chapter 5 externalities: problems and solutions 2007 worth publishers public finance and public...

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© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber

Externalities: Problems and Solutions

5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities

5.3 Public-Sector Remedies for Externalities

5.2 Private-Sector Solutions to Negative Externalities

5.1 Externality Theory

Chapter 5

5.5 Conclusion

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In December 1997, representatives from over 170 nations met in Kyoto, Japan, to attempt one of the most ambitious international negotiations ever: an international pact to limit the emissions of carbon dioxide worldwide because of global warming. The nations faced a daunting task.

The cost of reducing the use of fossil fuels, particularly in the major industrialized nations, is enormous.

Replacing these fossil fuels with alternatives would significantly raise the costs of living in developed countries.

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externality Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.

market failure A problem that causes the market economy to deliver an outcome that does not maximize efficiency.

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Externality Theory5 . 1

Economics of Negative Production Externalities

negative production externalityWhen a firm’s production reduces the well-being of others who are not compensated by the firm.

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Examples of Externalities

Negative ExternalitiesPollutionCell phones in a movie theaterCongestion on the internetDrinking and drivingStudent cheating that changes the grade curveThe “Club” anti-theft device for automobiles

Positive ExternalitiesResearch & developmentVaccinationsA neighbor’s nice landscapeStudents asking good questions in classThe “LoJack” anti-theft device for automobiles

Not Considered ExternalitiesLand prices rising in urban areaKnown as “pecuniary” externalities

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Figure 5.1 (with increasing cost MD function)

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private marginal cost (PMC)The direct cost to producers of producing an additional unit of a good.

social marginal cost (SMC) The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others.

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private marginal benefit (PMB) The direct benefit to consumers of consuming an additional unit of a good by the consumer.

social marginal benefit (SMB) The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others.

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Negative Consumption Externalities

negative consumption externalityWhen an individual’s consumptionreduces the well-being of others who are not compensated by the individual.

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The Externality of SUVs

A P P L I C A T I O N

The typical driver today is in a car that weighs 4,089 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,500 pounds.

The consumption of large cars such as SUVs produces three types of negative externalities: Environmental Externalities:

The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions.

Wear and Tear on Roads: Each year, federal, state, and local governments spend $33.2 billion repairing our

roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight.

Safety Externalities: One major appeal of SUVs is that they provide a feeling of security because they

are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.

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Positive Externalities

positive production externalityWhen a firm’s production increases the well-being of othersbut the firm is not compensated by those others.

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positive consumption externalityWhen an individual’s consumptionincreases the well-being of others but the individual is not compensated by those others.

One aspect of the graphical analysis of externalities is knowing which curve to shift, and in which direction. There are four possibilities:► Negative production externality: SMC curve lies above PMC curve► Positive production externality: SMC curve lies below PMC curve► Negative consumption externality: SMB curve lies below PMB curve► Positive consumption externality: SMB curve lies above PMB curveThe key is to assess which category a particular example fits into. First, you must assess whether the externality is associated with producing a good or with consuming a good. Then, you must assess whether the externality is positive or negative.

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Private-Sector Solutions to Negative Externalities5 . 2

The Solution

internalizing the externalityWhen either private negotiationsor government action lead theprice to the party to fully reflectthe external costs or benefits ofthat party’s actions.

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The Solution

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The Solution

Coase Theorem (Part I) When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affectedby the externality can bring about the socially optimal market quantity.

Coase Theorem (Part II) The efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights.

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The Problems with Coasian Solutions

The Assignment Problem

In practice, the Coase theorem is unlikely to solve many of the types of externalities that cause market failures.

Because of assignment problems, Coasian solutions are likely to be more effective for small, localized externalities than for larger, more global externalities.

The Holdout Problem

holdout problem Shared ownershipof property rights gives each owner power over all the others.

As with the assignment problem, the holdout problem would be amplified with a huge externality.

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The Free Rider Problem

Transaction Costs and Negotiating Problems

free rider problem When aninvestment has a personal cost but a common benefit, individuals will underinvest.

The Coasian approach ignores the fundamental problem that it is hard to negotiate when there are large numbers of individuals on one or both sides of the negotiation.

This problem is amplified for an externality such as global warming, where the potentially divergent interests of billions of parties on one side must be somehow aggregated for a negotiation.

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Bottom Line

Ronald Coase’s insight that externalities can sometimes be internalized was a brilliant one.

It provides the competitive market model with a defense against the onslaught of market failures.

It is also an excellent reason to suspect that the market may be able to internalize some small-scale, localized externalities.

It won’t help with large-scale, global externalities.

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Public-Sector Remedies for Externalities5 . 3

The Environmental Protection Agency (EPA) was formed in 1970 to provide public-sector solutions to the problems of externalities in the environment.

Public policy makers employ three types of remedies to resolve the problems associated with negative externalities.

-corrective taxation-subsidies-regulation

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Public Responses to Externalities - Taxes

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

Pigouviantax revenues

i

j

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Corrective Taxation

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Subsidies

subsidy Government payment to an individual or firm that lowersthe cost of consumption or production, respectively.

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Public Responses to Externalities - Subsidies

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

i

jgk

h

f

e

Pigouviansubsidy

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Subsidies

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Externality Problem

The private marginal benefit associated with a product’s consumption is PMB = 360 –4Q

and the private marginal cost associated with its production is PMC = 6Q.

The marginal external damage associated with this good’s production is MD =2Q.

To correct the externality, the government decides to impose a tax of T per unit sold.

What tax T should it set to achieve the social optimum?

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Regulation

In an ideal world, Pigouvian taxation and regulation would be identical. Because regulation appears much more straightforward, however, it has been the traditional choice for addressing environmental externalities in the United States and around the world.

In practice, there are complications that may make taxes a more effective means of addressing externalities.

Taxation doe not provide incentive for innovation of pollution reducing technologies

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Emissions Fee

0Pollution reduction

MSB

MC

e*

f*

$

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Uniform Pollution Reductions

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

Bart’s TaxPayment Homer’s Tax

Payment

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Cap-and-Trade

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

10

a

b

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Cap-and-Trade v Emissions Fee


MSB

MC*

e*

f*

$

MC’

ef e’

Too much pollution reductionToo little pollution reduction

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Cap-and-Trade v Emissions Fee


MC*

e*

f*

$

MC’

ef e’

MSB

Too much pollution reductionToo little pollution reduction

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Emissions Fee v Cap-and-Trade

Responsiveness to InflationResponsiveness to Cost ChangesResponsiveness to Uncertainty

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Distinctions Between Price and Quantity Approaches to Addressing Externalities

5 . 4

Uncertainty About Costs of Reduction

Implications for Effect of Price and Quantity Interventions

The uncertainty over costs has important implications for the type of intervention that reduces pollution most efficiently.

Implications for Instrument Choice

The central intuition here is that the instrument choice depends on whether the government wants to get the amount of pollution reduction right or whether it wants to minimize costs.

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Distributional Effects

Emissions feeCap-and-Trade

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Command-and-Control Regulation

Incentive-based regulationsCommand-and-control regulations

technology standardperformance standard

Is command-and-control ever better?hot spots

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The U.S. Response

Clean Air Act1970 amendmentsCommand-and-control in the 70sHow well did it work?

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Conclusion5 . 5

Externalities are the classic answer to the “when” question of public finance: when one party’s actions affect another party, and the first party doesn’t fully compensate (or get compensated by) the other for this effect, then the market has failed and government intervention is potentially justified.

This naturally leads to the “how” question of public finance. There are two classes of tools in the government’s arsenal for dealing with externalities: price-based measures (taxes and subsidies) and quantity-based measures (regulation).

Which of these methods will lead to the most efficient regulatory outcome depends on factors such as the heterogeneity of the firms being regulated, the flexibility embedded in quantity regulation, and the uncertainty over the costs of externality reduction.

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5 . 4

Basic Model

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5 . 4

Multiple Plants with Different Reduction Costs

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5 . 4

Multiple Plants with Different Reduction Costs

Policy Option 1: Quantity Regulation

Policy Option 2: Price Regulation Through a Corrective Tax

Policy Option 3: Quantity Regulation with Tradable Permits

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5 . 4


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5 . 4


chapter 5 externalities: problems and solutions 2007 worth publishers public finance and public...

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