CHAPTER 5 Externalities Mc GrawHillIrwin Copyright 2008 by

CHAPTER 5 Externalities Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Externalities o Externality – An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism o Not an Externality – suburban-urban migration example 5 -2

The Nature of Externalities o Privately-owned versus commonly-owned resources o Externalities can be produced by consumers as well as firms o Externalities are reciprocal in nature o Externalities can be positive o Public goods can be viewed as a special kind of externality 5 -3

The Nature of Externalities-Graphical Analysis MSC = MPC + MD $ MPC h d g c 0 Socially efficient output b a Q* MD f e MB Q 1 Q per year Actual output 5 -4

What Pollutants Do Harm? o Empirical Evidence: What is the Effect of Pollution on Health? o What Activities Produce Pollutants? o What is the Value of the Damage Done? o Empirical Evidence: The Effect of Air Pollution on Housing Values 5 -5

Bargaining and the Coase Theorem MSC = MPC + MD $ MPC h d g c MD MB 0 Q* Q 1 Q per year 5 -6

The Coase Theorem o Coase Theorem – Provided that transaction casts are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights o Assumptions necessary for Coase Theorem to work n The costs to the parties of bargaining are low n The owners of resources can identify the source of damages to their property and legally prevent damages 5 -7

Other Private Solutions o Mergers o Social conventions 5 -8

Public Responses to Externalities - Taxes MSC = MPC + MD (MPC + cd) $ Pigouvian tax revenues i j MPC d c MD MB 0 Q* Q 1 Q per year 5 -9

Public Responses to Externalities - Subsidies MSC = MPC + MD (MPC + cd) $ MPC Pigouvian subsidy i j 0 d c k f g h e Q* Q 1 MD MB Q per year 5 -10

Emissions Fee $ MC f* MSB 0 e* Pollution reduction 5 -11

Uniform Pollution Reductions MCH Bart’s Tax Payment Homer’s Tax Payment MCB f= $50 50 75 90 Bart’s pollution reduction 25 50 75 90 Homer’s pollution reduction 5 -12

Cap-and-Trade MCH b MCB f= $50 a 10 50 75 90 Bart’s pollution reduction 25 50 75 90 Homer’s pollution reduction 5 -13

Cap-and-Trade v Emissions Fee MC’ $ MC* f* MSB 0 ef Too little pollution reduction e’ e* Too much pollution reduction Pollution reduction 5 -14

Cap-and-Trade v Emissions Fee MC’ $ MC* f* MSB 0 ef Too little pollution reduction e’ e* Too much pollution reduction Pollution reduction 5 -15

Emissions Fee v Cap-and-Trade o Responsiveness to Inflation o Responsiveness to Cost Changes o Responsiveness to Uncertainty 5 -16

Distributional Effects o Emissions fee o Cap-and-Trade 5 -17

Command-Control Regulation o Incentive-based regulations o Command-control regulations o n technology standard n performance standard Is command-control ever better? n hot spots 5 -18

The U. S. Response o Clean Air Act n 1970 amendments n Command-control in the 70 s n How well did it work? 5 -19

Progress with Incentive-based Approaches o Policy Perspective: Cap-and-Trade for Sulfur Dioxide o Policy Perspective: Cap-and-Trade to Protect Fisheries and Wildlife n individual transferable quotas 5 -20

Implications for Income Distribution o Who Benefits? o Who Bears the Cost? 5 -21

Positive Externalities $ MC MSB = MPB + MEB MPB MEB R 1 R* Research per year 5 -22

A Cautionary Note o o Requests for subsidies n Resource extracted from taxpayers n Market does not always fail Policy Perspective: Owner-Occupied Housing 5 -23