Externalities Chapter 21 Slides by Pamela L Hall

Externalities Chapter 21 Slides by Pamela L. Hall Western Washington University © 2005, Southwestern

Introduction n Driving an automobile is probably a household’s most polluting activity § Efforts since 1970 have greatly reduced typical vehicle emissions • However, number of miles driven has more than doubled ¨ n Offset benefits of controlling emissions § Net result is only a small reduction in automobile pollutants Cause of automobile pollution is a major market failure in presence of an externality (pollution) resulting from missing markets § With missing markets, signals in form of market prices do not exist to reveal consumer preferences for society’s allocation of resources 2

Introduction n If well-defined property rights exist, markets will generally occur for externalities § Reduces necessity for mechanisms designed to correct externalitygenerated inefficiencies • One role for government is to provide a legal system to support welldefined property rights for all of society’s resources n We investigate property rights and consequences of externalities resulting from ill-defined property rights § Then broadly classify externalities as either bilateral or multilateral • Discuss inefficiencies associated with bilateral externalities • Address enforceable property rights (given Coase Theorem) as a means for resolving these inefficiencies 3

Introduction n Coase Theorem states § If a market can be created for an externality, an efficient outcome will result regardless of how well-defined property rights are allocated n We investigate markets where Coase Theorem does not hold § Discuss issue of multilateral externalities § Evaluate government policies involving quotas, taxes, and fostering markets for externalities (eliminating missing markets) as tools for addressing market inefficiencies • Government agencies develop mechanisms that assign property rights and regulate agent behavior ¨ Enforcing policies through penalties for noncompliance and dividends for compliance § However, government mechanisms may not always result in improving social welfare § Such mechanisms can only result in alternative second-best Paretoefficient allocations 4

Introduction n Opportunity cost of allocating resources toward establishing and maintaining mechanisms may exceed cost of inefficiency associated with some externalities § Existence of opportunity cost implies that there are still externalities at some allocation where social welfare is maximized • Applied economists are active in estimating costs and benefits of alternative mechanisms for addressing externalities n Aim in chapter is not to determine least-cost allocation for removing an externality § But to understand why ill-defined property rights result in missing markets for commodities and resulting externalities • Can determine optimal level of an externality and minimum cost of achieving a given externality level 5

Externalities Defined n n n An externality (z) is present whenever some agent’s (say, A’s) utility or production technology includes commodities whose amounts are determined by other agents § Without particular attention to effect on A’s welfare Definition rules out any market-price affects on agents’ utility or production, called pecuniary externalities § Arise when external effect is transmitted through price changes A pecuniary externality does not cause a market failure § For example, suppose a new firm enters a market and drives up rental price of land • Market for land provides a mechanism by which parties can bid for land ¨ Resulting prices will reflect value of land in its various uses 6

Externalities Defined n n n Without pecuniary externalities price signals would fail to sustain an efficient allocation Consumers relying on firms for supply of commodities are not externalities Deliberately affecting welfare of others is not an externality § For example, deliberate criminal actions against agents are not externalities n However, waiting for someone who is not particularly concerned about your welfare is an externality 7

Property Rights n A bundle of entitlements defining an owner’s rights, privileges, and limitations for use of a resource § For example, in many cities owning a plot of land may give you entitlement to build a house but not drill a well n Entitlements vary considerably § From being very restrictive in a planned community to essentially no restrictions in some rural areas n A well-defined structure of property rights will provide incentives for efficient allocation of resources 8

Property Rights n Following list is one set of well-defined private-property rights that results in a Pareto-efficient allocation § Universality • All resources are privately owned and all entitlements completely specified § Exclusivity • All benefits and costs from owning and employing resources accrue to owner § Transferability • All property rights are transferable from one owner to another in a voluntary exchange § Enforceability • Property rights are secure from involuntary seizure or encroachment by others 9

Property Rights n Previously we implicitly assumed well-defined property rights existed § We demonstrated that perfectly competitive markets yield an efficient price system for resource allocation • Such a system is where producers maximize their profits and households maximize their utility ¨ n Given their respective resource constraints and current state of technology Presence of externalities violates assumption of well-defined property rights § For example, building a cabin that blocks neighbor’s view of lake results in a cost that accrues to neighbor n With externalities, household preferences for commodities are not defined solely over bundle of commodities that it has ability to choose 10

Property Rights n n Assumption of firms freely choosing inputs is also violated with presence of production externalities Generally, consumption or production externalities exist when agents (households and firms) are directly affected by actions (external effects) of other agents § Examples are • Presence of other vehicles on a congested highway (negative • externality) Sight of a neighbor’s flower garden (positive externality) 11

Property Rights n n When externalities exist, perfectly competitive equilibrium does not correspond with a Pareto-optimal allocation A common property exists when no individual agent has property entitlements § Agent cannot employ resource for individual gain • In a communist economy, all society’s resources are considered common property ¨ In a centrally planned socialist economy, state (government) has property entitlements and controls property (resource) allocation for common good of society • In a free-market economy, property entitlements are vested privately with individual agents ¨ Leading to private property as dominant form of property rights 12

Bilateral Externalities n Where one agent’s utility or profit is affected by another agent’s actions § Agents could be two firms with their production technologies linked • Firms could be producing either same or different outputs ¨ For example, firms could be a chemical plant and a kayak rental company located on the same river § Alternatively, agents could be two households or one firm and a household • For example, two households living in a duplex where one household enjoys loud music 13

Bilateral Externalities n n For expository purposes, we will assume agents are firms § With one firm experiencing a negative externality from the other Rather than well-defined property rights, assume Firm 1’s short-run total cost function is a function of marketable output q 1 and a nonmarket output (externality) z, STC 1(q 1, z) § For example, q 1 could be production of steel and z the associated river water pollution n Assuming Stage II of production for q 1, associated marginal cost curve, ∂STC 1/∂q 1 = SMC 1 > 0 § Has a positive slope, ∂SMC 1/∂q 1 > 0 • For externality z, ∂STC 1/∂z < 0 ¨ Increasing z will decrease cost of production § Represents a marginal benefit to firm 14

Bilateral Externalities n Define marginal benefit as marginal benefit of the externality (MBE) § MBE = -∂STC 1/∂Z > 0 n Associated MBE curve is illustrated in Figure 21. 1, given Law of Diminishing Marginal Returns § As z increases, MBE declines § Given a missing market for z, there is no positive market price for z • A profit-maximizing firm would produce where ∂STC 1/∂z = 0 15

Figure 21. 1 Negative externality 16

Bilateral Externalities n An increase in costs with no associated change in revenue will decrease profit § Level of z that minimizes costs is ∂STC 1/∂z = 0 n Assume firm 2’s short-run total cost function is directly affected by firm 1’s nonmarket output z, STC 2(q 2, z) § q 2 denotes Firm 2’s marketable output, kayak rentals n n Firm 2’s cost of producing q 2 is directly affected by amount of z firm 1 produces A negative externality implies ∂STC 2/∂z > 0 § An increase in z increases STC 2 and depresses profit • Partial ∂STC 2/∂z > 0 is called marginal social cost (MSC) of externality ¨ n Illustrated in Figure 21. 1 Positive slope associated with MSC indicates § As z increases, marginal social cost increases • ∂MSC/∂z > 0 and ∂2 MSC/∂z 2 > 0 § Firm 2’s costs are increased by an increase in z at an increasing rate • For example, the river may be able to assimilate initial increases in water pollution, so MSC of water pollution for kayaking is low ¨ However, as water pollution increases, capacity of river for assimilating pollution may be exceeded, resulting in marginal cost for the kayak firm increasing at an increasing rate 17

Bilateral Externalities n Positive slope associated with MSC indicates § As z increases, marginal social cost increases • ∂MSC/∂z > 0 and ∂2 MSC/∂z 2 > 0 § Firm 2’s costs are increased by an increase in z at an increasing rate • For example, river may be able to assimilate initial increases in water pollution ¨ MSC of water pollution for kayaking is low § However, as water pollution increases, capacity of river for assimilating pollution may be exceeded § Resulting in marginal cost for kayak firm increasing at an increasing rate 18

Independent Decision Making n n In its profit maximization, firm 1 has control over both q 1 and z § p 1 is per-unit price firm 1 receives for its output, q 1 Since z is a nonmarket output, there is no associated market price § F. O. C. s are • ∂ 1/∂q 1 = p 1 – SMB 1(q 1, z) = 0 ¨ Discussed in Chapter 9 and illustrated in Figure 21. 1 • ∂ 1/∂z = -∂STC 1(q 1, z)/∂z = 0 ¨ Establishes cost-minimizing level of z as a necessary condition for profit maximization 19

Independent Decision Making n Level of externality z should be adjusted to point where additional reduction in cost of generating an additional unit of z is zero § Solving F. O. C. s simultaneously for z and q 1 results in their optimal levels z. P and q. P 1 • Figure 21. 1 illustrates this optimal solution ¨ n z. P is associated with -∂STC 1/∂z = MBE = 0 and q. P 1 with SMC 1 = p 1 For its profit maximization, firm 2 only has control over its output, q 2, but production of q 2 is influenced by externality z, so § p 2 is per-unit price of q 2 • F. O. C. is ¨ ¨ ∂ 2/∂q 2 = p 2 – SMC 2(q 2, z) = 0 Establishes price equaling marginal cost as a condition for profit maximization 20

Independent Decision Making n Externality results from firm 2 having no control over z, which affects its production § Firm 1 controls level of z and has no incentive to consider § effect z has on firm 2’s production When firm 2’s additional social cost, MSC, associated with firm 1’s pollution, z, is not considered by firm 1, an inefficient high level of pollution may result • At z. P in Figure 21. 1, MSC > MBE ¨ Decreasing z will subtract more from cost than from benefits § Not considering additional social costs or benefits from an externality generally results in an inefficient allocation of resources 21

Dependent (Joint) Decision Making n n Internalizing social costs of a negative externality into agent’s decisions § Results in a Pareto-efficient allocation of resources Internalization of social costs results in firm 1 taking into consideration impact its production decisions have on firm 2’s production possibilities § With this consideration, output z is no longer an externality • All effects of z are now internalized into firm 1’s production decisions ¨ ¨ Accomplished by maximizing joint profit of the two firms ( = 1 + 2) Equivalent to two firms merging to form one firm that produces marketable outputs q 1 and q 2, with associated prices p 1 and p 2, along with nonmarket output z § With joint action, there is no longer an externality § Additional social costs are now internalized within this one firm 22

Dependent (Joint) Decision Making n Mathematically, joint profit maximization is n F. O. C. s are § ∂ /∂q 1 = p 1 – SMCJ 1(q 1, z) = 0 § ∂ /q 2 = p 2 – SMCJ 2(q 2, z) = 0 § ∂ /∂z = -∂STC 1(q 1, z)/∂z - ∂STC 2(q 2, z)/ ∂z = 0 • SMCJj is short-run marginal joint cost of producing qj, j = 1, 2 n First two F. O. C. s are same as when firms act privately § A perfectly competitive firm equates price to marginal cost § Under joint action, optimal levels of q 1 and q 2, (q. J 1 and q. J 2) are where price is equated with marginal cost • For a negative externality, q. J 1 < q. P 1, given z increases costs for producing q 2 23

Dependent (Joint) Decision Making n Last F. O. C. differs from independent conditions where firms act privately § Now optimal levels of q 1, q 2, and z depend on effect z has on firm 2’s costs n n Figure 21. 1 illustrates optimal levels of z and q 1 Instead of setting ∂STC 1/∂z equal to zero, joint production sets -STC 1/∂z equal to marginal social cost § -∂STC 1(q 1, z)/∂z = ∂STC 2(q 2, z)/ ∂z § MBEJ = MSC • MBEJ is marginal joint benefit of externality from joint production of q 1 • • and q 2 Joint action will result in firm 1 decreasing level of z below point where MBE = 0 Marginal social cost derived from firm 2 is now internalized into decision process 24

Dependent (Joint) Decision Making n Difference between private and joint optimal solution is illustrated in Figure 21. 1 § Optimal level of z decreases, from z. P to z. J, along with a decrease in the § optimal level of output, from q. P 1 to q. J 1 Firm 1’s short-run marginal cost of producing q 1 shifts to the left, from SMC 1 to SMCJ 1 • Given increased cost of internalizing production of z • Similarly, firm 1’s marginal benefit of externality shifts to left, to MBEJ, given decrease in q 1 § Through internalization, firm 1 pays a cost for producing z • At Pareto-efficient level of z, z. J, amount firm 1 is willing to pay for producing an additional unit of z is equal to firm 2’s additional costs associated with this additional unit of z ¨ Note that if firm 2’s cost of producing q 2 is independent of z, no externality exists § Firm 2’s cost associated with z is zero • Firm 1 will again equate additional cost of producing an additional unit of z to zero 25

Resolving Externality Inefficiency n In February 2002, Oakland County International Airport in Waterford, Michigan, helped 650 residents to sound insulate and vibration reinforce their homes against airplane takeoffs and landings § Such solutions to externality inefficiencies are possible when conditions allow agents to negotiate an optimal solution n Providing favorable negotiating conditions is one approach to mitigating inefficiencies associated with externalities § Based on these negotiations, a market for externality is then established n For example, suppose for a negative externality z, enforceable property rights are established where firm 2 is assigned rights to production level of z (noise) § Firm 1 is unable to produce z without firm 2’s approval 26

Resolving Externality Inefficiency n Denote total price (fee) for z units that firm 2 charges firm 1 as Fee § For profit maximization, firm 2 will determine level of Fee • Where firm 1 is indifferent between paying Fee to produce z units • of externality or not producing any of the externality If firm 2 charges a price below Fee, firm 1 will still produce z units ¨ ¨ ¨ An increase in Fee will enhance firm 2’s profits without changing level of z Increasing Fee transfers some of firm 1’s producer surplus in production of z to firm 2 Firm 2 will increase Fee to point where all producer surplus from producing z units is absorbed by Fee § At this point, firm 1 is indifferent between paying Fee to produce z units or not producing any z 27

Resolving Externality Inefficiency n Mathematically, this occurs where § 1(q 1, z) – Fee = 1(q 01, 0) § p 1 q 1 – STC 1(q 1, z) – Fee = p 1, q 01 – STC 1(q 01, 0) • q 01 represents optimal level of output given z = 0 n Firm 2 will then maximize profits subject to level of Fee where firm 1 is indifferent § Solving for Fee in the constraint and substituting into objective function yields 28

Resolving Externality Inefficiency n F. O. C. s are § ∂ 2/∂q 2 = p 2 – SMCJ 2 = 0 § ∂ 2/∂z = -∂STC 2(q 2, z)/∂z - ∂STC 1(q 1, z)/∂z = 0 = -MSC + MBEJ = 0 • Optimal levels for q 2 and z are same solutions for joint production, z. J and q. J 2 n Given this charge, Fee, for producing z. J units of a negative externality, firm 1’s profit-maximizing problem is § F. O. C. is • ∂ 1/∂q 1 = p 1 – SMCJ 1 = 0 ¨ n F. O. C. s are identical to F. O. C. s for joint profit maximization By assigning a property right to z, a market is created for z § Allows a firm to charge a price for its production of z • Resulting solution is the same optimal solution obtained under joint action, z. J 29

Resolving Externality Inefficiency n Coase Theorem § If trade of an externality can occur (a market exists) • Bargaining will lead to an efficient outcome no matter how property rights • n are allocated Assumes there are no transaction costs associated with bargaining Any asymmetry in information between buyer and seller can cause transaction costs § Will not result in an efficient outcome no matter how property rights are allocated n Specifically, suppose firm 1 now has property rights to produce as much of the externality z as it desires § In absence of any trading, firm 1 will select private level of z, z. P § Firm 2 will offer to pay firm 1 to move from firm 1’s private solution z. P to joint-optimal solution z. J 30

Resolving Externality Inefficiency n Firm 1 will be indifferent between producing an alternative level of z and receiving S as payment from firm 2 or producing z. P and receiving no payment § 1(q 1, z) + S = 1(q. P 1, z. P) § p 1 q 1 – STC 1(q 1, z) + S = p 1 q. P 1 – STC 1(q. P 1, z. P) • Firm 2 will then maximize profits, subject to levels of S, where firm 1 is indifferent 31

Resolving Externality Inefficiency n Solving for S in the constraint and substituting into objective function yields n F. O. C. s are § ∂ 2/∂q 2 = p 2 – SMCJ 2 = 0 § ∂ 2/∂z = -∂STC 2(q 2, z)/∂z - ∂STC 1(q 1, z)/∂z = 0 • Again, optimal levels for q 2 and z are the same as in joint production, z. J and q. J 2 32

Resolving Externality Inefficiency n Firm 1’s profit-maximizing problem is n F. O. C. is § ∂ 1/∂q 1 = p 1 – SMCJ 1 = 0 • Exactly the same optimal result as when property rights are controlled by firm 2 or with joint production n Given well-defined property rights and that agents can bargain with essentially zero transaction costs, resulting solution will be Pareto efficient § In practice, it is rare to find externalities with these characteristics § Normally, a profit incentive exists to either internalize the externality by merging or establish a market for the externality • Thus, market forces tend to remove any possible existence of a bilateral externality 33

Resolving Externality Inefficiency n There are distributional effects that depend on assignment of property rights § Property rights are a form of initial endowments, which do have market value n For example, even though Coase Theorem states that optimal levels of z, q 1, and q 2 remain unaffected by property rights assignment § Resulting profit levels of firms are affected § When an agent is bestowed property right, its benefits will not decrease • Potential exists for enhancing benefits § Greater control over property rights improves bargaining power of an agent and, hence, potential rewards n • Distribution of benefits can change with assignment of property rights A market with well-defined property rights and essentially zero transaction costs will provide a Pareto-optimal allocation § Any improvement in social welfare is dependent on equity impacts of resulting allocation 34

Multilateral Externalities n Decreasing automobile emissions can have a major impact on air quality and on asthma in children § This example illustrates multilateral externalities • Far more common than bilateral externalities n Numerous agents create transaction costs associated with ill-defined property rights § Obstruct market from internalizing externalities § Coase Theorem no longer holds under these transaction costs • Efforts to internalize these externalities may require some type of government intervention into markets 35

Government Policies n Government actions to mitigate inefficient exploitation of resources have taken a number of forms § One policy is to instill some form of private-property rights on a commonproperty resource • For example, in western U. S. , common- property problem of livestock overgrazing was addressed by issuing grazing permits ¨ ¨ ¨ n Ranchers who own grazing permits are allowed to use public rangeland for a set fee Original grazing permits issued by state and federal agencies were freely given to ranchers § Common property of public lands was transferred to private ownership Without a permit, one could not use public land for its major use grazing § Permits acquired a market value through their incorporation into land value of ranch holding permits Policy of granting private-property rights to common property may result in improving economic efficiency § However, it raises equity issues in terms of enhancing ranchers’ endowments at expense of other agents 36

Permit System n n Trading of emission permits represents a government management tool for a common property Government controls resource and establishes barriers to prevent agents from exacting resource unless licensed by the government § For example, government may issue a permit to extract a certain quantity and/or size of a resource • Fishing and hunting licenses are examples 37

Permit System n A permit system can also be employed for reducing a firm’s undesirable emissions that adversely affect air and water quality § Prior to generating a negative externality firm would be required to obtain a permit • Number of permits can be limited to achieve some target level n Allocation of permits transfers certain property rights to permit holder § In the case of a hunting permit, hunter pays for this transfer of property right n In terms of firms generating some negative externality, they may be issued permits at or below their historical emissions level § Given they possess a history of quasi-property rights to emission releases 38

Permit System n n Permits that can be traded (called marketable permits), create a market for permits with an associated equilibrium price If a firm’s marginal cost of reducing emissions is greater than market price for a permit to release emissions § It would minimize cost by purchasing permit and releasing emissions If its marginal cost is less than market price, it would minimize cost by selling permits and reducing its emissions In equilibrium, each firm’s marginal cost of reducing emissions would be equal to market price for permits 39

Permit System n Specifically, let’s consider two firms engaged in generating a negative externality § Let z 1 and z 2 represent emission levels of firm 1 and firm § 2, respectively, with associated short-run total cost functions STC 1(q 1, z 1) and STC 2(q 2, z 2) Assume target level of total emissions (z. J) is established, so z. J = z 1 + z 2 • Determine minimum cost of achieving emissions level z. J by § TC is total cost of reduced emissions 40

Permit System n Lagrangian is n F. O. C. s are 41

Permit System n Minimum-cost condition of achieving a z. J level of emissions is MBEJ 1 = MBEJ 2 = J § Firms’ short-run marginal benefits of emissions are set § equal to J In this case, Lagrange multiplier is marginal social cost of combined emissions by two firms, J = ∂TC/∂z • Setting this equal to each firm’s MBEJ yields minimum cost of establishing a z. J level of emissions ¨ n Illustrated in Figure 21. 2 Target level z. J is obtained at minimum cost with firm 1 and firm 2 generating z. J 1 and z. J 2 emissions, respectively 42

Figure 21. 2 Minimum cost of achieving a given emission level 43

Permit System n n n Establishing a marketable permit system achieves this minimum social cost of emissions Let pz represent per-unit equilibrium price of a permit and z 01 and z 02 initial level of permits for firms 1 and 2, respectively § z. J = z 01 + z 02 With j = 1, 2, representing either of the firms, each firm will maximize profits as follows § When z 0 j - zj < 0, firm is using more permits than it was allocated • It will acquire additional permits in amount of (zj - z 0 j) at per-unit price of pz § If z 0 j – zj > 0, firm is not using all of its permit allocation • Will sell (z 0 j - zj) at per-unit price of pz 44

Permit System n F. O. C. s are § ∂ j/∂qj = pj – SMCJj(qj, zj) = 0 • Discussed in Chapter 9 § ∂ j/∂zj = -∂STCj(qj, zj)/ ∂zj – pz = 0 = MBEJj – pz = 0, j = 1, 2 • Each firm equates their marginal benefit of emissions to pz n A major limitation of this marketable permit system exists when spatial distribution of externality generated by all firms is not uniform § If agents who are being affected by externalities are not uniformly affected by each firm • Permit system will result in some agents receiving even more of the externality • For example, assume households of type A are only affected by firm 1’s emissions and households of type B only by firm 2’s emissions ¨ n As illustrated in Figure 21. 3, firm 1 sells permits to firm 2 Thus, from initial emission levels (z 01, z 02) emissions for type A households are reduced at expense of type B households, who receive a higher emissions level § Although emissions level is now generated at a minimum cost, distribution of resulting emissions are not optimal 45

Figure 21. 3 Minimum cost of achieving a given emission level with marketable permits 46

Taxes and Standards (Quotas) n If general knowledge exists about which firms can efficiently reduce a negative externality relative to other firms § Direct taxes or standards may be employed • Direct taxes on negative externalities have theoretical foundation of the agent receiving an inefficient price for negative externality it is generating n With ill-defined property rights firms would receive a zero price for generation of emissions § An efficient price would be a tax equivalent to marginal social cost of negative externality • Profit-maximizing problem for firm j is ¨ j is a per-unit tax for firm j on negative externality, z 47

Taxes and Standards (Quotas) n Potentially, firms with differing production capabilities for efficiently reducing negative externality would face different tax levels § On a practical level, tax would generally be the same for firms with like production technologies within same industry and causing similar harm to other agents n Assuming a constant tax level across two firms, , F. O. C. s are § ∂ j/∂qj = pj – SMCJj(qj, zj) = 0 • Discussed in Chapter 9 § ∂ j/∂zj = -∂STCj(qj, zj)/∂zj - = 0 = MBEJj - = 0, j = 1, 2 n • Firm j equates its marginal benefit of emission to Equating tax to MSCj will yield an efficient level of emissions generation by each firm, z. Jj • Illustrated in Figure 21. 4 48

Figure 21. 4 Pigouvian tax on emissions 49

Taxes and Standards (Quotas) n As illustrated in Figure 21. 1, if there is only one agent being affected by firm j’s emissions, then = ∂STC 2/∂zj § Given well-defined property rights, Coase Theorem would apply • No government-established price for market would be required for efficiency • However, as number of agents increase, even with well-defined property rights ¨ n Transaction costs of determining who are being affected by a negative externality increases A government mechanism design in form of an emissions tax may be socially desirable § Such a tax, equivalent to MSC, is called a Pigouvian tax, after Arthur Pigou • Assuming general knowledge exists of which firms can efficiently reduce a negative externality relative to other firms ¨ ¨ Pigouvian taxes directly associated possible spatial MSC would not have spatial distribution limitation associated with a permit system Aside from the problem of acquiring this general knowledge for implementation § Pigouvian taxes are a Lindahl tax face same limitations § Agents facing a higher tax rate relative to others may not respond well to taxdiscriminating nature of Pigouvian taxes 50

Taxes and Standards (Quotas) n Major problem with a Pigouvian tax § Indirect method of reducing a negative externality versus direct method of setting some quota (called emissions standard) • Setting emissions standards directly reduces level of a negative externality to some stated level ¨ n In contrast, a tax requires firms to consider effect of tax on their profits In a dynamic setting where MSC is continuously changing, adjusting emissions standards to these changes will yield a direct short-run response of establishing desired emissions level § Whereas changing tax rate may not • Short-run MBE curve may be rather inelastic to change in a tax ¨ Results in less than desired reduction in emissions • Desired level of emissions may not be obtained until long run ¨ By then MSC may have changed § Illustrated in Figure 21. 5 51

Taxes and Standards (Quotas) n An upward shift in MSC curve to MSC', indicating a higher marginal social cost at all levels of emissions, warrants a reduction in emissions from z 0 to z" § Changing emissions standards from z 0 to z" will directly produce this desired effect • Firm’s response is not dependent on elasticity of MBEJ curve • However, effect of emissions from a tax change does depend on elasticity of MBEJ curve ¨ n In short run, an increase in tax from 0 to “ results in a decrease in emissions from z 0 to z' § Only in long run will emissions fall to z" System of taxes requires additional knowledge concerning long- and short-run response of firms’ emissions to tax changes 52

Figure 21. 5 Standards versus taxes with long-run and short-run adjustments 53

Taxes and Standards (Quotas) n An example of taxes versus standards is maintaining air quality within an air basin (such as Los Angeles) § Changing weather conditions will affect air quality on a daily basis • An inversion layer, where ambient air temperatures increase with altitude, traps air pollution within basin ¨ Potentially resulting in poor air quality • Announcing stricter emissions standards when such weather conditions occur would directly mitigate the problem ¨ ¨ Announcing an increase in emissions taxes may not have such immediate effects In contrast, when MSC curve is relatively static (doesn’t shift), a tax will minimize firms’ cost relative to a standard § An example is water quality where socially desirable level of affluent remains relatively constant 54

Taxes and Standards (Quotas) n One of the F. O. C. s for two firms maximizing profits given a negative externality tax is § -∂STC 1(q 1, z 1)/∂z 1 = -∂STC 2(q 2, z 2)/∂z 2 = § MBEJ 1 = MBEJ 2 = • Demonstrated in Figure 21. 6 for two firms located relatively close to each other ¨ n n MSC is the same regardless of which firm changes its affluent level As indicated in the figure, cost-minimizing levels of affluents are z 1 J and z 2 J for firms 1 and 2, respectively § Only if MBEJ' for both firms is the same will z 1 J = z 2 J Taxation offers a lower cost for reducing a given level of affluent compared to setting the same emissions standard for both firms 55

Figure 21. 6 Minimum cost of achieving a given affluent level with a Pigouvian tax 56

Firms’ Preference n Firms’ preference for emissions standards versus taxes § Depends on which mechanism yields a higher profit for a given level of emissions • For example, if emissions standards directly limit total output, firms may prefer such standards to a Pigouvian tax n As indicated in Figure 21. 7, standards may provide a cartel situation, which can result in improved profit § Prior to any standards, let perfectly competitive equilibrium price and output be (pe, qe) • With imposition of standards, socially optimal output declines to qs and price increases to ps ¨ Results in a net gain in producer surplus of peps. AC - DCB • Alternatively, imposition of a tax that reduces output price to p' with the same output, qs, results in a loss in producer surplus of p'pe. BD ¨ Firms have incentives to support emissions standards versus Pigouvian taxes 57

Figure 21. 7 Producer surplus for standards versus taxes 58