1. © 2007 Thomson South-Western

2. Pollution Think about air pollution from a factory.Think about air pollution from a factory. The firm does not have to pay the costs associated with pollutionThe firm does not have to pay the costs associated with pollution The firm will produce more than the socially efficient quantity.The firm will produce more than the socially efficient quantity. This is an example of aThis is an example of a negative externality

3. © 2007 Thomson South-Western Education Private benefits of educationPrivate benefits of education Median income of college graduates $46,285Median income of college graduates $46,285 $20,000 more than those with only high school diploma$20,000 more than those with only high school diploma External benefits of educationExternal benefits of education lower crime rates: educated people have more opportunities, so less likely to rob and steallower crime rates: educated people have more opportunities, so less likely to rob and steal better government: educated people make better-informed votersbetter government: educated people make better-informed voters Result: Market equilibrium quantity of education will be too lowResult: Market equilibrium quantity of education will be too low This is an example of aThis is an example of a positive externality

4. © 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY An externality refers to the uncompensated impact of one person’s actions on the well- being of a bystander.An externality refers to the uncompensated impact of one person’s actions on the well- being of a bystander. Externalities cause markets to be inefficient, and thus fail to maximize total surplus.Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

5. © 2007 Thomson South-Western EXTERNALITIES AND MARKET INEFFICIENCY When the impact on the bystander is adverse, the externality is called a negative externality.When the impact on the bystander is adverse, the externality is called a negative externality. When the impact on the bystander is beneficial, the externality is called a positive externality.When the impact on the bystander is beneficial, the externality is called a positive externality.

6. © 2007 Thomson South-Western NEGATIVE EXTERNALITIES Examples:Examples: –Automobile exhaust –Barking dogs (loud pets) –Loud stereos in an apartment building

7. © 2007 Thomson South-Western POSITIVE EXTERNALITIES Examples:Examples: –Immunizations –Restored historic buildings –Research into new technologies

8. © 2007 Thomson South-Western 0 1 2 3 4 5 0102030 Q (tons) P $ The market for aluminum Recap of Welfare Economics Demand Curve reflects the value of that product to those consuming it, measured by price that consumers are willing (and able) to pay  Assumed it captures all the benefits associated with consuming the next unit of a good. (Private Value) $2.50 25 Supply Curve reflects the cost to producers of making the good  Assumed it captures all costs associated with creating the next unit of the good (Private Costs)

9. © 2007 Thomson South-Western 0 1 2 3 4 5 0102030 Q (tons) P $ The market for aluminum Recap of Welfare Economics The market eq’m maximizes consumer + producer surplus (or total surplus) $2.50 25  all units for which the value placed on production is greater than the cost of creating are produced

10. © 2007 Thomson South-Western Application to Externalities The Market for Production of AluminumThe Market for Production of Aluminum Since the production of aluminum results in pollution (a negative externality), the cost to society of making aluminum is larger than the cost to aluminum producers.Since the production of aluminum results in pollution (a negative externality), the cost to society of making aluminum is larger than the cost to aluminum producers. For each unit of aluminum consumed, the includes the private costs of the producers plus the cost to people/environment adversely affected by the pollution (external costs).For each unit of aluminum consumed, the social cost includes the private costs of the producers plus the cost to people/environment adversely affected by the pollution (external costs).

11. © 2007 Thomson South-Western 0 1 2 3 4 5 0102030 Q (tons) P $ The market for aluminum Analysis of a Negative Externality in Production Supply (private cost) External cost = value of the negative impact on bystanders = $1 per ton (value of harm from pollution) Social cost = private + external cost External cost

12. © 2007 Thomson South-Western 0 1 2 3 4 5 0102030 Q (tons) P $ The market for aluminum Analysis of a Negative Externality in Production D S Social cost The socially optimal quantity is 20 gallons. At any Q < 20, value of additional ton exceeds social cost At any Q < 20, value of additional ton exceeds social cost At any Q > 20, social cost of the last ton is greater than its value At any Q > 20, social cost of the last ton is greater than its value 25 DWL Dead Weight Loss as a result of externality?

13. © 2007 Thomson South-Western Negative Externalities The intersection of the demand curve and the social-cost curve determines the optimal output level.The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity.The socially optimal output level is less than the market equilibrium quantity.

14. © 2007 Thomson South-Western 0 1 2 3 4 5 0102030 Q (tons) P $ The market for aluminum Analysis of a Negative Externality D S Social cost Market eq’m (Q = 25) is greater than social optimum (Q = 20) 25 One solution: tax sellers $1/ton, would shift supply curve up $1.

15. © 2007 Thomson South-Western Negative Externalities Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.Internalizing an externality involves altering incentives so that people take account of the external effects of their actions. To achieve the socially optimal output…To achieve the socially optimal output… the government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.the government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

16. © 2007 Thomson South-Western Negative Externalities In the previous example, the $1/ton tax on sellers makes sellers’ costs equal to social costs.In the previous example, the $1/ton tax on sellers makes sellers’ costs equal to social costs. When market participants must pay both the private and external costs (social costs), the market eq’m matches the social optimum.When market participants must pay both the private and external costs (social costs), the market eq’m matches the social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)

17. © 2007 Thomson South-Western Analysis of a positive externality in consumption The market for flu shots D S 0 10 20 30 40 50 0102030 P Q $ External benefit = $10/shot Draw the social value curve. Find the socially optimal Q. What is the DWL? What policy would internalize this externality?

18. © 2007 Thomson South-Western Answers Socially optimal Q = 25 shots DWL = ½(10*5)=25 To internalize the externality, use subsidy = $10/shot. The market for flu shots D S Social value = private value + external benefit 0 10 20 30 40 50 0102030 P Q $ external benefit 25 DWL

19. © 2007 Thomson South-Western Summary Externalities PositiveNegative Production Consumption Research and Development Hershey’s Pollution Noise Education Housing Repair Vaccines Alcohol Tobacco Cell Phones

20. © 2007 Thomson South-Western Additional Externalities With a partner, draw positive production externality and negative consumption externality.With a partner, draw positive production externality and negative consumption externality. Identify the DWL associated with each type of externality.Identify the DWL associated with each type of externality.

21. © 2007 Thomson South-Western Positive Production Externality

22. © 2007 Thomson South-Western Negative Consumption Externality

23. © 2007 Thomson South-Western If negative externality  market produces a larger quantity than is socially desirable If positive externality  market produces a smaller quantity than is socially desirable To remedy the problem, “internalize the externality”  tax goods with negative externalities  subsidize goods with positive externalities If negative externality  market produces a larger quantity than is socially desirable If positive externality  market produces a smaller quantity than is socially desirable To remedy the problem, “internalize the externality”  tax goods with negative externalities  subsidize goods with positive externalities Effects of Externalities: Summary

24. © 2007 Thomson South-Western PRIVATE SOLUTIONS TO EXTERNALITIES Can people solve these problems on their own (without government involvement)?Can people solve these problems on their own (without government involvement)? Types of Private SolutionsTypes of Private Solutions –Moral codes and social sanctions (ex/littering) –Charitable organizations (Sierra Club to protect environment) –Integrating different types of businesses (ex/Bees and Orchard)

25. © 2007 Thomson South-Western The Coase Theorem The Coase theorem is a proposition thatThe Coase theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

26. © 2007 Thomson South-Western The Coase Theorem: An Example Dick owns a dog named Spot. Negative externality: Spot’s barking disturbs Jane, Dick’s neighbor. The socially efficient outcome maximizes Dick’s + Jane’s well-being. If Dick values having Spot more than Jane values peace & quiet, the dog should stay.If Dick values having Spot more than Jane values peace & quiet, the dog should stay. Coase theorem: The private market will reach the efficient outcome on its own… See Spot bark.

27. © 2007 Thomson South-Western The Coase Theorem: An Example CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800 Socially efficient outcome: Spot goes bye-bye.Socially efficient outcome: Spot goes bye-bye. Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off.Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off. Private outcome = Efficient outcome.Private outcome = Efficient outcome.

28. © 2007 Thomson South-Western The Coase Theorem: An Example CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800 Socially efficient outcome: See Spot stay.Socially efficient outcome: See Spot stay. Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays.Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays. Private outcome = Efficient outcome.Private outcome = Efficient outcome.

29. © 2007 Thomson South-Western The Coase Theorem: An Example CASE 3: Benefit to Dick of having Spot = $800 Cost to Jane of Spot’s barking = $500 But Jane has the legal right to peace & quiet.CASE 3: Benefit to Dick of having Spot = $800 Cost to Jane of Spot’s barking = $500 But Jane has the legal right to peace & quiet. Socially efficient outcome: Dick keeps Spot.Socially efficient outcome: Dick keeps Spot. Private outcome: Dick pays Jane $600 to put up with Spot’s barking.Private outcome: Dick pays Jane $600 to put up with Spot’s barking. Private outcome = Efficient outcome.Private outcome = Efficient outcome. The private market achieves the efficient outcome regardless of the initial distribution of rights.

30. © 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Brainstorming Collectively, the 1000 residents of Green Valley value swimming in Blue Lake at $100,000. A nearby factory pollutes the lake water, and would have to pay $50,000 for non-polluting equipment. A. Describe a Coase-like private solution. B. Can you think of any reasons why this solution might not work in the real world?

31. © 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Brainstorming A. Describe a Coase-like private solution. A good Coasian solution would be for each of the 1000 residents to chip in $75, so the town can offer $75,000 to the factory to stop polluting.

32. © 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Brainstorming B. Can you think of any reasons why this solution might not work in the real world? 1.Transaction costs (cost of hiring lawyers) 2.Bargaining breakdown 3.Difficult to get so many people to agree on something

33. © 2007 Thomson South-Western Why Private Solutions Do Not Always Work Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain. Holdouts occur when a beneficial agreement is possible but some parties hold out for a better deal.Holdouts occur when a beneficial agreement is possible but some parties hold out for a better deal. Coordination costs when the number of parties is very large.Coordination costs when the number of parties is very large.

34. © 2007 Thomson South-Western PUBLIC POLICIES TOWARD EXTERNALITIES When externalities are significant and private solutions are not found, government may attempt to solve the problem through...When externalities are significant and private solutions are not found, government may attempt to solve the problem through... –command-and-control policies. limits on quantity of pollution emittedlimits on quantity of pollution emitted requirements that firms adopt a particular technology to reduce emissionsrequirements that firms adopt a particular technology to reduce emissions –market-based policies. provide incentives so that private decision-makers will choose to solve the problem on their own.provide incentives so that private decision-makers will choose to solve the problem on their own.

35. © 2007 Thomson South-Western Command-and-Control Policies: Regulation Usually take the form of regulations:Usually take the form of regulations: Forbid certain behaviors.Forbid certain behaviors. Require certain behaviors.Require certain behaviors. Examples:Examples: Requirements that all students be immunized.Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). Regulations are often used when the costs are so high that the optimal quantity is zero (ex/dumping poisonous chemicals into the water supply)Regulations are often used when the costs are so high that the optimal quantity is zero (ex/dumping poisonous chemicals into the water supply)

36. © 2007 Thomson South-Western Market-Based Policy 1: Corrective Taxes and Subsidies Corrective taxes are taxes enacted to correct the effects of a negative externality.Corrective taxes are taxes enacted to correct the effects of a negative externality. The ideal corrective tax = external costThe ideal corrective tax = external cost Also known as Pigouvian Taxes after Arthur Pigou (1877- 1959)Also known as Pigouvian Taxes after Arthur Pigou (1877- 1959) Corrective subsidies are subsidies enacted to adjust for the effects of a positive externality.Corrective subsidies are subsidies enacted to adjust for the effects of a positive externality. The ideal corrective subsidy = external benefitThe ideal corrective subsidy = external benefit

37. © 2007 Thomson South-Western Regulation vs. Corrective Tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could…If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could… tell the firm to reduce its pollution by a specific amount (i.e. regulation).tell the firm to reduce its pollution by a specific amount (i.e. regulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. corrective tax).levy a tax of a given amount for each unit of pollution the firm emits (i.e. corrective tax). Lets compare the costs associated with these two approachesLets compare the costs associated with these two approaches

38. © 2007 Thomson South-Western Regulation vs. Corrective Tax Example Two Firms: Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO 2 causes acid rain & other health issues.Example Two Firms: Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO 2 causes acid rain & other health issues. Policy goal: reducing SO 2 emissions 25%Policy goal: reducing SO 2 emissions 25% (from 80-60) Policy options:Policy options: (1) Regulation require each plant to cut emissions by 25% (2) Corrective Tax Make each plant pay a tax on each ton of SO 2 emissions. Set tax at level that achieves goal.

39. © 2007 Thomson South-Western Regulation vs. Corrective Tax Firms have different costs for reducing emissions:Firms have different costs for reducing emissions: Acme – cost of reducing emissions is $100/tonAcme – cost of reducing emissions is $100/ton US Electric – cost of reducing emissions is $200/tonUS Electric – cost of reducing emissions is $200/ton Socially efficient outcome: Acme reduces emissions more than US Electric.Socially efficient outcome: Acme reduces emissions more than US Electric. (1) Regulation: Both firms will reduce missions by the same amount. (2) Taxation: Tax allocates this “good” to the firms who value it most highly (ex/Tax of $150) US Electric will continue polluting and pay taxUS Electric will continue polluting and pay tax Acme will choose to reduce pollution rather than pay taxAcme will choose to reduce pollution rather than pay tax

40. © 2007 Thomson South-Western Regulation vs. Corrective Tax Under regulation, firms have no incentive to reduce emissions beyond the 25% target.Under regulation, firms have no incentive to reduce emissions beyond the 25% target. A tax on emissions gives firms incentive to continue reducing emissions as long as the cost of doing so is less than the tax.A tax on emissions gives firms incentive to continue reducing emissions as long as the cost of doing so is less than the tax. If a cleaner technology becomes available, the tax gives firms an incentive to adopt it.If a cleaner technology becomes available, the tax gives firms an incentive to adopt it.

41. © 2007 Thomson South-Western Challenges associated with corrective tax A lot of information is needed to get the tax right  If tax is too high will restrict production too much, causing inefficiency  If tax is too low will not adequately reduce pollution.  Is there a way that we can set the quantity and let the market choose the price?  Yes! Tradable Permits

42. © 2007 Thomson South-Western Market-Based Policy 2: Tradable Pollution Permits Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another.Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. A market for these permits will eventually develop.A market for these permits will eventually develop. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

43. © 2007 Thomson South-Western Market-Based Policy #2: Tradable Pollution Permits Alternative:Alternative: issue 60 permits, each allows its bearer one ton of SO 2 emissions (so total emissions = 60 tons)issue 60 permits, each allows its bearer one ton of SO 2 emissions (so total emissions = 60 tons) give 30 permits to each firmgive 30 permits to each firm establish market for trading permitsestablish market for trading permits Each firm can choose among these options:Each firm can choose among these options: emit 30 tons of SO 2, using all its permitsemit 30 tons of SO 2, using all its permits emit < 30 tons, sell unused permitsemit < 30 tons, sell unused permits buy additional permits so it can emit > 30 tonsbuy additional permits so it can emit > 30 tons

44. © 2007 Thomson South-Western Market-Based Policy #2: Tradable Pollution Permits Suppose market price of permit = $150 US Electric buys 10 permits from Acme for $1,500buys 10 permits from Acme for $1,500 emissions remain at 40 tonsemissions remain at 40 tons net cost to USE: $1,500net cost to USE: $1,500Acme sells 10 permits to US Electric for $1,500sells 10 permits to US Electric for $1,500 spends $2,000 to cut emissions by 20 tonsspends $2,000 to cut emissions by 20 tons net cost to Acme: $500net cost to Acme: $500 Total cost of achieving goal: $2,000 Total cost through regulation: $3,000 Cost of Reducing Pollution Regulation Acme(-10*100)= -1,000 US Electric(-10*200)= - 2,000 Total Cost= -$3,000 Taxation (ex/$150 for any pollution above 20 tons) Acme(-20*100)= - 2,000 US Electric(20*150)= - 3,000 Government Revenue= +3,000 = -$2,000 Tradable Permits (issue 60 permits, market price $150) US Electric- (10*150)= -1,500 Acme+ (10*150)= +1,500 - (20*100)= - 2,000 = -$2,000

45. © 2007 Thomson South-Western Market-Based Policy #2: Tradable Pollution Permits A system of tradable pollution permits achieves goal at lower cost than regulation.A system of tradable pollution permits achieves goal at lower cost than regulation. Firms with low cost of reducing pollution sell whatever permits they can.Firms with low cost of reducing pollution sell whatever permits they can. Firms with high cost of reducing pollution buy permits.Firms with high cost of reducing pollution buy permits. Result: Pollution reduction is concentrated among those firms with lowest costs.Result: Pollution reduction is concentrated among those firms with lowest costs.

46. © 2007 Thomson South-Western Tradable Pollution Permits in the Real World SO 2 permits traded in the U.S. since 1995.SO 2 permits traded in the U.S. since 1995. Nitrogen oxide permits traded in the northeastern U.S. since 1999.Nitrogen oxide permits traded in the northeastern U.S. since 1999. Carbon emissions permits traded in Europe since January 1, 2005.Carbon emissions permits traded in Europe since January 1, 2005.