1. Copyright © 2002 by Thomson Learning, Inc. Chapter 3 Externalities and Public Policy Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X

2. Copyright © 2002 by Thomson Learning, Inc. Externalities  I - What are externalities ?  II - Externalities and efficiency  III – Internalization of externalities  1- Corrective taxes  2- Second best efficiency solutions  3- Corrective subsidies  4- Property rights and Coase Theorem  5- Efficient abatement level  6- Regulatory solutions

3. Copyright © 2002 by Thomson Learning, Inc. I- Externalities  Externalities are costs or benefits of market transactions not reflected in prices.  Negative externalities are costs to third parties.  Positive externalities are benefits to third parties.  Real and pecuniary externalities

4. Copyright © 2002 by Thomson Learning, Inc. II- Externalities and Efficiency  The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. This occurs when there is a negative externality.

5. Copyright © 2002 by Thomson Learning, Inc. Social Costs MSC = MPC + MEC

6. Copyright © 2002 by Thomson Learning, Inc. Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency D = MSB S = MPC MPC + MEC = MSC 10 Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) 110 105 100 4.55 A B G 10

7. Copyright © 2002 by Thomson Learning, Inc. Implications of Figure 3.1  Market equilibrium occurs where MPC = MSB  Efficiency Requires that MSC = MPC + MEC = MSB

8. Copyright © 2002 by Thomson Learning, Inc. Positive externalities  The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.

9. Copyright © 2002 by Thomson Learning, Inc. Social Benefit MSB = MPB + MEB

10. Copyright © 2002 by Thomson Learning, Inc. Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency S = MSC MPB + MEB = MSB H Z U V Price, Benefit, and Cost (Dollars) Inoculations Per Year (Millions) 10 25 30 45 1012 0

11. Copyright © 2002 by Thomson Learning, Inc. Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output B F A S = MSC MPB i MPB i + MEB = MSB Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions) 0 30 25 20 10121620

12. Copyright © 2002 by Thomson Learning, Inc. III- Internalization of Externalities  An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions.

13. Copyright © 2002 by Thomson Learning, Inc. 1- Corrective Taxes to Negative Externalities  Setting a tax equal to the MEC will internalize a negative externality.

14. Copyright © 2002 by Thomson Learning, Inc. Figure 3.4 A Corrective Tax Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) 100 5 110 105 95 4.5 D = MSB S = MPC A S’ = MPC + T = MSC Tax Revenue = Total External Costs T Net Gains in Well-Being G B

15. Copyright © 2002 by Thomson Learning, Inc. Results of a Corrective Tax  Socially optimal levels of production are achieved.  The tax revenue is sufficient to pay costs to third parties.

16. Copyright © 2002 by Thomson Learning, Inc. Using a Corrective Tax  The greenhouse effect and a “Carbon Tax”  If it is accepted that the greenhouse effect is caused by burning carbon-based fuels, a carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels.  It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.

17. Copyright © 2002 by Thomson Learning, Inc. 2- Theory of the Second Best  When one condition for an optimum is violated then maintaining the others will not guarantee a second- best solution.

18. Copyright © 2002 by Thomson Learning, Inc. A Polluting Monopolist  In Chapter 2 it was shown that monopoly created a loss to society. In this chapter it was shown that a negative externality causes a loss as well.  The losses do not necessarily add to one another. In fact, they can cancel each other out.

19. Copyright © 2002 by Thomson Learning, Inc. Figure 3.5 A Second Best Efficient Solution D = MSB MPC MPC + MEC = MSC MR Price Output per Year 0 Q M Q* P M A F B C

20. Copyright © 2002 by Thomson Learning, Inc. 3- Corrective Subsidies  Setting a subsidy equal to MEB will internalize a positive externality

21. Copyright © 2002 by Thomson Learning, Inc. Subsidy Payments Figure 3.6 A Corrective Subsidy i i Y D = MPB D' = MPB + $20 = MSB S = MSC Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions) 0 45 30 25 10 12 Z V R X U

22. Copyright © 2002 by Thomson Learning, Inc. 4- Property rights & Coase theorem  The theorem  An example  The significance of Coase Theorem  Application : Pollution rights

23. Copyright © 2002 by Thomson Learning, Inc. Coase's Theorem  By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.

24. Copyright © 2002 by Thomson Learning, Inc. An example. Figure 3.7 Coase’s Theorem BA MC W MC* W MPC B + MEC = MSC MPC B Price of Beef (Dollars) Price of Wheat (Dollars) Wheat Output per Year PWPW Q* W QW1QW1 Beef Output per Year Q* B QB1QB1 PBPB

25. Copyright © 2002 by Thomson Learning, Inc. Limitations of Coase’s Theorem  Transactions costs are not zero in many situations.  However you allocate the property right, the distribution of income is affected.

26. Copyright © 2002 by Thomson Learning, Inc. Applying Coase's Theorem  The Clean Air Act of 1990 allows for the sale of the "right to pollute." Firms face a tradeoff when they pollute. If they pollute they forgo the right to sell the emission permit to others.  With electricity this has motivated firms to shift to natural gas and away from coal as a means of producing electricity.

27. Copyright © 2002 by Thomson Learning, Inc. Figure 3.8 Pollution Rights and Emissions S = Supply of Pollution Rights D = MSB of Emitting Wastes Price and Marginal Social Benefit Tons of Annual Emissions and Number of Pollution Rights 0 $20 75,000100,000

28. Copyright © 2002 by Thomson Learning, Inc. Figure 3.9 The Efficient Amount of Pollution Abatement E MSB MSC Marginal Social Cost and Benefit Percent Reduction in Wastes Emitted per Year 0 A *100

29. Copyright © 2002 by Thomson Learning, Inc. 6- Regulatory Solutions  Instead of using market forces to cause firms to internalize externalities we can use emission standards and apply these to all.

30. Copyright © 2002 by Thomson Learning, Inc. Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions A MEC = MSC MSB MEC = MSC MSB B C F  Q RB  Q RA G H 0 QRQR 10 Firm A 10 Cost and Benefit (Dollars) Firm B Q* A B QB1QB1 QB1QB1 Tons of Emissions per Year

31. Copyright © 2002 by Thomson Learning, Inc. Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions MEC = MSC MSB MEC = MSC S Y Z T R X  Q RD  Q RC Firm C Tons of Emissions per Year Firm D 20 Q* C Q R D Q R Cost and Benefit (Dollars)

32. Copyright © 2002 by Thomson Learning, Inc. Sulfur Dioxide Emission Prices SOURCE:UnitedStatesEnvironmentalProtectionAgency 250 200 150 100 50 0 8/1/94 Allowance Price (Dollars) Month/Year 8/1/95 8/1/97 8/1/998/1/968/1/98 Fieldston Publications Price IndexCantor Fitzgerald Market Price Index

33. Copyright © 2002 by Thomson Learning, Inc. Global Externalities  CFC’s  Deforestation  Global Warming