is it cost effective? Why?
Public Responses to ExternalitiesCap (80)-and-Trade: Polluters must have a permit
Bart: The cost of reducing pollution
is less than market price of a
permit, so sell permit.
Homer: The cost of reducing
pollution is greater than market
price of a permit so buy permit.
BOTH GAIN FROM TRADE
MCH
b
MCB
f=
$50
f=
$50
a
10
50
75
90
Bart’s
pollution
reduction
25
50
75
90 Homer’s
pollution
reduction
5-18
• Total pollution 180
• Total cap is 80
• Permit issued by gov’t =80
• To semplify the chart . 80 permits to Bart
(tradable => do initial distribution matter?)
Emissions Fee v Cap-and-Trade
• Responsiveness to Inflation
Nominal and real
Adjustment
• Responsiveness to Cost Changes
Increasing marginal cost =>pollution ?
5-20
Command-and-Control Regulation
• Command-and-control regulations require a
given amount of pollution reduction:
– Technology requirements
– Performance requirements
Flexibility? Cost effective?
• Is command-and-control ever better?
- Monitoring?
– Hot spots: Areas with relatively high
concentrations of emissions
5-21
Chapter 5 Summary
• Externalities occurs when the activity of one person or firm
positively or negatively affects another person/group/firm
outside the market mechanism
• An inefficient allocation of resources results because the market
price does not reflect the external costs or benefits
• The Coase Theorem indicates that private solutions through
bargaining can achieve the efficient outcome under certain
circumstances
• Public solutions to externalities designed to achieve efficiency
include taxes/subsidies; emissions fees; and command-andcontrol regulations
• A market-based, cost-effective, public solution is cap-and-trade
where pollution permits – the right to pollute – are traded
5-22