1. Public Finance - Introductory
Externalities
Public Finance - Introductory

2. Public Finance - Introductory
Definition
An externality occurs when the activity of an ind affects the utility of another ind in a way not accounted by the price system
externality = external to the P mechanism
E.g. pollution
So called “pecuniary externalities” are reflected in the P mechanism → not an externality, no market inefficiency involved
Very important concept, fundamental for economic analysis of the law, environmental economics etc.
Public Finance - Introductory

3. Nature of externalities
Firm A (paper producer) throws waste in a river upon which there are no property rights → negatively affects ind B (fisherman) → negative externality
River water is input for firm A but has also alternative uses→ e.g. input for fisherman
Input s are efficiently used if paid to owners on the basis of opportunity costs (e.g. wage is opportunity cost of leisure time of worker)
P of water in example is 0 → nobody owns river→ no incentive to use it efficiently
→ Externality is consequence of lack of property rights
Public Finance - Introductory

4. Features of externalities
Produced by consumers and producers
E. in consumption → affects utility
E. in production → affects profits
Reciprocal: firm A pollutes river, but also fisherman produces externalities → raises costs of polluting
Negative and positive (e.g.. neighbor’s well tendered garden)
PG are source of externalities
Public Finance - Introductory

5. Picture of negative externality in consumption
Public Finance - Introductory

6. The Nature of Externalities-Graphical Analysis
MSC = MPC + MD
Reduction from Q1 to Q* means dcg profit loss for Supplier and dchg welfare gain for Demander. $
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
Public Finance - Introductory

7. Public Finance - Introductory
Description
Firm produces up to Q1 where πmax (Mπ=0)
From the point of view of society → production must be up to MB=MSC (social costs, not firm’s private costs) → point Q*
If there is an externality FTWE does not hold
MB=MPC holds, not MB=MSC
→ if negative externality → excessive production wrt efficient quantity
Public Finance - Introductory

8. Description of diagrams-2
Efficiency increases by moving from Q1 to Q*
→ Firm profits lowered (area dcg)
→ Fishermen’s welfare increases → every unit of output less increases fisherman welfare by MC of externality (abfe=cdgh because MSC=MPC+MD)
If U functions of firm and of fisherman equivalent → society’s welfare increases by dgh
0 pollution is NOT socially desirable → both activity affect each other (“reciprocal externality”)
→ 0 pollution=0 production=0 profits
Public Finance - Introductory

9. Public Finance - Introductory
Limits of analysis
4 main limits → analysis assumes
Knowledge of functional forms that generate curves
Quite unlikely
Identification of polluter
Who’s responsible for acid rainfalls?
Identification of pollutant agents
Often disagreements about this (e.g.. ozone hole)
Identification of damage
What’s the cost of being polluted? Who decides it?
Public Finance - Introductory

10. Remedies to externalities
Mergers
Social rules
Pigouvian taxes
Creation of markets
Assignment of property rights
Regulation
Nothing
Public Finance - Introductory

11. Mergers and social rules
Mergers → externalities are internalized by merging the affected parties
Agents coordinate to make joint π superior to sum of individual π
→ Damage (externality) eliminated
e.g. Bank mergers where competition is externality → pooling of risks, as in financial crisis of 2008
Social rules → Education plays an important role in reduction of externalities
Public Finance - Introductory

12. Public Finance - Introductory
Pigouvian tax
Externality inefficient because production costs do not reflect social costs
→ Pigouvian tax (by name of Arthur Pigou) aims at correcting such difference → increase P of underpriced inputs (e.g. P=0 in previous example) because of property rights not assigned
Tax = externality = ij
P=0j+ij
New cost structure for firm is MPC+cd
Firm produces Q* where MB=MPC+cd
Revenue is cd*0Q*
Public Finance - Introductory

13. Diagram of a Pigouvian tax
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 Finance - Introductory

14. Public Finance - Introductory
Pigouvian tax - limits
Pigouvian tax revenues must not go to people affected by externality
Incentive to declare damage
→ Compensation of victims not needed to attain efficient production
Identification of value of externality (MD function)
Identification of who pollutes and how much
Point is not whether Pigouvian tax is perfect, but whether it is better than the alternatives
Public Finance - Introductory

15. Public Finance - Introductory
Creation of markets - 1
Eternality due to lack of a market for it → state can create the market
E.g. Trade of emission permits → market for non polluted air → air becomes economically valuable (=with a price)
Aka “Cap and trade”
State first sets (“caps”) the quantity of acceptable emissions (e.g. Z*), then auction off the right to pollute up to Z* (“trade”)
P offered by best bidder is market equilibrium price P1 → efficient
Those who do not want to pay P1 either reduce production or chooses cleaner technologies
P1 = effluent fee
Public Finance - Introductory

16. Diagram of market creation
Public Finance - Introductory

17. Public Finance - Introductory
Creation of markets - 2
Government can also distribute emission permits and let firm do the distribution in a secondary market
Equilibrium not affected → firms sell rights only if value them less than P1
Distribution changes → gov. does not cash any revenues
Main advantage is reduction of uncertainty about pollution level → this system works best when knowing the curves of the Pigouvian tax diagram is costly
Markets for emission permits exist in USA and now in Europe as well
Public Finance - Introductory

18. Attribution of property rights
In certain conditions government can assign property rights on the resource that generates the externality → creating a market for externalities and then stay out of it
→ Coase Theorem (Coase, 1963): parties affected in an externality will always agree on a pareto-otpimal solution (Q*), regardless the prior attribution of property rights, provided that the transaction costs be 0 (or sufficiently low )
If firm owns river but MB of production is below MD (externality) → exchange opportunity → fishermen pay firm to produce up to Q* where MD=MB-MPC
If fishermen own the river (opposite attribution of property rights) firms will pay to produce until MB=MPC, fishermen will demand MD → back to Q*
Public Finance - Introductory

19. Public Finance - Introductory
Coase theorem
Public Finance - Introductory

20. Commentaries to Coase theorem
No need for the state to intervene
Within conditions where theorem applies, ind solve externalities through voluntary exchange
Base for modern law and economics (e.g. extra trial negotiations and deals)
3 problems:
Transaction costs 0
Identification of polluter and costs to enforce deal
Few parties must be involved in externality and externality must be well defined (but experimental economics shows that range of deals is larger than expected; Mueller 2003)
Government often increases transaction costs to be part of the deal (supply side)
Public Finance - Introductory

21. Public Finance - Introductory
Regulation
Government establish rule not to pollute beyond a certain threshold → otherwise sanctions
Kyoto protocol is regulation with weak sanctions
Inefficient when involved firms are numerous and heterogeneous
Firms X and Z have same fixed costs → their technology is potentially polluting → but face different demand curves
Damage is d: with regulation, efficient production is where MB=MPC+d
Firm with more elastic demand curve Z reduces Q more → made worse off by regulation to a larger degree than X
→ Not all firms that pollute in the same way pay the same amount
e.g. Catalytic converters more useful in Paris traffic than in Rennes, but price is the same
Firms use regulation strategically
Public Finance - Introductory

22. Public Finance - Introductory
Diagram of regulation
Public Finance - Introductory

23. Public Finance - Introductory
Which is best remedy?
Choice of solution depends from circumstances
Verify hypotheses that condition the efficiency of alternative solutions
No best unique solution
Economists generally prefer Pigouvian taxes, trade of emission permits and/or voluntary solutions
Governments generally use taxes (revenues) or regulation to show that they are acting (visible action)
Regulation has high costs → even if firm pollutes beyond thresholds sanctions are often not applied because if firms goes bankrupt unemployment is itself a cost → strategic use of regulation, which politicians use precisely because it is inefficient (e.g. Kyoto)
Gradual move towards use of tradable emission permits
Ideology makes finding solutions harder
Public Finance - Introductory

24. Distributive consequences
Who actually pays reduction of pollution?
Evaluating distributional consequences is difficult
Many parties involved, in different ways
Empirical evidence
Unemployment increases→ production costs increase, output goes down → environmental regulation responsible for lower growth rates of western economies since the 1970s (Mankiw, 2004)
Prices go up→ consumers bear the costs of environmental friendly technologies (costs shifted onto final products)
It seems that low income people face worst distributional consequences (e.g., having to buy a new car, with lower polluting emissions is a heavier financial sacrifice for low income families)
Public Finance - Introductory

25. The impact of the Kyoto Protocol
Other high
income
countries
Eastern
Europe
Rest of
the World
Source William Nordhaus and Joseph Boyer, Warming the World: Economic Models of Global Warming, MIT Press, 2000
Public Finance - Introductory

26. Differences in polluting emissions
Efficient policy: curve where costs and benefits of reduction of emissions are balanced
Public Finance - Introductory

27. Differences in energy and primary inputs prices
Public Finance - Introductory