Chapter 5 Externalities Problems and Solutions Jonathan Gruber

Chapter 5 Externalities Problems and Solutions Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction n Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so. n As we will see, this represents a market failure for which government action could be appropriate and improve welfare.

Introduction n Externalities can be negative or positive: n Acid rain, global warming, pollution, or a neighbor’s loud music are all negative externalities. n Research and development or asking good questions in class are positive externalities.

Introduction n Consider global warming, a negative externality. Many scientists believe this warming trend is caused by human activity, namely the use of fossil fuels. n These fuels, such as coal, oil, natural gas, and gasoline produce carbon dioxide that in turn traps heat from the sun in the earth’s atmosphere. n Figure 1 shows the trend in warming over the last century.

Figure 1 This table shows the global temperature during the 20 th century. There has been a distinct trend upward in temperature

Introduction n Although this warming trend has negative effects overall on society, the distributional consequences vary. In much of the United States, warmer temperatures will improve agricultural output and quality of life. n In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea levels. n n If you’re wondering why you should care about Bangladesh, then you have identified the market failure that arises from externalities. n From your private perspective, you shouldn’t!

EXTERNALITY THEORY n Externalities can either be negative or positive, and they can also arise on the supply side (production externalities) or the demand side (consumption externalities). n A negative production externality is when a firm’s production reduces the well-being of others who are not compensated by the firm. n A negative consumption externality is when an individual’s consumption reduces the well-being of others who are not compensated by the individual. n The basic concepts in positive externalities mirror those in negative externalities.

Economics of Negative Production Externalities n To understand the case of negative production externalities, consider the following example: n n A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river. The fishermen downstream are harmed by this activity, as the fish die and their profits fall. n This is a negative production externalities because: n Fishermen downstream are adversely affected. n And they are not compensated for this harm. n Figure 2 illustrates each party’s incentives in this situation.

SMC = PMC + MD Price of steel S=PMC The yellow steeltriangle firm sets is the consumer PMB=PMC andto producer find its firmoptimal The steel socially overproduces level of privately surplus optimal at from Qproduction. society’s 1 profit is at viewpoint. Q 2, the maximizing output, This Theframework marginal damage does not. Q 1. of SMC and SMB. intersection The red triangle is the curve capture (MD) therepresents harm donethe to The social marginal cost deadweight is loss from the fishery’s the fishery, harm however. per unit. the sum of PMC and MD, and private production level. represents the cost to society. MD p 2 p 1 D = PMB = SMB 0 Figure 2 Q 1 Negative Production Externalities QSTEEL

Economics of Negative Production Externalities n The steel firm’s privately optimal production solves: n This yields a quantity of steel Q 1 at a price of P 1.

Economics of Negative Production Externalities n The steel firm’s emits pollution causing damage to the fishery. This is represented by the marginal damage curve. Ideally, the fishery prefers: n This would yield zero steel production, which is obviously not in the steel firm’s best interests.

Economics of Negative Production Externalities n The social marginal cost accounts for both the direct costs to the steel firm and the indirect harm to the fishery: n We find the socially optimal quantity of steel Q 2 at a price of P 2, by solving:

Economics of Negative Production Externalities n The socially optimal quantity entails less production of steel. By doing so, the steel firm would be worse off but the fishery would be better off. n Graphically, this triangle in between the PMB and PMC curves from Q 2 to Q 1. n The damage to the fishery is reduced as well. n Graphically, this is the area under the MD curve from Q 2 to Q 1.

Economics of Negative Production Externalities n The deadweight loss from the original production level Q 1 is graphically illustrated as the triangle in between the SMC and SMB curves from Q 2 to Q 1. n Note that the SMB equals the PMB curve in this case.

Negative Consumption Externalities n We now move on to negative consumption externalities. Consider the following example: A person at a restaurant smokes cigarettes. n That smoking has a negative effect on your enjoyment of the restaurant meal. n n In this case, the consumption of a good reduces the well-being of someone else. n Figure 3 illustrates each party’s incentives in the presence of a negative consumption externality.

Price of cigarettes S=PMC=SMC The yellow smoker triangle sets is the surplus PMB=PMC to thetosmokers find his privately (and producers) optimal quantity at Q 1. of cigarettes, The This. The MD framework curve represents does Q not 1. benefit is social marginal the capture nonsmoker’s harm done per to PMB the difference between The red triangle is the non-smokers, pack of cigarettes. however. and MD. deadweight loss from the private production The socially smoker optimal consumes leveltoo of level. MD manysmoking cigarettes is at from Q 2, society’s the intersection viewpoint. of SMC and SMB. p 1 p 2 SMB=PMB-MD 0 Figure 3 Q 2 Q 1 Negative Consumption Externalities D=PMB QCIGARETTES

Negative Consumption Externalities n The smoker’s privately optimal quantity solves: n This yields a quantity of cigarettes Q 1 at a price of P 1. The surplus is the same as before.

Negative Consumption Externalities n The smoker’s consumption causes damage to the other restaurant patrons. They would prefer: n This would yield zero cigarette smoking, which is detrimental to the smoker.

Negative Consumption Externalities n The social marginal benefit accounts for both the direct benefit to the smoker and the indirect harm to the other patrons: n We find the socially optimal quantity of cigarettes Q 2 at a price of P 2, by solving:

Negative Consumption Externalities n The socially optimal quantity entails less smoking. By doing so, the cigarette smoker is worse off, but the other patrons are better off. The surplus to the smoker (and tobacco companies) falls. n Graphically, this is the triangle in between the PMB and PMC curves from Q 2 to Q 1. n The harm to other restaurant patrons is reduced as well. n Graphically, this is the area under the MD curve from Q 2 to Q 1.

Negative Consumption Externalities n The deadweight loss from the original consumption level Q 1 is illustrated graphically as the triangle in between the SMC and SMB curves from Q 2 to Q 1. n Note that the SMC equals the PMC curve in this case.

n o i at c i pl p A The Externality of SUVs n Consider a real-life example: the use of sport utility vehicles (SUVs). They create three sorts of externalities: Environmental externalities: They consume a lot of gasoline and create more pollution. n Wear and tear on roads: SUV drivers do not bear the costs that result from their vehicles. n Safety externalities: When SUVs are in accidents, the other drivers are often more severely injured. n

Positive Externalities n Positive externalities can occur in production or consumption. n A positive production externality is when a firm’s production increases the well-being of others, but the firm is not compensated by those others. n Research and development is a production externality. n A positive consumption externality is when an individual’s consumption increases the well-being of others, but the individual is not compensated by those others. n Nice landscaping could be a consumption externality.

Positive Externalities n Let’s consider positive production externalities. Consider the following example: A policeman buys donuts near your home. n As a consequence, the neighbors are safer because of the policeman’s continued presence. n n In this case, the production of donuts increases the well-being of the neighbors. n Figure 4 illustrates each party’s incentives in the presence of a positive production externality.

Price of donuts S = PMC Thedonut yellowshop triangle setsis. PMB the =consumer PMC to find anditsproducer privately optimal surplus profit at maximizing Q 1. not This Theframework external marginal does The red triangle is theoutput, benefit capture (EMB) the represents to the The deadweight loss from thebenefit The donut socially shop optimal underproduces level of the neighbors, neighbor’s benefit. SMC = PMC private production level. however. donuts fromissociety’s at Q 2, the viewpoint. intersection p 1 of SMC and. EMB SMB. EMB p 2 The social marginal cost subtracts EMB from. DPMC. = PMB = SMB 0 Figure 4 Q 1 Q 2 Positive Production Externalities QDONUTS

Positive Externalities n The donut shop’s privately optimal production solves: n This yields a quantity of donuts Q 1 at a price of P 1.

Positive Externalities n The shop creates positive externalities to the neighbors through the presence of police. This is represented by the external marginal benefit. Ideally, the neighbors prefer: n This would yield much more donut production, which is obviously not in shop’s best interests.

Positive Externalities n The social marginal cost accounts for both the direct costs to the donut shop and the indirect benefit to the neighbors: n We find the socially optimal quantity of donuts Q 2 at a price of P 2, by solving:

Positive Externalities n The socially optimal quantity entails more production of donuts. By doing so, the donut shop would be worse off but the neighbors would be better off. The consumer and producer surplus fall. n Graphically, this triangle is between the PMC and PMB curves from Q 1 to Q 2. n The benefit to the neighbors is increased as well. It goes up. n Graphically, this is the area under the EMB curve from Q 1 to Q 2.

Positive Externalities n The deadweight loss from the original donut production level Q 1 is graphically illustrated by the triangle in between the SMB and SMC curves from Q 1 to Q 2. n Note that the SMB equals the PMB curve in this case.

Positive Externalities n Finally, there can be positive consumption externalities. n A neighbor’s improved landscape is a good example of this. n The graphical analysis is similar to negative consumption externalities, except that the SMB curve shifts outward, not inward.

Positive Externalities n The theory shows that when a negative externality is present, the private market will produce too much of the good, creating deadweight loss. n When a positive externality is present, the private market produces too little of the good, again creating deadweight loss.

The Solution (Coase Theorem) n The Coase Theorem: When there are well-defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level. n Thus, the role of government intervention may be very limited—that of simply enforcing property rights.

The Solution (Coase Theorem) n Consider the Coase Theorem in the context of the negative production externality example from before. n Give the fishermen property rights over the amount of steel production. n Figure 5 illustrates this scenario.

SMC = PMC + This bargaining process. MD will continue until theissocially The gain to society is this area, the The gain to society this area, efficient level. (PMB -PMC) between the difference PMC) and MD MD for the second first unit. Price of steel p 2 S = PMC The If the reason fisheryishad because property any rights, steel itproduction would initially makes impose the p 1 zero fishery steelworse production. off. MD Thus, While But While there itthe is possible is fishery the still room fishery room suffers to forbargain. suffers to the bargain. only steel the Thus, it. There is possible for the steel a The modest firm same steel to steel “bribe” amount damage firm gets the of gets fishery as damage. a lot from ainbit ofinthe less firm to. The “bribe” the fishery order surplus to produce from first the the unit. first second next unit. order to produce the first unit. 0 Figure 5 1 2 Q 1 D = PMB SMB QSTEEL Negative Production Externalities and Bargaining

The Solution (Coase theorem) n Through a process of bargaining, the steel firm will bribe the fishery to arrive at Q 2, the socially optimal level. n After that point, the MD exceeds (PMB - PMC), so the steel firm cannot come up with a large enough bribe to expand production further.

The Solution (Coase Theorem) n Another implication of the Coase Theorem is that the efficient solution does not depend on which party is assigned the property rights, as long as someone is assigned them. n The direction in which the bribes go does depend on the assignment, however. n Now, let’s give the property rights to the steel firm over the amount of steel production. n Figure 6 illustrates this scenario.

SMC = PMC + MD Price of steel S = PMC This bargaining process will The gain to to society is this area, the The gain continue until the society socially is this area, the If the This steel levelfirm of production had property difference between MDMD andand (PMB difference between (PMBefficient level. While the steel firm suffers a rights, maximizes it would the consumer choose and unit. PMC) byinitially cutting another PMC) by cutting back 1 unit. only larger a modest loss in loss profits. in profits. producer Q surplus. . p 2 1 p 1 MD The Thus, fishery it is fishery itpossible gets is possible gets the for same a lot the forofthe fishery surplus toas“bribe” to cutting from “bribe” the cutting back the steel from steel back firm D=PMB=SMB to steel cutthe production back first toanother cut unit. back. by unit. one unit. 0 Figure 6 Q 2 Q 1 QSTEEL Negative Production Externalities and Bargaining

The Solution (Coase Theorem) n Figure 6 shows that even though the bargaining process is somewhat different, the socially efficient quantity of Q 2 is achieved.

Problems with Coasian Solutions n There are several problems with the Coase Theorem, however. The assignment problem n The holdout problem n The free rider problem n Transaction costs and negotiating problems n

Problems with Coasian Solutions n The “assignment problem” relates to two issues: n It can be difficult to truly assign blame. n It is hard to value the marginal damage in reality.

Problems with Coasian Solutions n The “holdout problem” arises when the property rights in question are held by more than one party. The shared property rights give each party power over all others. n This could lead to a breakdown in negotiations. n

Problems with Coasian Solutions n The “free rider” problem is that when an investment has a personal cost but a common benefit, individuals will underinvest. n For example, if the steel firm were assigned property rights and you are the last (of many) fishermen to pay, the bribe is larger than the marginal damage to you personally.

Problems with Coasian Solutions n Finally, it is hard to negotiate when there are large numbers of individuals on one or both sides.

Problems with Coasian Solutions n In summary, the Coase Theorem is provocative, but perhaps not terribly relevant to many of the most pressing environmental problems.

PUBLIC-SECTOR REMEDIES FOR EXTERNALITIES n Coasian solutions are insufficient to deal with large scale externalities. Public policy makes use of three types of remedies to address negative externalities: Corrective taxation n Subsidies n Regulation n

Corrective Taxation n The government can impose a “Pigouvian” tax on the steel firm, which lower its output and reduces deadweight loss. n If the per-unit tax equals the marginal damage at the socially optimal quantity, the firm will cut back to that point. n Figure 7 illustrates such a tax.

SMC=PMC+MD S=PMC+tax S=PMC Price of steel The socially optimal level of production, Q 2, then maximizes profits. The steel firm initially produces at QImposing of PMC Imposing aatax taxequal shifts to thethe PMC MD 1, the intersection and PMB. curve shifts curve the upward PMC and reduces such that steel it equals production. SMC. p 2 p 1 D = PMB = SMB 0 Figure 7 Q 2 Pigouvian Tax Q 1 QSTEEL

Corrective Taxation n The Pigouvian tax essentially shifts the private marginal cost. n The firm cuts back output, which is a good thing when there is a negative externality.

Corrective Taxation n The steel firm’s privately optimal production solves: n When the tax equals MD, this becomes: n But this last equation is simply the one used to determine the efficient level of production.

Subsidies n The government can impose a “Pigouvian” subsidy on producers of positive externalities, which increases its output. n If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point. n Figure 8 illustrates such a subsidy.

Price of donuts The donut shop initially a subsidy equal shifts chooses QProviding 1, maximizing its the to. PMC EMB curve shifts downward. the PMC profits. curve downward to SMC. S = PMC The socially optimal level of SMC=PMC-EMB donuts, Q 2, is achieved by such a subsidy. p 1 p 2 D = PMB = SMB 0 Figure 8 Q 1 Pigouvian Subsidy Q 2 QDONUTS

Subsidies n The subsidy also shifts the private marginal cost. n The firm cuts expand output, which is a good thing when there is a positive externality.

Subsidies n The donut shop’s production solves: n When the subsidy equals EMB, this becomes: n But this last equation is simply the one used to determine the efficient level of production.

Regulation n Finally, the government can impose quantity regulation, rather than relying on the price mechanism. n For example, return to the steel firm in Figure 9. 9

SMC = PMC + MD S = PMC Price of steel p 2 The Yet firm the government has an incentive couldto simply require produce it to. Qproduce no 1. more than Q 2. p 1 D = PMB = SMB 0 Figure 9 Q 2 Q 1 Quantity Regulation QSTEEL

Regulation n In an ideal world, Pigouvian taxation and quantity regulation give identical policy outcomes. n In practice, there are complications that may make taxes a more effective means of addressing externalities.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n The key goal is, for any reduction in pollution, to find the least-cost means of achieving that reduction. n One approach could simply be to reduce output. n Another approach would be to adopt pollutionreduction technology.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n The models we have relied on so far have examined reductions in output. Thus, we will modify this. n Our basic model now examines pollution reduction, rather than say, steel production. n Figure 10 illustrates its features.

Since While it pays it faces for increasing the pollution Pollution reduction has a price reduction, marginal costs the SMC from isreducing the same associated with it. level. its pollution as PMC. PR S=PMC=SMC S=PMC The optimal level of While the benefit of pollution reduction is therefore R*. reduction is zero the firm, society benefits by MD. MD = Thus, At some the x-axis levelalso of pollution measures. SMB The steel firm’s private pollutionthe levels firm as has wethat achieved move marginal benefit from reduction, pollution The good is being created On Such its an own, action steel maximizes company itsthe full toward pollution origin. reduction is the zero. isreduction. “pollution reduction. ” would set Qprofits. =0 and Q =Q. R Steel 1 D= PMB 0 PFull R* P* RFull 0 More pollution Figure 10 Model of Pollution Reduction QR

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n As Figure 10 shows, the private market outcome is zero pollution reduction, while the socially efficient level is higher. n In the figure, the optimal tax would simply be MD – the firm would reduce pollution levels to R*, because its MC is less than the tax up until that point, but no further. n Quantity regulation is even simpler–just mandate pollution reduction of R*.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n Assume now there are two firms, with different technologies for reducing pollution. n Assume firm “A” is more efficient than firm “B” at such reduction. n Figure 11 illustrates the situation.

PR Firmthe B Firm has A’s relatively is more PMCB To. While get total For any given output PMCefficient. A inefficient marginal cost, we Bpollution sum level, PMC >PMCA. S = PMCA + PMCB = reduction technology. horizontally. SMC Efficient is got more Quantity If, regulation instead, regulation we in this curve is the where thereduction marginal cost. The of SMB way from inefficient, Firm A, we The efficient level ofis clearly same as pollution reduction for. Bthe each could sinceislower Firm is total “worse” social at before. pollution reduction firm equals SMB. reducing cost. pollution. the same as before. PMCB PMCA Quantity regulation could Imposing involve equal reductions in a Pigouvian tax pollution by bothequal firms, to MD induces these such that R 1 + R 2 = R*. levels of output. 0 Figure 11 RB RA, RA RB R* Two Firms Emit Pollution MD=SMB QR

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n Figure 11 shows that price regulation through taxes is more efficient than is quantity regulation. n A final option is quantity regulation with tradable permits. Idea is to: Issue permits that allow firms to pollute n And allow firms to trade the permits n

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n As in the previous figure, initially the permits might be assigned as quantity regulation was assigned. n This means that initially RA = RB. n But now Firm B has an interest in buying some of Firm A’s permits, since reducing its emissions costs PMCB (>PMCA). Both sides could be made better off by Firm A selling a permit to Firm B, and then Firm A simply reducing its pollution level. n This trading process continue until PMCB=PMCA.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n Finally, the government may not always know with certainty how costly it is for a firm to reduce its pollution levels. n Figure 12 shows the case when the social marginal benefit is “locally flat. ”

PR In But addition, it is possible imagine for that the PMC firm’s the government’s costs to be PMC best 2. 2 Then Suppose therethe is large true guess of costs is PMC 1. deadweight costs are PMC loss. PMC 1 2. This results in a much smaller DWL, If, instead, the. First, and much less This could assume be the government levied a pollution reduction. SMB caseisfor downward global tax, it would equal sloping, warming, but fairly for flat. MD at QR = R 1. example. Regulation mandates R 1. 0 R 3 PFull R 1 MD = SMB RFull 0 More pollution Figure 12 Model with Uncertainty and Locally Flat Benefits QR

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n Figure 13 shows the case when the social marginal benefit is “locally steep. ”

In But addition, it is possible imagine for that the PMC firm’s the government’s costs to be PMC best 2. 2 Then Suppose therethe is small true guess of costs is PMC 1. deadweight costs are PMC loss. PMC 1 2. This results in a larger DWL, and If, instead, the much less pollution government levied a reduction. tax, it would equal MD at QR = R 1. PR Regulation mandates R 1. First, This could assume be the SMB caseisfor downward nuclear sloping, leakage, andfor fairly example. steep. MD = SMB 0 R 3 PFull R 1 RFull 0 More pollution Figure 13 Model with Uncertainty and Locally Steep Benefits QR

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES n These figures show the implications for choice of quantity regulation versus corrective taxes. n The key issue is whether the government wants to get the amount of pollution reduction correct, or to minimize firm costs. n Quantity regulation assures the desired level of pollution reduction. When it is important to get the right level (such as with nuclear leakage), this instrument works well. n However, corrective taxation protects firms against large cost overruns.

Recap of Externalities: Problems and Solutions n Externality theory n Private-sector solutions n Public-sector solutions n Distinctions between price and quantity approaches to addressing externalities