Chapter 5: Externality policies

Consumption Externalities

Regulating monopolies and middlemen

Positive externalities

Education and direct control

Externalities from Cigarette Smoking

The Economics of Illicit Drugs

Production Externalities:Example Inverse demand (D) = Marginal Benefit (MB)= a - bQ

Marginal private cost (MPC)=C(Q) = c + dQ

Marginal externality cost (MEC) = e + fQ

Marginal social cost (MSC) = MPC + MEC = c + dQ + e + fQ = c + e + (d + f)Q

Outcomes: alternative institutionsscenario quantity price t

ax

competitive (a-c)/(b+d) a-b (a-c)/ (b+d)

optimal (a-c-e) /(b+d+f) a-b (a-c-e) /(b+d+f)

monopoly (a-c)/(2b+d) a-b (a-c)/ (2b+d)

monopsony (a-c)/(b+2d) a-b (a-c)/ (2b+d)

Middle men (a-c)/2(b+d) (a-c)/2(b+d)

Monopoly is polluting excessively

$

Q

D

MR

Qm Qc

Low MSC

Q*low

High MSC

Q* High

MPC

A

B

Low MSC=small MECHigh MSC=large MECUnregulated competition=QcMonopoly=Qm

Regulating the monopoly- High MSC case

$

Q

D

MR

Qm Qc

Low MSC

Q*low

High MSC

Q* High

MPC

A

B

Move to Q* where MB=MSC

Using a tax,subsidy or standard

The tax =MR-MPC at Q*

TAX

Regulating the monopoly- LOW MSC CASE

$

Q

D

MR

Qm Qc

Low MSC

Q*low

High MSC

Q* High

MPC

B

Move to Q* where MB=MSC

Using upper bound on price, or a standard

The upper bound price is P*

Minimum Quantity Q*low

P*

Optimal policy: monopolyIf Q*<Qm monopoly is over polluting

Regulation:Tax, subsidy,standard

The tax=MR-MPC a-2bQ*-(c+dQ*)(2b+d)(a-c-e)

MR minus MPC at Q* (a-c)- ------------------ (b+d+f)

DMSC

MPC

MR

TAX

Q* Qm

Example-old numbers- Monopolyif a=20,b=2,c=4,d=2,e=2 f=.5

Qm=3.2<Q*=4 under production intervention p=12 Price is reduced from 13.60 to 12

If f=3 Qm=3.20 > Q*=2.33

Over production by monopoly

A tax of 4.33 will lead the monopoly to reach optimal outcome (20-4-2.33*(2*2+1)-4.33=0)

Intervention for middle men IF middle men produces less than optimal

set upper bound on consumer price to be P*

If Middle men produces more than optimal output:

set a tax MR-MO at Q* in case of example it is 2.00.

To check if that will lead to optimal Q with middle men

MR will be 20-2*2*Q-2

MO will be 4+2*Q

Solution will be where 20-4-2-(4+2)Q=14-6Q

Q=Q*=2.33

Positive Externalities

We now turn to positiveexternalities.

Consumers benefit from conservation activities of producers-they generate environmental services

Positive externalitiesMPC=Marginal privatel cost of production (0 production externality)

MPBcons=Marginal Private Benefit = Individual Demand

MSBcons=Marginal Social Benefit = MPBcons + MECbenefits

Socially optimal outcome = Q*, P*,

Inefficient outcome under unregulated competition=Qc,Pc

P*+subsidyPc

$

Q

MPC

MSB cons

Q *

MPB cons

Qc

P*

Positive externality Case with a=20,b=2,c=4,d=1 ,e=-2 f=-1

Competition Pm=9.33,Qm=5.33CS=28.44,PS=14.22,ES=24.89,SS=67.56

Optimal Q*=9 Sub=11Consumer price P*=2.0 Producer price=13CS=9*(20-2)/2=81 PS=9*((11+2)-(4+13)/2)=40.5 ES=9*(2+11)/2=58.5Government expense=9*11=99Social welfare=81+99-99=81

Positive vs negative externality

Positive

Basic principle- beneficiary pays -subsidy

If government does not pay subsidy- private parties may

Negative

Basic principle-polluter pay-pollution tax

Subsidy liked by industry

Tradable permits leads to compromise

Policy toolsIncentives ( taxes, subsidies)

Cap and trade

Direct controls

Property rights

Voluntary agreements

Education

Voluntary agreementGovernment or NGO reach an agreement with a polluter to reduce pollution.

It can be motivated by need to project a “green image”

It may occur when government does not have sufficient power to control gains

Education& communicationEducation can inform people of consequences of their activities. (e.g., farmers may modify waste management practices if they learn that these practices contaminate a lake they use).

Education can modify preferences and lead to change in behavior. (e.g., people may learn to appreciate the environment, value the preservation of natural resources, and thus behave in a more environmentally friendly way).

Education can inform the public of the firms that generate the most pollution. This may induce some of these firms to change their practices because this information may reduce the demand for their products.

Externalities from SmokingHealth Costs Associated with Smoking: Smokers' health costs shared by society. Cost of family support (in case of early death). Risk to nonsmokers (second-hand smoke).Estimated Death Toll (1989):

Estimated Annual external costs of smoking:$ 35 billion (medical cost)$ 20 billion (lost work)$ 5 billion (fires, smoke, odor damage)$ 60 billion (total cost)

Activity Annual deaths

Smoking 400,000

Drinking 150,000

Drugs 30,000

Policies to control cigarettes

(1) A cigarette tax or tobacco tax.(2) A standard/quota to restrict quantities of

cigarettes and tobacco. Approximately 30 billion packs of

cigarettes are smoked annually. If marginal externality cost = average

externality cost, then the tax should be $2.00 per pack ($60 billion of externality cost / 30 billion packs).

Policy consequences

(1) Producers: Restriction on quantities may benefit producers or distributors if elasticity of demand is smaller than 1.

(2) Government: Tax revenues can be used to compensate victims of smoking damages, or it can be used in lieu of other distortionary taxes (such as income taxes and sales taxes) to support government programs.

(3) Unintended Consequences: May strengthen the case for the legalization of drugs.

The Economics of Illicit DrugsShould there be a drug legalization policy similar to the one for cigarettes?Proposals

Legalize illicit drugs. Ban advertisement and sale to minors. Institute a tax on drugs.

Benefits: Increased government revenue. Reduced government costs (fewer prisoners and less drug enforcement). Reduced crime.

Costs: Increased addiction. Legalization may induce more to try.

Economic impacts of drug policy1. Legalization of drugs would shift income from the illegal network of drug traffickers to government (taxes) and legal marketers (pharmacies).

2. Drug producers may be better off if drug cartels behave like the middlemen, since eliminating drug trafficker middlemen may result in increased quantity and higher producer prices.

3. Costs of crime enforcement may go down.

4. Consumer prices (inclusive of taxes) may go down and quantity may go up. There may be higher health costs associated with drug addiction.