1. CHAPTER 5 Externalities McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Externalities
Externality – An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism
Not an Externality – suburban-urban migration example(effect people’s welfare through market-price changes)
Externalities reduce economic efficiency.

3. The Nature of Externalities
Privately-owned versus commonly-owned resources
Externalities can be produced by consumers as well as firms
Externalities are reciprocal in nature
Externalities can be positive(vaccination)
Public goods can be viewed as a special kind of externality

4. The Nature of Externalities-Graphical Analysis
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

5. What Pollutants Do Harm?
Empirical Evidence: What is the Effect of Pollution on Health?
not ethical to do randomized experiment. Observational studies are mostly biased.
What Activities Produce Pollutants?
How much SO2 causes acid rain?
What is the Value of the Damage Done?
Marginal damage. People’s willingness to pay for it. But pollution is not sold in markets.
Empirical Evidence: The Effect of Air Pollution on Housing Values(two houses with the same characteristics except pollution levels)

6. Validity of Willingness to pay approach
People may be unaware of the effects of air pollution on their health, hence underestimate the value of reducing it.

7. Bargaining and the Coase Theorem
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 MB Q* Q1
Q per year

8. The Coase Theorem
Coase Theorem – Provided that transaction costs are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights
Assumptions necessary for Coase Theorem to work
The costs to the parties of bargaining are low
The owners of resources can identify the source of damages to their property and legally prevent damages

9. Other Private Solutions
Mergers
Internalizing the externality. Ex: Bart buys the fishery
Social conventions
Some social conventions may force people to take into account the externalities they generate.
“Do unto others as you would have others do unto you”
Internalize the externality by empathize.

10. Public Responses to Externalities - Taxes
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

11. Public Responses to Externalities - Subsidies
MSC = MPC + MD $
(MPC + cd)
MPC
Pigouvian subsidy d k 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

12. Public Responses to Externalities- Emissions Fee$ MC f*
Axes and labels
1st click – MSB
2nd click – MC
3rd click – dashed line and e*
4th click – f* and brown horizontal line
MSB e*
Pollution reduction

13. Emissions Fees Continued- Uniform Pollution Reductions
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

14. Public Responses to Externalities- Cap-and-Trade
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

15. Cap-and-Trade vs. Emissions Fee
MC’ $
MC* f*
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
Too much pollution reduction

16. Cap-and-Trade v Emissions Fee
MC’ $
MC* f*
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
Too much pollution reduction

17. Emissions Fee v Cap-and-Trade
Responsiveness to Inflation
Responsiveness to Cost Changes
Responsiveness to Uncertainty
Distributional Effects
Emissions fee
Cap-and-Trade
Policy Perspective: Addressing Climate Change

18. Command-and-Control Regulation
Incentive-based regulations
Command-and-control regulations
Technology standard
Performance standard
Is command-and-control ever better?
Hot spots

19. The U.S. Response Clean Air Act 1970 amendments
Command-and-control in the 70s
How well did it work?

20. Progress with Incentive-Based Approaches
Policy Perspective: Cap-and-Trade for Sulfur Dioxide

21. Implications for Income Distribution
Who Benefits?
Who Bears the Cost?

22. Positive Externalities$ MC
Axes and labels
1st click – MPB
2nd click – MC and R*
3rd click – MEB
4th click MSB and R1
MSB = MPB + MEB
MPB
MEB R1 R*
Research per year

23. A Cautionary Note Requests for subsidies
Resource extracted from taxpayers
Market does not always fail
Policy Perspective: Owner-Occupied Housing