Chapter 10 Externalities Econ 2100 EXTERNALITIES 0 Course

Chapter 10: Externalities Econ 2100 EXTERNALITIES 0

Course Outline What; why; who? How markets work? Are markets good? What works in the public sector? Chapters 10 -12 Why are you hired? How firms behave?

Chapter 10 Outline Why Create Inefficiencies Externalities Definition Private Solutions Public Solutions EXTERNALITIES 2

Introduction • One of the principles from Chapter 1: Markets are usually a good way to organize economy activity. In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. • One type of market failure: externality, the uncompensated impact of one person’s actions on the well-being of a bystander. • Externalities can be negative or positive, depending on whether impact on bystander is adverse or beneficial. EXTERNALITIES 3

Introduction • Self-interested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient. • Another principle from Chapter 1: Governments can sometimes improve market outcomes. In presence of externalities, public policy can improve efficiency. EXTERNALITIES 4

Examples of Negative Externalities • Air pollution from a factory • The neighbor’s barking dog • Late-night stereo blasting from the dorm room next to yours • Noise pollution from construction projects • Health risk to others from second-hand smoke • Talking on cell phone while driving makes the roads less safe for others EXTERNALITIES 5

Chapter 10 Outline Why Create Inefficiencies Externalities Definition Private Solutions Public Solutions EXTERNALITIES 6

Recap of Welfare Economics The market for gasoline P $5 4 Supply curve shows private cost, the costs directly incurred by sellers. 3 $2. 50 2 Demand curve shows private value, the value to buyers (the prices they are willing to pay). 1 0 The market eq’m maximizes consumer + producer surplus. 0 10 20 25 30 Q (gallons) EXTERNALITIES 7

Analysis of a Negative Externality The market for gasoline P $5 Social cost = private + external cost 4 external cost Supply (private cost) 3 External cost = value of the negative impact on bystanders 2 1 0 0 10 20 30 Q (gallons) EXTERNALITIES = $1 per gallon (value of harm from smog, greenhouse gases) 8

Analysis of a Negative Externality The market for gasoline P $5 Social cost 4 S 3 2 D 1 0 0 10 20 25 30 Q (gallons) EXTERNALITIES The socially optimal quantity is 20 gallons. At any Q < 20, value of additional gas exceeds social cost. At any Q > 20, social cost of the last gallon is greater than its value to society. 9

Analysis of a Negative Externality The market for gasoline P $5 Social cost 4 S 3 2 D 1 0 0 10 20 25 30 Q (gallons) EXTERNALITIES Market eq’m (Q = 25) is greater than social optimum (Q = 20). One solution: tax sellers $1/gallon, would shift S curve up $1. 10

“Internalizing the Externality” • Internalizing the externality: altering incentives so that people take account of the external effects of their actions • In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs. • When market participants must pay social costs, market eq’m = social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q. ) EXTERNALITIES 11

Examples of Positive Externalities • Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you. • R&D creates knowledge others can use. • People going to college raise the population’s education level, which reduces crime and improves government. EXTERNALITIES Thank you for not contaminating the fruit supply! 12

Positive Externalities • In the presence of a positive externality, the social value of a good includes – private value – the direct value to buyers – external benefit – the value of the positive impact on bystanders • The socially optimal Q maximizes welfare: – At any lower Q, the social value of additional units exceeds their cost. – At any higher Q, the cost of the last unit exceeds its social value. EXTERNALITIES 13

ACTIVE LEARNING 1 Analysis of a positive externality P The market for flu shots External benefit = $10/shot $50 § Draw the social 40 value curve. S 30 § Find the socially optimal Q. 20 § What policy would 10 internalize this externality? D 0 0 10 20 30 Q 14

ACTIVE LEARNING Answers 1 Socially optimal Q = 25 shots. P The market for flu shots $50 To internalize the externality, use subsidy = $10/shot. external benefit 40 S 30 Social value = private value + $10 external benefit 20 10 D 0 0 10 20 25 30 Q 15

Effects of Externalities: Summary If negative externality – market quantity larger than socially desirable If positive externality – market quantity smaller than socially desirable To remedy the problem, “internalize the externality” – tax goods with negative externalities – subsidize goods with positive externalities EXTERNALITIES 16

Chapter 10 Outline Why Create Inefficiencies Externalities Definition Private Solutions Public Solutions EXTERNALITIES 17

Public Policies Toward Externalities Two approaches: • Command-control policies regulate behavior directly. Examples: – limits on quantity of pollution emitted – requirements that firms adopt a particular technology to reduce emissions • Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own. Examples: – corrective taxes and subsidies – tradable pollution permits EXTERNALITIES 18

Corrective Taxes & Subsidies • Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality • Also called Pigouvian taxes after Arthur Pigou (1877 -1959). • The ideal corrective tax = external cost • For activities with positive externalities, ideal corrective subsidy = external benefit EXTERNALITIES 19

Corrective Taxes & Subsidies • Other taxes and subsidies distort incentives and move economy away from the social optimum. • Corrective taxes & subsidies – align private incentives with society’s interests – make private decision-makers take into account the external costs and benefits of their actions – move economy toward a more efficient allocation of resources. EXTERNALITIES 20

Corrective Taxes vs. Regulations • Different firms have different costs of pollution abatement. • Efficient outcome: Firms with the lowest abatement costs reduce pollution the most. • A pollution tax is efficient: – Firms with low abatement costs will reduce pollution to reduce their tax burden. – Firms with high abatement costs have greater willingness to pay tax. • In contrast, a regulation requiring all firms to reduce pollution by a specific amount not efficient – costs higher. EXTERNALITIES 21

Corrective Taxes vs. Regulations Corrective taxes are better for the environment: • The corrective tax gives firms incentive to continue reducing pollution as long as the cost of doing so is less than the tax. • If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. • In contrast, firms have no incentive for further reduction beyond the level specified in a regulation. EXTERNALITIES 22

ACTIVE LEARNING 2 A. Regulating lower SO 2 emissions • Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month, total emissions = 80 tons/month. • Goal: Reduce SO 2 emissions 25%, to 60 tons/month • Cost of reducing emissions: $100/ton for Acme, $200/ton for USE Policy option 1: Regulation Every firm must cut its emissions 25% (10 tons). Your task: Compute the cost to each firm and total cost of achieving goal using this policy. 23

ACTIVE LEARNING A. Answers 2 • Each firm must reduce emissions by 10 tons. • Cost of reducing emissions: $100/ton for Acme, $200/ton for USE. • Compute cost of achieving goal with this policy: Cost to Acme: (10 tons) x ($100/ton) = $1000 Cost to USE: (10 tons) x ($200/ton) = $2000 Total cost of achieving goal = $3000 24

ACTIVE LEARNING 2 B. Tradable pollution permits • Initially, Acme and USE each emit 40 tons SO 2/month. • Goal: reduce SO 2 emissions to 60 tons/month total. Policy option 2: Tradable pollution permits • Issue 60 permits, each allows one ton SO 2 emissions. Give 30 permits to each firm. Establish market for trading permits. • Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons. Your task: Compute cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each. 25

ACTIVE LEARNING B. Answers 2 • Goal: reduce emissions from 80 to 60 tons • Cost of reducing emissions: $100/ton for Acme, $200/ton for USE. Compute cost of achieving goal: Acme – sells 10 permits to USE for $150 each, gets $1500 – uses 20 permits, emits 20 tons SO 2 – spends $2000 to reduce emissions by 20 tons – net cost to Acme: $2000 - $1500 = $500 continued… 26

ACTIVE LEARNING B. Answers, continued 2 • Goal: reduce emissions from 80 to 60 tons • Cost of reducing emissions: $100/ton for Acme, $200/ton for USE – buys 10 permits from Acme, spends $1500 – uses these 10 plus original 30 permits, emits 40 tons – spends nothing on abatement – net cost to USE = $1500 Total cost of achieving goal = $500 + $1500 = $2000 Using tradable permits, goal is achieved at lower total cost and lower cost to each firm than using regulation. 27

Tradable Pollution Permits • A tradable pollution permits system reduces pollution at lower cost than regulation. – Firms with low cost of reducing pollution sell whatever permits they can. – Firms with high cost of reducing pollution buy permits. • Result: Pollution reduction is concentrated among those firms with lowest costs. EXTERNALITIES 28

Objections to the Economic Analysis of Pollution • Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment. • However, people face tradeoffs. The value of clean air & water must be compared to their cost. • The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment. EXTERNALITIES 29

Chapter 10 Outline Why Create Inefficiencies Externalities Definition Private Solutions Public Solutions EXTERNALITIES 30

Private Solutions to Externalities Types of private solutions: • Moral codes and social sanctions, e. g. , the “Golden Rule” • Charities, e. g. , the Sierra Club • Contracts between market participants and the affected bystanders EXTERNALITIES 31

Private Solutions to Externalities • The Coase theorem: If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own. See Text for description of Dick, Jane and Spot as an illustration of the Coase theorem See Spot bark. EXTERNALITIES 32

Why Private Solutions Do Not Always Work 1. 2. 3. Transaction costs: The costs parties incur in the process of agreeing to and following through on a bargain. These costs may make it impossible to reach a mutually beneficial agreement. Stubbornness: Even if a beneficial agreement is possible, each party may hold out for a better deal. Coordination problems: If # of parties is very large, coordinating them may be costly, difficult, or impossible. EXTERNALITIES 33

Test Bank Questions EXTERNALITIES 34

Questions 6 & 10 6. An externality is the impact of a. society's decisions on the well-being of society. b. a person's actions on that person's well-being. c. one person's actions on the well-being of a bystander. d. society's decisions on the poorest person in the society. 10. A cost imposed on someone who is neither the consumer nor the producer is called a a. corrective tax. b. command control policy. c. positive externality. d. negative externality. EXTERNALITIES 35

Questions 15 & 17 15. Which of the following statements about a well-maintained yard best conveys the general nature of the externality? a. A well-maintained yard conveys a positive externality because it increases the home's market value. b. A well-maintained yard conveys a negative externality because it increases the property tax liability of the owner. c. A well-maintained yard conveys a positive externality because it increases the value of adjacent properties in the neighborhood. d. A well-maintained yard cannot provide any type of externality. 17. All externalities a. cause markets to fail to allocate resources efficiently. b. cause equilibrium prices to be too high. c. benefit producers at the expense of consumers. d. cause equilibrium prices to be too low. EXTERNALITIES 36

Questions 15 & 16 15. Refer to Figure 10 -1. This graph represents the tobacco industry. Without any government intervention, the equilibrium price and quantity are a. $1. 90 and 38 units, respectively. b. $1. 80 and 35 units, respectively. c. $1. 60 and 42 units, respectively. d. $1. 35 and 58 units, respectively. 16. Refer to Figure 10 -1. This graph represents the tobacco industry. The socially optimal price and quantity are EXTERNALITIES a. b. c. d. $1. 90 and 38 units, respectively. $1. 80 and 35 units, respectively. $1. 60 and 42 units, respectively. $1. 35 and 58 units, respectively. 37

Question 3 3. Refer to Figure 10 -5. Which of the following statements is correct? a. b. c. d. To induce firms to internalize the externality in this market, the government should impose a tax measured by P 2 - P 0. To induce firms to internalize the externality in this market, the government should offer a subsidy measured by P 2 - P 0. To induce firms to internalize the externality in this market, the government should impose a tax measured by P 2 - P 1. There is no externality in this market. EXTERNALITIES 38

Questions 10 & 16 10. A command-control policy is another term for a a. b. c. d. pollution permit. government regulation. corrective tax. Both a and b are correct. 16. If the government were to impose a fine of $1, 000 for each unit of air-pollution released by a steel mill, the policy would be considered a. b. c. d. EXTERNALITIES a subsidy. a regulation. a corrective tax. an application of the Coase theorem. 39

Questions 67 & 71 67. Once tradable pollution permits have been allocated to firms, a. b. c. d. 71. Which of the following is an advantage of tradable pollution permits? the government controls the price of permits. firms that can reduce pollution only at high cost will be willing to pay the most for the pollution permits. the value of pollution-saving technology will be lower than the market value of a pollution permit. the Coase theorem is no longer applicable as a solution to reducing pollution. a. Each firm is allowed to pollute exactly the same amount. b. Revenue from the sale of permits is greater than revenue from a corrective tax. c. The initial allocation of permits to firms does not affect the efficiency of the market. d. Firms will engage in joint research efforts to reduce pollution. EXTERNALITIES 40

Questions 1 & 4. Externalities can be corrected by each of the following except 1 a. self-interest. b. moral codes and social sanctions. c. charity. d. normal market adjustments. 4. When externalities cause markets to be inefficient, a. b. c. d. EXTERNALITIES government action is always needed to solve the problem. private solutions can be developed to solve the problem. given enough time, externalities can be solved through normal market adjustments. there is no way to eliminate the problem of externalities in a market. 41

Questions 8 & 16 8. Private contracts between parties with mutual interests 16. One reason that private solutions to externalities do not always work is that a. will reduce the well-being of society. b. will lead to market outcomes in which the public interest is sacrificed for personal gain. c. can solve some inefficiencies associated with positive externalities. d. will create negative externalities. a. government intervention negates the benefits of positive externalities. b. some people benefit from externalities. c. interested parties incur costs in the bargaining process. d. charities are not well organized. EXTERNALITIES 42