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

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.

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

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

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)

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.

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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