1. Today: The fundamentals of externality theory
Externalities
Today:
The fundamentals of externality theory

2. Externalities Markets are well functioning for most private goods
Many buyers and sellers
Little or no market power by anybody
Example: When demand shifts right for a good, new equilibrium will have higher price and quantity
Some markets do not have good mechanisms to account for everything in a market
Example: Talking on a cell phone in an airplane

3. Externalities
Externalities are effects that are not incorporated into market quantities and prices
R/G (p.73) define an externality as “an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism”
When markets have externalities, they are typically not efficient
This is the topic of Chapter 5

4. Public good versus externality
Although public goods are often looked at as goods with externalities, we study the two topics separately
Know which analysis applies when you solve a problem

5. Negative externalities
Some examples of negative externalities
Air pollution
Water pollution
Sometimes you do not even think about polluting the water: Washing a car in your driveway
Noise pollution
Highway congestion
Standing at a concert or sporting event

6. Positive externalities
Some externalities are benefits
Planting flowers in your front lawn
Scientific research
Vaccination
Prevents others from getting a disease from you
Exercise?
Yes, if it leads to lower health care insurance premiums for others
More on the private health care market in Chapter 9

7. More externalities: Benefit or cost?
Christmas decorations
Enjoyment or nuisance?
A fan blowing in a warm office building
Cooling breeze or blowing your important papers?
Use of perfume or cologne
Nice smell or allergen?

8. A simple example with externalities
Suppose private MC equals quantity
MPC = Q
Let demand be denoted by P = 100 – Q
Let marginal damage be $10 per unit

9. A simple example with externalities
MSC = Q + 10
MPC = Q
marginal damage per unit of $10
P = 100 – Q
Translate equations and external cost to our graphical example

10. A simple example: Private equilibrium
MPC = Q
P = 100 – Q
Inefficient equilibrium w/o controls:
Set Q = 100 – Q  Q = 50 (quantity F)

11. A simple example: Optimal equilibrium
MSC = Q + 10
P = 100 – Q
Socially optimal quantity
Q + 10 = 100 – Q  Q = 45 (quantity E)

12. An algebraic example: Price
MSC = Q + 10
MPC = Q
Price B = 55
marginal damage per unit of $10
Price C = 50
P = 100 – Q
Recall E = 45 and F = 50
Inefficient equilibrium, P = Q  P = 50
Socially optimal quantity, P = Q + 10  P = 55

13. The externality problem
With externalities, quantity produced is typically not optimal
Finding optimal quantity when marginal damage is not constant
Deadweight loss of inefficient production

14. Next… A more general analysis of externalities
External cost per unit does not have to be constant

15. Graphical analysis of externalities
MSC = MPC + MD $
MPC h d g c
Axes and labels
1st click – MB
2nd click – MPC, Q1
3rd click – MD
4t click – MSC, Q* MD f b MB a e Q* Q1
Q per year
Socially efficient output
Actual output

16. Graphical analysis of externalities
Producer surplus lost going from Q1 to Q*

17. Graphical analysis of externalities
Consumer surplus gained going from Q1 to Q*

18. Graphical analysis of externalities
Net social gain going from Q1 to Q*

19. Graphical analysis of externalities
This is also the deadweight loss (or excess burden) when Q1 is produced

20. Pollution
Pollution is one of the biggest negative externalities around
Multiple steps needed to try to find optimal amount of pollution
Which pollutants actually do damage?
Are there pollutants that indirectly cause damage?
Example: CFCs on the ozone layer
How do we value the damage done?
Very difficult to do, due to lack of markets

21. Pollution and empirical studies
Empirical studies have been done to try to determine the damages caused by pollution
Remember from Chapter 2 that we need to use events that prevent bias

22. Pollution and empirical studies
Chay and Greenstone (2003, 2005)
Pollution on health
1 percent reduction in total suspended particulates resulted in a 0.35 percent reduction in infant mortality rate
Pollution on housing prices
Improved air quality between 1970 and 1980 in pollution-regulated cities led to property value increases of $45 billion

23. The externalities of smoking
Increased health care costs
Affects others through increased health care insurance premiums
Lower workplace productivity due to smoking
Lowers non-smoker wages also if firms cannot discriminate against smokers
Increased fires
Additional fire fighting cost on society
The death benefit: A positive externality
Secondhand smoke

24. The externalities of smoking
All together, the externalities due to smoking lead to a net cost on society
Empirical estimates lead to a total cost that is probably somewhere between $0.50-$1.50 per pack
Estimates can vary depending on factors such as discount rate, assumptions in a model, and value of life
Current cigarette taxes in the US average about $2 per pack

25. Why don’t we just negotiate?
Negotiation is typically costly
Remember, time is worth something
Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

26. Coase theorem
The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur
People can negotiate costlessly
The right can be purchased and sold
Property rights
Given the above conditions, efficient solutions can be negotiated
Ronald Coase

27. Coase theorem Notice that the Coase theorem addresses efficiency
To get to efficiency, the quantity of most goods and services produced is still positive
Example: It is not efficient to get rid of all pollution
If all pollution was gone, we could not live (since we exhale CO2)

28. Bargaining and the Coase Theorem
MB exceeds MPC in this range  Production will be Q1 without negotiation
MSC = MPC + MD $
MPC h d g c MD MB Q* Q1
Q per year

29. Bargaining and the Coase Theorem
MSC exceeds MB here  With costless bargaining, consumers will pay to reduce production from Q1 to Q*
MSC = MPC + MD $
MPC h d g c MD MB Q* Q1
Q per year

30. Other private responses to externalities
Mergers
When negative externalities only affect other firms, two firms can merge to internalize the externalities
Social convention
Social pressure to be nice can lower the amount of certain negative externalities

31. Public responses to externalities
Four public responses
Taxes
Also known as emissions fee in markets with pollution
Subsidies
Command-and-control
Government dictates standards without regard to cost
Cap-and-trade policies
Also known as a permit system

32. Taxes
With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss
Quantity is below the optimal amount with taxes
With negative externalities, taxes can improve efficiency
The optimal tax is known as the Pigouvian tax
Pigouvian tax equals marginal damage at the efficient output
Increased Pigouvian taxes can also lead to lower income taxes without sacrificing overall tax revenue
Double dividend hypothesis (More in Chapter 15)

33. Pigouvian taxes in action
MSC = MPC + MD $
(MPC + cd)
Pigouvian tax revenues
MPC d i j c
Axes and labels
1st click – MP shifts up to MPC + cd
2nd click – Pigouvian tax revenues box MD MB Q* Q1
Q per year

34. Emissions fee
One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output
This kind of tax is known as an emissions fee

35. Emissions fee in action$
MC of abatement f*
Axes and labels
1st click – MSB
2nd click – MC
3rd click – dashed line and e*
4th click – f* and brown horizontal line
MSB of abatement e*
Abatement quantity

36. Subsidies
An alternative to taxes is providing a subsidy to each firm for every unit that it abates
Problems with subsidies:
Efficient outcome only with a fixed number of firms
Increased profits of firms in the industry will encourage new entrants into the industry
Positive economic profits if new entry is not allowed
Revenue is needed to provide subsidies
Taxing income reduces inefficiencies
Ethical issues: Who has the right to pollute?

37. Subsidies in action MSC = MPC + MD $ (MPC + cd) MPC Pigouvian subsidyk i f g j c h
Axes and labels
1st click – MP shifts up to MPC + cd
2nd click – dashed lines fi, hj, and hf
3rd click = Pigouvian subsidy MD MB e Q* Q1
Q per year

38. Command-and-control pollution reduction
Two firms
Each would pollute 90 units if there are no pollution controls
Suppose each firm was forced to reduce pollution by 50 units
Known as uniform pollution reduction
Usually not efficient

39. Uniform pollution reductions
MC is for abatement on these graphs
Total abatement costs are in red for each firm
MCH $ $
MCB
axes and labels for both graphs
1st click – MCB and dashed vertical lines, MCH and dashed vertical black line
2nd click – horizontal dashed brown line and vertical dashed brown line
3rd click – dashed brown line and Bart’s dashed black line at 50 disappear
4th click – line at f = $50 wipes right
5th click – Bart’s tax payment
6th click – Homer’s tax payment 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction

40. Inefficiencies of uniform reductions
Notice that MC of Homer’s last unit of abatement is higher than Bart’s $ $

41. Inefficiencies of uniform reductions
Notice that MC of Homer’s last unit of abatement is higher than Bart’s  D’oh $ $

42. Inefficiencies of uniform reductions
Overall abatement costs can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit $ $

43. Command-and-control regulation
Command-and-control regulations can take many forms
Uniform reductions
Percentage reductions
Technology standards
Each firm must use a certain type of technology
This method may work best when emissions cannot be monitored easily
Performance standards
Government sets emissions goal for each polluter
Firm can use any technology it wants
Less expensive than technology standards

44. Lowering abatement costs
Going from command-and-control requirements to emissions fees can lower overall abatement costs
Marginal cost of abatement of the last unit is equal for each firm with an emissions fee

45. Emissions fees MC is for abatement on these graphs MCH
Bart’s Tax Payment
Homer’s Tax Payment
MCB
f = $50
axes and labels for both graphs
1st click – MCB and dashed vertical lines, MCH and dashed vertical black line
2nd click – horizontal dashed brown line and vertical dashed brown line
3rd click – dashed brown line and Bart’s dashed black line at 50 disappear
4th click – line at f = $50 wipes right
5th click – Bart’s tax payment
6th click – Homer’s tax payment
f = $50 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction

46. Cap-and-trade policies
Policy in which a permit is needed for each unit of pollution emitted
Permits can be traded
Policy is efficient if
Bargaining costs are negligible
Competitive permit markets exist
Number of permits matches efficient pollution level
Initial allocation of permits does not affect efficiency as long as the above criteria are met

47. Cap-and-trade
Bart and Homer will negotiate until they agree on a $50 price for permits
Suppose Bart starts with 80 permits and Homer starts with none (see points a and b)
MCH b
MCB
f = $50
axes and labels for both graphs
1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line
2nd click –
3rd click – dashed brown line and Bart’s dashed black line at 50 disappear
4th click – line at f = $50 wipes right
5th click – Bart’s tax payment
6th click – Homer’s tax payment
f = $50 a 10 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction
Bart sells 65 permits
Homer buys 65 permits

48. Emissions fee versus cap-and-trade
Given certain conditions, we notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency
$50 fee for each unit polluted (implicit fee under permits)
Bart reduces pollution by 75 units
Homer reduces pollution by 25 units

49. In what direction are we heading?
Command-and-control policies often rely on states to enforce
States do not always comply with these measures
Fees and permits can often be controlled on the national level
US policies have generally moved from command-and-control to taxes and permits
Exceptions do still apply: Emissions hot spots

50. In a perfect world… …we would know everything with certainty
The real world is not perfect
How does this complicate our analysis?

51. The real world is more complicated
We do not live in a world with perfect economic assumptions
Complicating factors
Inflation
Cost changes
Uncertainty
Distributional effects

52. Inflation
If emissions fees do not represent real prices, the amount of pollution will change as real price changes
Cap-and-trade policies do not need inflation factored in, since quantity limits are used

53. Cost changes Suppose cost to abate decreases every year
Optimal amount of abatement will increase each year
If a new abatement technology is just being developed, future cost changes could be small or large
Potential solution: Impose a hybrid system
Permit market
Offer a high tax for pollution emitted without a permit

54. Uncertainty Costs and benefits are typically not known with certainty
With uncertainty, too much or too little pollution can be produced (relative to the efficient outcome)
Two situations analyzed, with MC curve uncertain
Inelastic MSB
Elastic MSB

55. Inelastic MSB curve Marginal cost schedule could be as high as MC’ MC’$
MC*
Assume best guess of marginal cost schedule is MC* f*
Permits are closer to efficient than fees in this case
Axes and labels
1st click – MSB
2nd click – MC*
3rd click – MC’
4th click – f*
MSB ef e’ e*
Pollution reduction
Too little pollution reduction with fees
Too much pollution reduction with permits

56. Elastic MSB curve MC’ $ MC* f*
Axes and labels
1st click – MSB
2nd click – MC*
3rd click – MC’
4th click – f*
Fees are closer to efficient than permits in this case
MSB ef e’ e*
Pollution reduction
Too little pollution reduction with fees
Too much pollution reduction with permits

57. Distributional effects
Firms…
Lose when they pay a tax
Win when they are given permits
Government can generate revenue…
If a tax is imposed
If permits are sold
Double dividend hypothesis supports taxes or selling permits
Political pressure may encourage permit giveaways

58. Distributional effects
Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods
Displacement concerns
Job losses from environmental regulation: Does this increase income inequity?
Who bears the cost of pollution control?
Depends on who uses the good that has the pollution control
Example: Cars that are 15 or more years old

59. Summary
Externalities lead to inefficient production of many goods and services
Costless negotiation can lead to efficient outcomes in the presence of externalities
Not realistic in most markets
There are many ways to implement government policies to improve efficiency

60. Wednesday Positive externalities An application of externalities
Highway travel
Problems related to externalities

61. What’s in your scrubber?