Externalities Chapter 10

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ExternalitiesChapter 10

• Ratna K. Shrestha

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Introduction/Background

• Lets assume that your cigarette smoking in the
  classroom benefits you by 10 but harms the rest
  of the 150 students by 300 (2 harm per head).
  In this case if there is no regulation, you will
  smoke in the classroom which will cause 300
  10 290 harm to the class as a whole (total
  harm net of your benefits).
• Then the question is how can the government
  prevent this 290 harm from occurring?

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An externality arises...

• . . . when a person engages in an activity
  (production or consumption) that influences the
  well-being of a bystander and yet neither pays
  nor receives any compensation for that effect.
• Externality can be Negative or Positive depending
  upon whether the action of one party imposes a
  cost or benefit on another party.
• Externality can also be production or consumption
  depending on whether the externality is caused by
  production or consumption activities.

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Types of Externalities

• Negative Externalities Examples
• Steel plant dumping waste in a river.
• Noise in the neighborhood.
• Vehicle exhaust causing harm to the environment.
• acid rain caused by coal burning production
  releasing SO2.
• global warming due to greenhouse gases (carbon
  particles from fossil fuel combustion, etc.).

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ACID RAIN
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Types of Externality

• Positive Externality Examples
• research and innovation.
• neighbors nice backyard.
• Immunization.
• Examples of production externality
• A paper factory dumping its waste to the river.
• Example of consumption externality
• Cigarette smoking in the classroom, Drinking and
  driving.

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The Externality of SUVs

• Consider a real-life example the use of sport
  utility vehicles (SUVs). They create three sorts
  of externalities
• Environmental externalities They consume a lot
  of gasoline and create more air pollution.
• Wear and tear on roads SUV drivers do not bear
  the full costs of damage to the roads (other
  vehicles also share the costs) that result from
  their vehicles.
• Safety externalities When SUVs are in accidents,
  the other drivers are often more severely injured.

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The Market for Aluminum...
Supply (private MC)
Demand (private value)
Quantity of AL
0
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Market for Aluminum

• In the absence of any externality, the quantity
  produced and consumed in the market equilibrium
  is efficient in the sense that in this case the
  sum of producer and consumer surplus is
  maximized.
• If the aluminum factory emits pollution (a
  negative externality), then the cost to society
  of producing aluminum is larger than the cost of
  production to the factory.
• MC to Society, MSC MC of production of the
  factory MC of pollution to the environment.
• The MC of pollution to the environment is called
  marginal external cost (MEC).

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Pollution and Dead Weight Loss
Dead Weight Loss
Supply
(private MC)
Popt.
PMarket
Demand
(private value)
0
Quantity of AL
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Socially Optimal Output

• The government can internalize a negative
  externality by imposing a Pigovian tax (t MEC
  at Qopt) on the producer.
• This tax induces the producer to reduce the
  equilibrium quantity to the socially desirable
  quantity, and thus eliminate the Dead Weight
  Loss.

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Pigouvian tax as a solution to negative
externality
Market Eqlbm. with tax
MCt
Supply
(private MC)
Ptax.
Pno tax
t
Demand
(private value)
0
Quantity of AL
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Positive Externalities in Production

• When an externality benefits bystanders, a
  positive externality exists.
• A technology spillover is a type of positive
  externality because a firms innovation or design
  not only benefits the firm, but enters societys
  pool of technological knowledge and benefits
  society as a whole.

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Positive Externalities in Production...
Supply (private MC)
Deadweight Loss
Demand
(private value)
Quantity
0
Of technology
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Internalizing Externalities

• Subsidy Government usually uses subsidies (s
  MEB at the optimum Q) as the primary method for
  attempting to internalize positive externalities.
• Technology Policy Government intervention in the
  economy that aims to promote technology-enhancing
  industries is called technology policy.
  Technology policy is also one way to internalize
  positive production externality

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Technology Policy

• Patent laws are a form of technology policy that
  give the individual (or firm) with patent
  protection a property right over its invention.
• The patent is then said to internalize the
  externality, in that it provides more incentives
  to invest in modern technology than that would
  occur otherwise.

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Externalities in Consumption

• Externalities associated with consumption
  activities.
• Examples
• Alcohol If people drive under the influence of
  alcohol, it imposes a negative externality.
• Education a positive externality because more
  education means a better society.

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Consumption Externalities...
(b) Positive Consumption Externality

• Negative Consumption
• Externality

Price
Price of
of Alcohol
DWL
Supply
Education
(private cost)
Supply
(private cost)
DWL
Social
Demand (private value)
value
Demand
Social value
(private value)
0
0
QM
Qo
Quantity of
Qo
QM
Quantity
Education
of Alcohol
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Externalities and Market Inefficiency

• Negative externalities in production or
  consumption lead markets to produce a larger
  quantity than is socially desirable.
• Positive externalities in production or
  consumption lead markets to produce a smaller
  quantity than is socially desirable.

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Private Solutions to Externalities

• Government action is not always needed to solve
  the problem of externalities. Sometimes private
  polluters themselves take care of it.
• Examples
• Moral codes and social sanctions.
• Charitable organizations.
• Integrating different types of businesses.
• Bargaining between parties

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The Coase Theorem

• The Coase Theorem states that if private parties
  can bargain without cost over the allocation of
  resources, then the private market will always
  solve the problem of externalities on its own
  regardless of who (i.e., polluter or victims)
  owns the property rights.
• Transaction costs are the costs that parties
  incur in the process of agreeing to and following
  through on a bargain.

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Bargaining An Example

• Suppose Jim owns a dog from which he gets
  benefits 500.
• The dogs barking causes harm to Jerry 800.
• Since benefit lt harm, getting rid of dog is good
  for Jim and Jerry combined (that is society as a
  whole).
• How can they come to a negotiated solution?
• If Jerry has the right to noise-free environment,
  then Jim cannot offer any amount that is
  acceptable to Jerry. Jim cannot keep the dog--the
  efficient solution.
• If Jim has the right, then Jerry can offer Jim
  501 to 799 to sell off the dog, which he will
  gladly acceptthe efficient solution.

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Coase Theorem at Work

• Garbage spilling in NY harbor caused damage to
  New Jersey shore oftentimes littering its
  beaches.
• New Jersey had right to clean beaches and could
  have sued NY city.
• But by Sept of 1987, they came to a negotiated
  settlement.
• Sometimes the private solution approach fails
  because transaction costs can be so high that
  private agreement is not possible.

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Public Policy Toward Externalities

• When externalities are significant and private
  solutions are not found, government may attempt
  to solve the problem through . . .
• command-and-control policies.
• market-based policies.

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Command-and-Control Policies

• Usually take the form of regulations
• Forbid certain behaviors.
• Require certain behaviors
• Examples
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by
  the Environment Canada.
• Moratorium on cod fishing in the Atlantic Canada.

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Command and Control Examples
Smoking Ban
Emission Standard for Cars
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Market-Based Policies

• Government uses taxes and subsidies to align
  private incentives with social efficiency.
• Pigovian taxes are taxes enacted to correct the
  effects of a negative externality.
• Why gasoline is taxed so heavily?
• Causes many negative externalities congestion,
  accidents, pollution.

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Examples of Regulation versus Pigovian tax

• If the Environment Canada (EC) decides to reduce
  the amount of pollution coming from a specific
  plant, it could
• tell the firm to reduce its pollution by a
  specific amount (i.e. regulation).
• levy a tax of a given amount for each unit of
  pollution the firm emits (i.e. Pigovian tax).

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Market-Based Policies

• Tradable pollution permits allow the voluntary
  transfer of the right to pollute from one firm to
  another.
• How does it work?
• The govt. creates the number of emission or
  pollution permits equal to the desired level of
  pollution and distribute them among the
  polluters.
• Polluters can pollute only if they possess
  emission permits.
• Polluters are allowed to trade the permits among
  themselves.

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Market-Based Policies

• A market clearing price for the permits will
  evolve in the market for pollution rights.
• A polluting firm that can reduce pollution at a
  lower cost will find it beneficial to sell its
  permits (and control pollution). On the other
  hand, a high cost firm will find it beneficial to
  buy the permits and emit pollution.
• The trade takes place until the MC of pollution
  control are equal across all polluters with the
  achievement of the desired level of pollution at
  the minimum costs.

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The Equivalence of Pigovian Taxes and Pollution
Permits...
(b) Pollution Permits
(a) Pigovian Tax
Price of
Price of
Pollution
Supply of Permits
Pollution
Pigovian Tax
P
P
Demand
Demand
Quantity of
0
Q
0
Q
Quantity of
Pollution Permits
Permits