2ExternalitiesExternality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism =>unwanted effectsPaper production as by-product carcinogen dioxin => increases society’s health care costs => they are not included in the paper priceWhy not?Production => positiveConsumption=> positive/negative
3The Nature of Externalities Privately-owned vs. commonly-owned resourcesA privately owned resource: its price reflects its value so used efficiently (Marg Social Cost= Marg Private Cost= Marg Social Benefit= Marginal Private Benefit = ??Remember: eq comp mkt => marg cost = marg utility=priceA commonly-owned resource (air, oceans): price ($0) does not reflect its value so used inefficiently (MSC>MSB)Similar case with externalities:Production with negative externalities (pollution)Marg private cost? Marg social cost? Difference?
4Public goods as a special kind of externality Externality itself is a public goodElectrocuting mosquitosR&D fall out from a private firm
5The Nature of Externalities-Graphical Analysis MSC = MPC + MDReduction from Q1 to Q* means dcg profit loss for Supplier and dchg welfare gain for Demander.$MPChdgcAxes and labels1st click – MB2nd click – MPC, Q13rd click – MD4t click – MSC, Q*MDfbMBaeQ*Q1Q per yearSocially efficient outputActual output
6What Pollutants Do Harm? Empirical Research on Pollution Effects on HealthDifficult to measure because of inability to perform randomized studies on pollution effectsMust rely on cross-sectional or time-series analysisStudies unable to measure lifetime exposure to air pollutionOnce pollutant identified:Must identify the activities that produce the pollutantMust identify the value of the damage doneMust identify the costs of remedying the damageEmpirical Evidence: The Effect of Air Pollution on Housing Values
7Private Responses Bargaining and the Coase Theorem MSC = MPC + MDSupplier will ↓ Q1 to Q* if paid by Demander, who is willing to do so. Bargain possible over $ transferred.$MPChdgcAxes and labels1st click – MB2nd click – MPC, Q13rd click – MD4t click – MSC, Q*MDMBQ*Q1Q per year
8The Coase Theorem Coase Theorem – Given: Low transaction costs Clear assignment of property rightsAn efficient solution to an externality problem can be achieved: with or without Gov’t?Is it relevant to reach an equilibrium to whom property right are assigned?Is it relevant for final distribution to whom property right are assigned?
9Assumptions necessary for Coase Theorem to work The costs to the parties of bargaining are lowThe owners of resources can identify the source of damages to their property and legally prevent damages
10Public Responses to Externalities - Taxes MSC = MPC + MD$(MPC + cd)Pigouvian tax revenuesMPCdijcAxes and labels1st click – MP shifts up to MPC + cd2nd click – Pigouvian tax revenues boxMDMBQ*Q1Q per year
11Public Responses to Externalities – Subsidies that pay polluter not to pollute MSC = MPC + MD$(MPC + cd)MPCPigouvian subsidydkifgjchAxes and labels1st click – MP shifts up to MPC + cd2nd click – dashed lines fi, hj, and hf3rd click = Pigouvian subsidyMDMBeQ*Q1Q per year
12Pros and cons P. T. on output Knowledge (graphic is known!)Indirect effect (estimated)No personalisationNo incentives
13Public Responses to Externalities- Emissions Fee: tax on each pollution unit $MCf*Emissions feeAxes and labels1st click – MSB2nd click – MC3rd click – dashed line and e*4th click – f* and brown horizontal lineMSBe*Pollution reduction
14Pigouvian tax on each unit of emission instead of output Is f* a marginal tax?Producer decide between paying MC and paying f*IncentivePersonalised (?)
15Public Responses to Externalities- Uniform Pollution Reduction MCHRequiring each company to reduce pollution by 50 units is not cost effective. Better to have Bart reduce pollution by 100 units because he can do so at a lower cost. But is it fair???bMCBaxes and labels for both graphs1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line2nd click –3rd click – dashed brown line and Bart’s dashed black line at 50 disappear4th click – line at f = $50 wipes right5th click – Bart’s tax payment6th click – Homer’s tax payment10507590Bart’s pollution reduction25507590Homer’s pollution reduction
16Emissions Fees achieve fairness and efficiency An Emissions Fee=$50 means Bart will reduce by 75 and Homer only by 25, but Homer pays larger tax.MCHBart’s Tax PaymentHomer’s Tax PaymentMCBf = $50axes and labels for both graphs1st click – MCB and dashed vertical lines, MCH and dashed vertical black line2nd click – horizontal dashed brown line and vertical dashed brown line3rd click – dashed brown line and Bart’s dashed black line at 50 disappear4th click – line at f = $50 wipes right5th click – Bart’s tax payment6th click – Homer’s tax paymentf = $50507590Bart’s pollution reduction25507590Homer’s pollution reduction
17Marginal cost of reducing pollution across all polluters Equal or different?Equal to what in equilibrium?Is it cost effective? Why?
18Public Responses to Externalities- Cap (80)-and-Trade: Polluters must have a permit Bart: The cost of reducing pollution is less than market price of a permit, so sell permit.Homer: The cost of reducing pollution is greater than market price of a permit so buy permit.BOTH GAIN FROM TRADEMCHbMCBf = $50axes and labels for both graphs1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line2nd click –3rd click – dashed brown line and Bart’s dashed black line at 50 disappear4th click – line at f = $50 wipes right5th click – Bart’s tax payment6th click – Homer’s tax paymentf = $50a10507590Bart’s pollution reduction25507590Homer’s pollution reduction
19Total pollution 180Total cap is 80Permit issued by gov’t =80To semplify the chart . 80 permits to Bart(tradable => do initial distribution matter?)
20Emissions Fee v Cap-and-Trade Responsiveness to InflationNominal and realAdjustmentResponsiveness to Cost ChangesIncreasing marginal cost =>pollution ?
21Command-and-Control Regulation Command-and-control regulations require a given amount of pollution reduction:Technology requirementsPerformance requirementsFlexibility? Cost effective?Is command-and-control ever better?- Monitoring?Hot spots: Areas with relatively high concentrations of emissions
22Chapter 5 SummaryExternalities occurs when the activity of one person or firm positively or negatively affects another person/group/firm outside the market mechanismAn inefficient allocation of resources results because the market price does not reflect the external costs or benefitsThe Coase Theorem indicates that private solutions through bargaining can achieve the efficient outcome under certain circumstancesPublic solutions to externalities designed to achieve efficiency include taxes/subsidies; emissions fees; and command-and-control regulationsA market-based, cost-effective, public solution is cap-and-trade where pollution permits – the right to pollute – are traded