1. EXTERNALITIES
Chapter 5

2. Externalities
Externality – An activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism
A paper mill’s production of the carcinogen dioxin increases society’s health care costs; these costs to society are not included in the paper mill’s paper price
However, when large numbers of suburbanites relocate to a city, society is affected, although the effect is captured through higher prices of city housing

3. The Nature of Externalities
Privately-owned vs. commonly-owned resources
A privately owned resource: its price reflects its value so used efficiently (MSC=MSB)
A commonly-owned resource (air, oceans): price ($0) does not reflect its value so used inefficiently (MSC>MSB)
Externalities can be produced by consumers & firms
Externalities are reciprocal in nature
Externalities can be positive or negative
Public goods can be viewed as a special kind of externality

4. 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

5. What Pollutants Do Harm?
Empirical Research on Pollution Effects on Health
Difficult to measure because of inability to perform randomized studies on pollution effects
Must rely on cross-sectional or time-series analysis
Studies unable to measure lifetime exposure to air pollution
Once pollutant identified:
Must identify the activities that produce the pollutant
Must identify the value of the damage done
Must identify the costs of remedying the damage
Empirical Evidence: The Effect of Air Pollution on Housing Values

6. Private Responses Bargaining and the Coase Theorem
MSC = MPC + MD
Supplier will ↓ Q1 to Q* if paid by Demander, who is willing to do so. Bargain possible over $ transferred. $
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

7. The Coase Theorem Coase Theorem – Given:
Low transaction costs
Clear assignment of property rights
An efficient solution to an externality problem can be achieved
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

8. Other Private Solutions
Mergers – way to internalize the externality
The externality transmitter and recipient become one company.
Social conventions/Morals
For example: “Littering” is wrong.

9. 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

10. Public Responses to Externalities – Subsidies that pay polluter not to pollute
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

11. Public Responses to Externalities- Emissions Fee: tax on each pollution unit$
f1 results in only e1 reduction
f* results in e* reduction: the efficient level MC f1
Emissions fee f*
Emissions fee
Axes and labels
1st click – MSB
2nd click – MC
3rd click – dashed line and e*
4th click – f* and brown horizontal line
MSB e1 e*
Pollution reduction

12. Public Responses to Externalities- Uniform Pollution Reduction
MCH
Requiring each company to reduce pollution by 50 units is not cost effective. Better to have Bart reduce pollution by 100 units because he can do so at a lower cost. But is it fair??? b
MCB
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 10 50 75 90
Bart’s pollution reduction 25 50 75 90
Homer’s pollution reduction

13. Emissions Fees achieve fairness and efficiency
An Emissions Fee=$50 means Bart will reduce by 75 and Homer only by 25, but Homer pays larger tax.
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

14. Public Responses to Externalities- Cap-and-Trade: Polluters must have a permit
Bart: The cost of reducing pollution is less than market price of a permit, so sell permit.
Homer: The cost of reducing pollution is greater than market price of a permit so buy permit.
BOTH GAIN FROM 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

15. Emissions Fee v Cap-and-Trade
Responsiveness to Inflation
Responsiveness to Cost Changes
Distributional Effects
Responsiveness to Uncertainty of Costs of reducing pollution (cont on next slides)

16. Cap-and-Trade vs. Emissions Fee Inelastic MSB of pollution reduction
MC’ $
MC*
Cap/trade allows too much pollution
Emissions Fee allows too little pollution
C&T more efficient than Emissions Fee 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

17. Cap-and-Trade v Emissions Fee Elastic MSB of pollution reduction
MC’ $
MC*
Cap/trade allows too much pollution
Emissions Fee allows too little pollution
Emissions Fee more efficient than C&T 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

18. Command-and-Control Regulation
Command-and-control regulations require a given amount of pollution reduction with limited or no flexibility on how to achieve reduction
Technology requirements
Performance requirements
Is command-and-control ever better?
Hot spots: Areas with relatively high concentrations of emissions

19. The U.S. Response Clean Air Act
1970 amendments
Command-and-control in the 70s
How well did it work?
Policy Perspective: Cap-and-Trade for Sulfur Dioxide

20. Implications for Income Distribution
Who Benefits?
Low- or High-Income Individuals?
Who Bears the Cost?
Workers of firms who must reduce output
Buyers of firms’ output

21. 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

22. Positive Externalities: A Cautionary Note on Requests for Subsidies
Subsidies must come from taxpayers
Market does not always fail: the fact that an activity is beneficial does not always mean that a subsidy is required for efficiency
Policy Perspective: Owner-Occupied Housing

23. Chapter 5 Summary
Externalities occurs when the activity of one person or firm positively or negatively affects another person/group/firm outside the market mechanism
An inefficient allocation of resources results because the market price does not reflect the external costs or benefits
The Coase Theorem indicates that private solutions through bargaining can achieve the efficient outcome under certain circumstances
Public solutions to externalities designed to achieve efficiency include taxes/subsidies; emissions fees; and command-and-control regulations
A market-based, cost-effective, public solution is cap-and-trade where pollution permits – the right to pollute – are traded