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Externalities. Plan Definition of externalities and examples Responses to externalities private mergers (Coase Theorem) social conventions public (government)

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Presentation on theme: "Externalities. Plan Definition of externalities and examples Responses to externalities private mergers (Coase Theorem) social conventions public (government)"— Presentation transcript:

1 Externalities

2 Plan Definition of externalities and examples Responses to externalities private mergers (Coase Theorem) social conventions public (government) regulation taxes creation of markets

3 Externalities 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. Examples: sea pollution, noise, etc. Externalities are reciprocal in nature.

4 Price of steel p1p1 p2p2 0Q2Q2 Q1Q1 This framework does not capture the harm done to the fishery, however. The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q 1. Q STEEL D = PMB = SMB S=PMC SMC = PMC + MD MD Figure 2 Presence of Externalities May lead to Inefficiency Presence of Externalities May lead to Inefficiency Negative Production Externalities The socially optimal level of production is at Q 2, the intersection of SMC and SMB. The yellow triangle is the consumer and producer surplus at Q 1. The marginal damage curve (MD) represents the fisherys harm per unit. The social marginal cost is the sum of PMC and MD, and represents the cost to society. The red triangle is the deadweight loss from the private production level. The steel firm overproduces from societys viewpoint.

5 Private Responses Role of social conventions to be stable, they must be efficiently enforced

6 Coases Insight: Private Response to Externalities Example. Doctor and Confectioner operate in the neighboring buildings. The machinery of the confectioner makes the noise that prevents the doctor to examine patients. The value of the damage from the noise to the doctor is 60. The value of continuing to operate the business for the Confectioner is 40.

7 Outcomes under two legal regimes

8 Coases Assumptions Low (no) bargaining costs There is a reliable estimate of the costs and benefits to each side and this is a common knowledge among the negotiating parties

9 Government Responses Regulation: simple, but may be inefficient Taxes and subsidies Creating a market

10 Pigouvian Taxes In the presence of externality a tax/subsidy can be imposed, so that the party generating the externality will internalize the effect he produces on the other party. Advantage: it does not require negotiation between the parties, so it is applicable in the cases, in which negotiation is impossible or is very expensive

11 Q STEEL Price of steel 0Q2Q2 D = PMB = SMB Q1Q1 p1p1 S=PMC SMC=PMC+MD p2p2 The steel firm initially produces at Q 1, the intersection of PMC and PMB. Imposing a tax shifts the PMC curve upward and reduces steel production. S=PMC+tax Imposing a tax equal to the MD shifts the PMC curve such that it equals SMC. The socially optimal level of production, Q 2, then maximizes profits. Figure 7 Pigouvian Tax

12 Pigouvian Tax may lead to inefficiency Recall the Example. Doctor and Confectioner operate in the neighboring buildings. The machinery of the confectioner makes the noise that prevents the doctor to examine patients. The value of the damage from the noise to the doctor is 60. Doctor can rearrange his office to eliminate the effect of the noise at a cost of 18. The value of continuing to operate the business for the Confectioner is 40. The two can not negotiate

13 Outcomes under two legal regimes

14 Pigouvian tax may enhance efficiency If, instead, the confectioner could install the soundproofing device at a low cost (say,10), the presence of tax would have enhanced efficiency. In general, if negotiation is impractical, taxing negative externality can lead to an efficient outcome, if the party generating the externality has a cheaper way to eliminate it than the victim.

15 Taxing pollution may be better than direct regulation Both firms use technological process A. City council wants to reduce the pollution by half. It can require each firm use C.

16 Taxing pollution may be better than direct regulation Alternatively, they can impose a tax T per ton of emitted smoke. What is the appropriate level of T?

17 Costs of regulation and taxation Regulation that requires to cut the pollution for both firms by 1/2 (use process C) costs =500 for firm X and =90 for firm Y, total cost being 590 Taxation will lead firm X to adopt process B, which increases the cost by 90 and firm Y to adopt process D, increasing its cost by 180. Total cost is 270<590.


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