1 Chapter 3 Externalities and Public Policy

2 Externalities Externalities are costs or benefits of market transactions not reflected in prices. Negative externalities are costs to third parties. Positive externalities are benefits to third parties.

3 Externalities and Efficiency The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good.

4 Social Costs MSC = MPC + MEC

5 Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency MPC + MEC = MSC Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) D = MSB S = MPC A B G

6 Positive externalities The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production or consumption of a good.

7 Social Benefit MSB = MPB + MEB

8 Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency MPB + MEB = MSB H 10 V Price, Benefit, and Cost (Dollars) Inoculations Per Year (Millions) 0 S = MSC MPB U Z 45

9 Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output S = MSC S' = MSC' MPB i A B 12 MPB i + MEB = MSB 16 C 20 Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions) 0 F 30

10 Internalization of Externalities An externality can be internalized under policies that force market participants to account for the costs of benefits of their actions.

11 Corrective Taxes to Negative Externalities Setting a tax equal to the MEC will internalize a negative externality.

12 Figure 3.4 A Corrective Tax Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) D = MSB S = MPC S’ = MPC + T = MSC T A 110 Net Gains in Well-Being G Tax Revenue = Total External Costs B

13 Results of a Corrective Tax Price rises. The tax revenue is sufficient to pay costs to third parties. Socially optimal levels of production are achieved.

14 A Polluting Monopolist Monopoly creates a loss to society. A negative externality causes a loss as well. The losses do not necessarily add to one another. In fact, they can cancel each other out.

15 Figure 3.5 A Second Best Efficient Solution MR Price Output per Year 0 MPC + MEC = MSC D = MSB MPC M M Q P A C Q* B F

16 Theory of the Second Best When two opposing factors contribute to efficiency losses, the can offset one another’s distortions.

17 Corrective Subsidies Setting a subsidy equal to MEB will internalize a positive externality.

18 Subsidy Payments Figure 3.6 A Corrective Subsidy 0 Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions) Y 10 X D' = MPB i + $20 = MSBD = MPB i S = MSC U V R 45 Z

19 Property Rights and Internalization of Externalities Externalities arise because some resource users’ property rights are not considered in the marketplace by buyers or sellers of products. Governments can give businesses the right to emit wastes in the air and water or it can give individuals the right to clean air and water.

20 Coase's Theorem By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.

21 Limitations of Coase’s Theorem Transactions costs are not zero in many situations. However you allocate the property rights, the distribution of income is affected.

22 Applying Coase's Theorem The Clean Air Act of 1990 allows for the sale of the "right to pollute." Firms face a tradeoff when they pollute. If they pollute, they forgo the right to sell their emission permits to others. In markets for electricity, Clean Air Act has motivated firms to shift to natural gas and away from coal as a means of producing electricity.

23 Figure 3.8 Pollution Rights and Emissions S = Supply of Pollution Rights D = MSB of Emitting Wastes 100,000 Price and Marginal Social Benefit Tons of Annual Emissions and Number of Pollution Rights 0 $20 75,000

24 Figure 3.9 The Efficient Amount of Pollution Abatement MSB MSC E A* Marginal Social Cost and Benefit Percent Reduction in Waste Emitted per Year 0100

25 Regulatory Solutions Instead of using market forces to force firms to internalize externalities, we can use emission standards and apply these to all market players.

26 Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions MSB  Q RB  Q RA A B G H QRQR MEC = MSC 10 C F QA*QA* QB*QB* 0 Firm A Cost and Benefit (Dollars) Firm B QB1QB1 QA1QA1 Tons of Emissions per Year

27 Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions MEC = MSC  Q RD  Q RC MEC = MSC 20 X QC*QC* T QD*QD* Firm C Tons of Emissions per Year Firm D Cost and Benefit (Dollars) MSB S Y Z R QRQR QRQR

28 Costs and Benefits to the EPA The EPA estimates that annual compliance costs could be in the range of $225 billion per year. The EPA estimated in 1990 that the benefits of the Clean Air Act were nearly 50 times the costs. Ninety percent of the benefits are estimated to come from laws pertaining to power plants and factories.