1. Chapter 10: Negative Externalities and Market Failure
Don Perry

2. What is a Negative Externality?
Cost imposed on 3rd parties (people not buying/selling the good)
Only consumers’ benefits and firms’ costs used to determine how much of the good to consume/produce without intervention
first and second parties in the market

3. Pollution and the social optimum
Price of
Electricity
Full costs (private cost
and external cost)
External
Cost
Supply (1st)
(market private cost)
Demand (2nd)
(market private value)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Megawattsof Electricity
No intervention
In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET.

4. Negative Externality An Example
Coal: primary fuel used to produce electricity in the mid- west
Burning of coal creates an air pollutant (SO2)
People, animals and crops downwind from plant bear the “environmental” costs of the pollutant (3rd party)
Primary beneficiaries: producers (utilities) and consumers (households and businesses) of electricity
1st and 2nd parties in the market for electricity

5. Cost of the Externality on 3rd Parties
Without Government intervention
Environmental Costs (health, crop) will not be taken into account in the “normal” market
“Normal” market will only take into account benefits to Consumers and costs to Producers
Costs to 3rd parties will not be taken into account by the supplier without government intervention
Result
Too much electricity and pollution produced as full costs of production is not take into account by the “free” market

6. The Costs of Producing Too Much Economic Inefficiency = Dead Weight Loss
Full Resource Cost (kwH) >
Consumer’s value (MPB)
Full Res Cost
= Consumer’s value

7. How To Correct For the External Costs
Impose a tax on the Producer of Electricity
Per unit tax (per kwh) = externality cost (environmental, health, crop costs)
Cost of externality is now part of the firm’s cost of producing electricity
Shifts the firm’s supply curve to the Social Cost Curve
i.e., “internalizes” 3rd party costs into the firm’s supply curve/costs
New market equilibrium
Where Total (Social) Marginal Costs = Marginal Benefits of Consumption (Demand)

8. Two Other Approaches 1. Regulatory Standard
Determine “optimal” level of pollution
Require all firms to reduce emissions by x% to meet target level of pollution
May not be the least cost way to reduce emissions if firms have different costs of “treatment”
2. Tradable (carbon) permits
Determine number of permits (for allowing given quota of emissions)
Allocate permits to firms and allow them to trade unused portions or permit
Same economic efficiency as per unit tax; but allows market to determine “price”

9. Senior Republican statesmen propose replacing Obama’s climate policies with a carbon tax
Representatives from a coalition of veteran Republican officials — including five who have either served as treasury secretary or as chairman of the Council of Economic Advisers — met Wednesday with White House officials to discuss the idea of imposing a national carbon tax, rather than using federal regulations, to address climate change.
The newly formed Climate Leadership Council — which includes James A. Baker, Henry Paulson, George P. Shultz, Marty Feldstein and Greg Mankiw — is proposing elimination of nearly all of the Obama administration’s climate policies in exchange for a rising carbon tax that starts at $40 per ton, and is returned in the form of a quarterly check from the Social Security Administration to every American.