Externalities

Today:

The fundamentals of externality theory

Externalities

Markets are well functioning for most private goods Many buyers and sellers Little or no market power by anybody Example: When demand shifts right for a good,

new equilibrium will have higher price and quantity Some markets do not have good

mechanisms to account for everything in a market Example: Talking on a cell phone in an airplane

Externalities

Externalities are effects that are not incorporated into market quantities and prices R/G (p.71) define an externality as “an activity of

one entity that affects the welfare of another entity in a way that is outside the market mechanism”

When markets have externalities, they are typically not efficient This is the topic of Chapter 5

Public good versus externality Although public goods are often looked at as

goods with externalities, we study the two topics separately Know which analysis applies when you solve a

problem

Negative externalities

Some examples of negative externalities Air pollution Water pollution

Sometimes you do not even think about polluting the water: Washing a car in your driveway

Noise pollution Highway congestion Standing at a concert or sporting event

Positive externalities

Some externalities are benefits Planting flowers in your front lawn Scientific research Vaccination

Prevents others from getting a disease from you Exercise?

Yes, if it leads to lower health care insurance premiums for others

More on the private health care market in Chapter 9

More externalities: Benefit or cost? Christmas decorations

Enjoyment or nuisance? A fan blowing in a warm office building

Cooling breeze or blowing your important papers? Use of perfume or cologne

Nice smell or allergen?

A simple example with externalities Suppose private MC equals quantity

MPC = Q Let demand be denoted by P = 100 – Q Let marginal damage be $10 per unit

A simple example with externalities

Translate equations and external cost to our graphical example

marginal damage per unit of $10

P = 100 – Q

MPC = Q

MSC = Q + 10

A simple example: Private equilibrium

Inefficient equilibrium w/o controls:

Set Q = 100 – Q Q = 50 (quantity F)

MPC = Q

P = 100 – Q

A simple example: Optimal equilibrium

Socially optimal quantity Q + 10 = 100 – Q Q = 45 (quantity E)

P = 100 – Q

MSC = Q + 10

An algebraic example: Price

Inefficient equilibrium, P = Q P = 50 Socially optimal quantity, P = Q + 10 P = 55

marginal damage per unit of $10

P = 100 – Q

MPC = Q

MSC = Q + 10

Price C = 50

Price B = 55

Recall E = 45 and F = 50

The externality problem

With externalities, quantity produced is typically not optimal

Finding optimal quantity when marginal damage is not constant

Deadweight loss of inefficient production

Next…

A more general analysis of externalities External cost per unit does not have to be

constant Graphical analysis of externalities

See Figure 5.1, p. 74 See Figure 5.2, p. 76

Graphical analysis of externalities

This is also the deadweight loss (or excess burden) when Q1 is produced

Pollution

Pollution is one of the biggest negative externalities around

Multiple steps needed to try to find optimal amount of pollution Which pollutants actually do damage? Are there pollutants that indirectly cause damage?

Example: CFCs on the ozone layer How do we value the damage done?

Very difficult to do, due to lack of markets

Pollution and empirical studies Empirical studies have been done to try to

determine the damages caused by pollution Remember from Chapter 2 that we need to

use events that prevent bias

Pollution and empirical studies Chay and Greenstone (2003, 2005)

Pollution on health 1 percent reduction in total suspended particulates

resulted in a 0.35 percent reduction in infant mortality rate

Pollution on housing prices Improved air quality between 1970 and 1980 in pollution-

regulated cities led to property value increases of $45 billion

The externalities of smoking

Increased health care costs Affects others through increased health care insurance

premiums Lower workplace productivity due to smoking

Lowers non-smoker wages also if firms cannot discriminate against smokers

Increased fires Additional fire fighting cost on society

The death benefit: A positive externality Secondhand smoke

The externalities of smoking

All together, the externalities due to smoking lead to a net cost on society Empirical estimates lead to a total cost that is

probably somewhere between $0.50-$1.50 per pack Estimates can vary depending on factors such as

discount rate, assumptions in a model, and value of life Current cigarette taxes in the US are about $1 per

pack

Why don’t we just negotiate?

Negotiation is typically costly Remember, time is worth something

Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

Coase theorem

The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur People can negotiate costlessly The right can be purchased and sold

Property rights

Given the above conditions, efficient solutions can be negotiated

Ronald Coase

Coase theorem

Notice that the Coase theorem addresses efficiency

To get to efficiency, the quantity of most goods and services produced is still positive Example: It is not efficient to get rid of all pollution

If all pollution was gone, we could not live (since we exhale CO2)

Bargaining and the Coase Theorem See Figure 5.3, p. 80

MB exceeds MPC in this range Production will be Q1 without negotiation

MSC exceeds MB here With costless bargaining, consumers will pay to reduce production from Q1 to Q*

Other private responses to externalities Mergers

When negative externalities only affect other firms, two firms can merge to internalize the externalities

Social convention Social pressure to be nice can lower the amount

of certain negative externalities

Public responses to externalities Four public responses

Taxes Also known as emissions fee in markets with pollution

Subsidies Command-and-control

Government dictates standards without regard to cost Cap-and-trade policies

Also known as a permit system

Taxes: See Figure 5.4, p. 83

With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss Quantity is below the optimal amount with taxes

With negative externalities, taxes can improve efficiency The optimal tax is known as the Pigouvian tax

Pigouvian tax equals marginal damage at the efficient output Increased Pigouvian taxes can also lead to lower income

taxes without sacrificing overall tax revenue Double dividend hypothesis (More in Chapter 15)

Emissions fee

One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output This kind of tax is known as an emissions fee See Figure 5.6, p. 85

Subsidies: See Figure 5.5, p. 84 An alternative to taxes is providing a subsidy

to each firm for every unit that it abates Problems with subsidies:

Efficient outcome only with a fixed number of firms Increased profits of firms in the industry will encourage

new entrants into the industry Positive economic profits if new entry is not allowed

Revenue is needed to provide subsidies Taxing income reduces inefficiencies

Ethical issues: Who has the right to pollute?

Command-and-control pollution reduction Two firms

Each would pollute 90 units if there are no pollution controls

Suppose each firm was forced to reduce pollution by 50 units Known as uniform pollution reduction Usually not efficient

Inefficiencies of uniform reductions

Notice that MC of Homer’s last unit of abatement is higher than Bart’s

$ $

MC is for abatement on these graphs

Total abatement costs are in red for each firm

Inefficiencies of uniform reductionsOverall abatement costs

can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit

$ $

Command-and-control regulation Command-and-control regulations can take many

forms Uniform reductions Percentage reductions Technology standards

Each firm must use a certain type of technology This method may work best when emissions cannot be

monitored easily Performance standards

Government sets emissions goal for each polluter Firm can use any technology it wants Less expensive than technology standards

Lowering abatement costs

Going from command-and-control requirements to emissions fees can lower overall abatement costs

Marginal cost of abatement of the last unit is equal for each firm with an emissions fee

Emissions fee example See Figure 5.9, p. 88

Cap-and-trade policies

Policy in which a permit is needed for each unit of pollution emitted

Permits can be traded Policy is efficient if

Bargaining costs are negligible Competitive permit markets exist Number of permits matches efficient pollution level

Initial allocation of permits does not affect efficiency as long as the above criteria are met

Example: See Figure 5.10, p. 90

Emissions fee versus cap-and-trade Given certain conditions, we

notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency $50 fee for each unit polluted (implicit

fee under permits) Bart reduces pollution by 75 units Homer reduces pollution by 25 units

In what direction are we heading? Command-and-control policies often rely on

states to enforce States do not always comply with these measures Fees and permits can often be controlled on the

national level US policies have generally moved from

command-and-control to taxes and permits Exceptions do still apply: Emissions hot spots

In a perfect world…

…we would know everything with certainty The real world is not perfect

How does this complicate our analysis?

The real world is more complicated We do not live in a world with perfect

economic assumptions Complicating factors

Inflation Cost changes Uncertainty Distributional effects

Inflation

If emissions fees do not represent real prices, the amount of pollution will change as real price changes

Cap-and-trade policies do not need inflation factored in, since quantity limits are used

Cost changes

Suppose cost to abate decreases every year Optimal amount of abatement will increase each

year If a new abatement technology is just being

developed, future cost changes could be small or large Potential solution: Impose a hybrid system

Permit market Offer a high tax for pollution emitted without a permit

Uncertainty

Costs and benefits are typically not known with certainty With uncertainty, too much or too little pollution

can be produced (relative to the efficient outcome) Two situations analyzed, with MC curve

uncertain Inelastic MSB: See Figure 5.11, p. 92 Elastic MSB: See Figure 5.12, p. 93

Distributional effects

Firms… Lose when they pay a tax Win when they are given permits

Government can generate revenue… If a tax is imposed If permits are sold

Double dividend hypothesis supports taxes or selling permits

Political pressure may encourage permit giveaways

Distributional effects

Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods

Displacement concerns Job losses from environmental regulation: Does

this increase income inequity? Who bears the cost of pollution control?

Depends on who uses the good that has the pollution control Example: Cars that are 15 or more years old

Summary

Externalities lead to inefficient production of many goods and services

Costless negotiation can lead to efficient outcomes in the presence of externalities Not realistic in most markets

There are many ways to implement government policies to improve efficiency

Wednesday

Positive externalities An application of externalities

Highway travel Problems related to externalities