Chapter 3 Externalities and Public Policy Externalities Externalities
Chapter 3 Externalities and Public Policy
Externalities § Externalities are costs or benefits of market transactions not reflected in prices. § Negative externalities are costs to third parties. § Positive externalities are benefits to third parties.
Externalities and Efficiency § The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. This occurs when there is a negative externality.
Social Costs MSC = MPC + MEC
Price, Benefit, and Cost (Dollars) Figure 3. 1 Market Equilibrium, A Negative Externality and Efficiency MPC + MEC = MSC 110 105 100 G B 10 S = MPC 10 A D = MSB 4. 5 5 Tons of Paper Per Year (Millions)
Implications of Figure 3. 1 § Market equilibrium occurs where MSC = MSB § Efficiency Requires that MSC = MPC + MEC = MSB
Positive externalities § The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.
Social Benefit MSB = MPB + MEB
Price, Benefit, and Cost (Dollars) Figure 3. 2 Market Equilibrium, A Positive Externality and Efficiency 45 Z 30 25 10 0 S = MSC V U H MPB + MEB = MSB 10 12 Inoculations Per Year (Millions)
Price, Benefit, and Cost (Dollars) Figure 3. 3 A Positive Externality for Which MEB Declines With Annual Output MPBi + MEB = MSB 30 25 F A B S' = MSC' C 20 0 S = MSC MPBi 10 12 16 20 Inoculations per Year (Millions)
Internalization of Externalities § An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions.
Corrective Taxes to Negative Externalities § Setting a tax equal to the MEC will internalize a negative externality.
Price, Benefit, and Cost (Dollars) Figure 3. 4 A Corrective Tax S’ = MPC + T = MSC 110 105 100 95 S = MPC G B Tax Revenue = Total External Costs T A Net Gains in Well-Being D = MSB 4. 5 5 Tons of Paper Per Year (Millions)
Results of a Corrective Tax § Socially optimal levels of production are achieved. § The tax revenue is sufficient to pay costs to third parties.
Using a Corrective Tax § The greenhouse effect and a “Carbon Tax” § If it is accepted that the greenhouse effect is caused by burning carbon-based fuels, a carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels. § It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.
Theory of the Second Best § When one condition for an optimum is violated then maintaining the others will not guarantee a secondbest solution.
A Polluting Monopolist § In Chapter 2 it was shown that monopoly created a loss to society. In this chapter it was shown that a negative externality causes a loss as well. § The losses do not necessarily add to one another. In fact, they cancel each other out.
Figure 3. 5 A Second Best Efficient Solution MPC + MEC = MSC F PM MPC A Price B C D = MSB MR 0 QM Q* Output per Year
Corrective Subsidies § Setting a subsidy equal to MEB will internalize a positive externality
Price, Benefit, and Cost (Dollars) Figure 3. 6 A Corrective Subsidy Z 45 30 25 R S = MSC V U Subsidy Payments 10 Y X D' = MPB i+ $20 = MSB D = MPB i 0 10 12 Inoculations per Year (Millions)
Coase's Theorem § By establishing rights to use resources government can internalize externalities when transactions or bargaining costs are zero.
Figure 3. 7 Coase’s Theorem B MPCB + MEC = MSC MPCB PB Q*B QB 1 Beef Output per Year Price of Wheat (Dollars) Price of Beef (Dollars) A MCW MC*W PW QW 1 Q*W Wheat Output per Year
Limitations of Coase’s Theorem § Transactions costs are not zero in many situations. § However you allocate the property right, the distribution of income is affected.
Applying Coase's Theorem § The Clean Air Act of 1990 allows for the sale of the "right to pollute. " Firms face a tradeoff when they pollute. If they pollute they forgo the right to sell the emission permit to others. § With electricity this has motivated firms to shift to natural gas and away from coal as a means of producing electricity.
Price and Marginal Social Benefit Figure 3. 8 Pollution Rights and Emissions S = Supply of Pollution Rights $20 0 D = MSB of Emitting Wastes 75, 000 100, 000 Tons of Annual Emissions and Number of Pollution Rights
Marginal Social Cost and Benefit Figure 3. 9 The Efficient Amount of Pollution Abatement MSC E MSB A* 0 100 Percent Reduction in Wastes Emitted per Year
Regulatory Solutions § Instead of using market forces to cause firms to internalize externalities we can use emission standards and apply these to all.
Figure 3. 10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions Cost and Benefit (Dollars) Firm A B MEC = MSC C 10 A DQRA MSB Q*A Firm B 10 QB 1 Tons of Emissions per Year F MEC = MSC G H DQRB 0 Q*B QR MSB QB 1
Cost and Benefit (Dollars) Figure 3. 11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions Firm C 20 X Y Firm D MEC = MSC S Z DQRC Q*C QR MSB R T QR Q*D Tons of Emissions per Year MEC = MSC DQRD
Sulfur Dioxide Emission Prices Allowance Price (Dollars) 250 200 150 100 50 0 8/1/94 8/1/95 8/1/95 Month/Year Fieldston Publications Price Index SOURCE: United States Environmental Protection Agency Cantor Fitzgerald Market Price Index
Global Externalities § CFC’s § Deforestation § Global Warming
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