1. 10
Externalities

2. Externalities Externality
The uncompensated impact of one person’s actions on the well-being of a bystander
Negative externality
Impact on the bystander is adverse
Positive externality
Impact on the bystander is beneficial

3. Externalities A more technical definition
A cost that is suffered by a third party as a result of an economic transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organization, property owner, or resource that is indirectly affected by the production or consumption of the good by first/second parties.

4. Externalities and Market Inefficiency
Cause markets to allocate resources inefficiently
Welfare economics: a recap
Demand curve – value to consumers
Prices they are willing to pay
Supply curve – cost to suppliers
Equilibrium quantity and price
Efficient
Maximizes sum of producer & consumer surplus
Without externalities present

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Why Is There Pollution?
Pollution is a by-product of the production process
Treated as a zero-priced input
Dispose of waste for free
Otherwise have to purchase abatement equipment
Since price = 0 => consume to the point: MV = 0
However MC ≠ 0
So have a deadweight loss due to MV < MC
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Negative Externality
Marginal Private Costs < Marginal Social Costs
Ideal
Actual Pi Pa
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7. Economics and Pollution Control The Two Big Questions
What is the optimal level of pollution?
How should it be allocated among its sources (firms)?
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8. What Do We Need for Efficiency?
Economic efficiency requires
Minimize the costs of
Damages caused by pollution
Costs of reducing pollution
At the margin (or at the optimum)
Marginal (additional) costs of reducing pollution (pollution abatement costs) = marginal damages caused by incremental change in emissions
Alternatively
Maximize the benefits (derived from goods produced)
While minimizing abatement and damage costs
Yields same solution
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9. Determining the Optimal Amount of Pollution
Tax
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10. Negative Externalities – A Graph
A Cost Which is Incurred by Society That Should Be Accounted For
But those in the Market (1st and 2nd Parties) Don’t Have to Pay For It

11. Market Failure Negative Externality – Not Accounted For in the
Market’s Pricing/Costing of the Good
Creates Deadweight Loss – Inefficient Use of Resources

12. Increased Health Care Costs
Harvard Study: Coal Costs America $ Billion Annually
A Harvard University study published on Feb 17, 2011, has determined that the true costs of using coal to generate electricity in America are between $330 and $500 billion dollars annually. The study, "Mining Coal, Mounting Costs -- The Life Cycle Consequences of Coal" by the Harvard Medical School's Center for Health and the Global Environment examines the costs for so-called "cheap coal" that don't show up on the monthly electric bill: the so-called "externalities" or hidden costs.

13. Graphically

14. Externalities and Market Inefficiency
Negative externalities - Pollution
Cost to society (of producing electricity from coal)
Larger than the cost to the electric utilities
Does not include damage from acid rain
Social cost - supply
Private costs of the producers
Plus the costs to those bystanders affected adversely by the negative externality
Social cost curve – above the supply curve (private costs)

15. Pollution and the social optimum2
Pollution and the social optimum
Price of
Electricity
Social cost (private cost
and external cost)
External
Cost
Supply
(private cost)
Demand
(private value)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Megawattsof Electricity
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.

16. Externalities and Market Inefficiency
Negative externalities
Markets - produce a larger quantity than is socially desirable
Positive externalities
Markets - produce a smaller quantity than is socially desirable
Government: “internalize” the externality
Taxing goods that have negative externalities
Subsidizing goods that have positive externalities

17. Public Policies Toward Externalities
Command-and-control policies: regulation
Regulate behavior directly
Making certain behaviors either required or forbidden
Cannot eradicate pollution
Environmental Protection Agency (EPA)
Develop and enforce regulations
Protecting the environment
Dictates maximum level of pollution
Requires that firms adopt a particular technology to reduce emissions

18. Public Policies Toward Externalities
Market-based policies
Provide incentives
Private decision makers - choose to solve the problem on their own
1. Corrective taxes and subsidies
Corrective tax
Induce private decision makers to take account of the social costs that arise from a negative externality
Places a price on the right to pollute
Reduce pollution at a lower cost to society

19. Why is gasoline taxed so heavily?
The gas tax = corrective tax
Three negative externalities
Congestion
Accidents
Pollution
Doesn’t cause deadweight losses
Makes the economy more efficient
Less traffic congestion, safer roads, and cleaner environment

20. Why is gasoline taxed so heavily?
How high should the tax on gasoline be?
Most European countries
Gasoline taxes - much higher than those in the U.S.
2007 study, Journal of Economic Literature
Optimal corrective tax on gasoline was $2.10 per gallon
Actual tax in the United States: 40 cents
Tax revenue from a gasoline tax
Lower taxes that distort incentives and cause deadweight losses
Some government regulations
Production of fuel-efficient cars – unnecessary

21. Public Policies Toward Externalities
Market-based policies
2. Tradable pollution permits
Voluntary transfer of the right to pollute from one firm to another
New scarce resource: pollution permits
Market to trade permits
Firm’s willingness to pay
Depend on its cost of reducing pollution

22. Public Policies Toward Externalities
2. Tradable pollution permits
Advantage of free market for pollution permits
Initial allocation of pollution permits
Doesn't matter
Firms - reduce pollution at a low cost
Sell whatever permits they get
Firms - reduce pollution only at a high cost
Buy whatever permits they need
Efficient final allocation

23. Controlling Pollution
The following table shows the marginal costs for each of four firms (A, B, C, and D) to eliminate units of pollution from their production processes. For example, for Firm A to eliminate one unit of pollution, it would cost $54, and for Firm A to eliminate a second unit of pollution it would cost an additional $67.
Firm
Unit to be eliminated A B C D
First unit 54 57 62
Second unit 67 68 66 73
Third unit 82 86 91
Fourth unit
107
108
111

24. Three Policy Approaches
Suppose that the government determines that the optimal level of pollution is 8 total units for the entire industry
A) If the government requires each firm to reduce its current level of pollution (4 units) by 50% (2 units each), what would be the total cost of the industry (and to society) of reducing pollution?
B) What per-unit tax on emissions could the government set to reduce pollution by 50%?
C) Suppose that the government issues 2 tradable (can be sold to another firm) to each firm. The firm can either use it to reduce pollution by 50% (2 units) or can resell the permit to another firm. But then will have to pay the marginal cost of treating the unit for which the permit would have been used. What would be the market price for the permit and how many would be sold?

25. Public Policies Toward Externalities
Reducing pollution using pollution permits or corrective taxes
Firms pay for their pollution
Corrective taxes - to the government
Pollution permits, - buy permits
Internalize the externality of pollution

26. The equivalence of corrective taxes & pollution permits4
The equivalence of corrective taxes & pollution permits
(a) Corrective tax
(b) Pollution permits
Price of
pollution
Price of
pollution
1. A corrective tax sets
the price of pollution . . . Q
Supply of
pollution permits
Demand for
pollution rights
Demand for
pollution rights
1. Pollution
permits set
the quantity
of pollution . . . P
Corrective tax P Q
which, together
with the demand curve,
determines the price
of pollution.
which, together with the demand curve, determines the quantity of pollution.
Quantity of
pollution
Quantity of
pollution
In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand curve determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by limiting the number of pollution permits, and the demand curve determines the price of pollution. The price and quantity of pollution are the same in the two cases.

27. Public Policies Toward Externalities
Objections to the economic analysis of pollution
“We cannot give anyone the option of polluting for a fee.” - former Senator Edmund Muskie
People face trade-offs
Eliminating all pollution is impossible
Clean water and clean air – opportunity cost
Lower standard of living

28. Public Policies Toward Externalities
Clean environment - is a normal good
Positive income elasticity
Rich countries can afford a cleaner environment
More rigorous environmental protection
Clean air and clean water - law of demand
The lower the price of environmental protection
The more the public will want
Economic approach
Pollution permits and corrective taxes
Reduces the cost of environmental protection
Increase demand for a clean environment

29. Private Solutions to Externalities
The Coase theorem
If private parties can bargain without cost over the allocation of resources
They can solve the problem of externalities on their own
Private economic actors
Can solve the problem of externalities among themselves
Whatever the initial distribution of rights
Interested parties - reach a bargain:
Everyone is better off & Outcome is efficient

30. Private Solutions to Externalities
Why private solutions do not always work
High transaction costs
Costs that parties incur in the process of agreeing to and following through on a bargain
Bargaining simply breaks down
Large number of interested parties

31. Technology spillovers, industrial policy, and patent protection
Technology spillover = Positive externality
Impact of one firm’s research and production efforts on other firms’ access to technological advance
Government: internalize the externality
Subsidy = value of the technology spillover
Industrial policy
Government intervention in the economy that aims to promote technology-enhancing industries
Patent law
Protect the rights of inventors by giving them exclusive use of their inventions for a period of time

32. Market Failure Market Failure Sources
When the free market may not provide economically efficient (ideal) outcome
Sources
Too little competition
Monopoly/Cartels
Too little output/total surplus (deadweight loss)
Goods produced at too high a cost
Asymmetric Information
Financial Markets (insider trading – Facebook IPO)
Externalities (positive and negative)