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Transcript of Chapter 5 Externalities: Problems and Solutions 2007 Worth Publishers Public Finance and Public...
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© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
Externalities: Problems and Solutions
5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities
5.3 Public-Sector Remedies for Externalities
5.2 Private-Sector Solutions to Negative Externalities
5.1 Externality Theory
Chapter 5
5.5 Conclusion
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Externalities: Problems and Solutions
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© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
In December 1997, representatives from over 170 nations met in Kyoto, Japan, to attempt one of the most ambitious international negotiations ever: an international pact to limit the emissions of carbon dioxide worldwide because of global warming. The nations faced a daunting task.
The cost of reducing the use of fossil fuels, particularly in the major industrialized nations, is enormous.
Replacing these fossil fuels with alternatives would significantly raise the costs of living in developed countries.
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Externalities: Problems and Solutions
externality Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.
market failure A problem that causes the market economy to deliver an outcome that does not maximize efficiency.
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Externality Theory5 . 1
Economics of Negative Production Externalities
negative production externalityWhen a firm’s production reduces the well-being of others who are not compensated by the firm.
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Examples of Externalities
Negative ExternalitiesPollutionCell phones in a movie theaterCongestion on the internetDrinking and drivingStudent cheating that changes the grade curveThe “Club” anti-theft device for automobiles
Positive ExternalitiesResearch & developmentVaccinationsA neighbor’s nice landscapeStudents asking good questions in classThe “LoJack” anti-theft device for automobiles
Not Considered ExternalitiesLand prices rising in urban areaKnown as “pecuniary” externalities
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Figure 5.1 (with increasing cost MD function)
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Externality Theory5 . 1
Economics of Negative Production Externalities
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Externality Theory5 . 1
Economics of Negative Production Externalities
private marginal cost (PMC)The direct cost to producers of producing an additional unit of a good.
social marginal cost (SMC) The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others.
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Externality Theory5 . 1
Economics of Negative Production Externalities
private marginal benefit (PMB) The direct benefit to consumers of consuming an additional unit of a good by the consumer.
social marginal benefit (SMB) The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others.
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Externality Theory5 . 1
Negative Consumption Externalities
negative consumption externalityWhen an individual’s consumptionreduces the well-being of others who are not compensated by the individual.
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The Externality of SUVs
A P P L I C A T I O N
The typical driver today is in a car that weighs 4,089 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,500 pounds.
The consumption of large cars such as SUVs produces three types of negative externalities: Environmental Externalities:
The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions.
Wear and Tear on Roads: Each year, federal, state, and local governments spend $33.2 billion repairing our
roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight.
Safety Externalities: One major appeal of SUVs is that they provide a feeling of security because they
are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.
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Externality Theory5 . 1
Positive Externalities
positive production externalityWhen a firm’s production increases the well-being of othersbut the firm is not compensated by those others.
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Externality Theory5 . 1
Positive Externalities
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Externality Theory5 . 1
Positive Externalities
positive consumption externalityWhen an individual’s consumptionincreases the well-being of others but the individual is not compensated by those others.
One aspect of the graphical analysis of externalities is knowing which curve to shift, and in which direction. There are four possibilities:► Negative production externality: SMC curve lies above PMC curve► Positive production externality: SMC curve lies below PMC curve► Negative consumption externality: SMB curve lies below PMB curve► Positive consumption externality: SMB curve lies above PMB curveThe key is to assess which category a particular example fits into. First, you must assess whether the externality is associated with producing a good or with consuming a good. Then, you must assess whether the externality is positive or negative.
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Private-Sector Solutions to Negative Externalities5 . 2
The Solution
internalizing the externalityWhen either private negotiationsor government action lead theprice to the party to fully reflectthe external costs or benefits ofthat party’s actions.
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Private-Sector Solutions to Negative Externalities5 . 2
The Solution
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Private-Sector Solutions to Negative Externalities5 . 2
The Solution
Coase Theorem (Part I) When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affectedby the externality can bring about the socially optimal market quantity.
Coase Theorem (Part II) The efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights.
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Private-Sector Solutions to Negative Externalities5 . 2
The Problems with Coasian Solutions
The Assignment Problem
In practice, the Coase theorem is unlikely to solve many of the types of externalities that cause market failures.
Because of assignment problems, Coasian solutions are likely to be more effective for small, localized externalities than for larger, more global externalities.
The Holdout Problem
holdout problem Shared ownershipof property rights gives each owner power over all the others.
As with the assignment problem, the holdout problem would be amplified with a huge externality.
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Private-Sector Solutions to Negative Externalities5 . 2
The Problems with Coasian Solutions
The Free Rider Problem
Transaction Costs and Negotiating Problems
free rider problem When aninvestment has a personal cost but a common benefit, individuals will underinvest.
The Coasian approach ignores the fundamental problem that it is hard to negotiate when there are large numbers of individuals on one or both sides of the negotiation.
This problem is amplified for an externality such as global warming, where the potentially divergent interests of billions of parties on one side must be somehow aggregated for a negotiation.
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Private-Sector Solutions to Negative Externalities5 . 2
The Problems with Coasian Solutions
Bottom Line
Ronald Coase’s insight that externalities can sometimes be internalized was a brilliant one.
It provides the competitive market model with a defense against the onslaught of market failures.
It is also an excellent reason to suspect that the market may be able to internalize some small-scale, localized externalities.
It won’t help with large-scale, global externalities.
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Public-Sector Remedies for Externalities5 . 3
The Environmental Protection Agency (EPA) was formed in 1970 to provide public-sector solutions to the problems of externalities in the environment.
Public policy makers employ three types of remedies to resolve the problems associated with negative externalities.
-corrective taxation-subsidies-regulation
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Public Responses to Externalities - Taxes
Q per year
$
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0
MD
MPC
MSC = MPC + MD
Q1Q*
c
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(MPC + cd)
Pigouviantax revenues
i
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Public-Sector Remedies for Externalities5 . 3
Corrective Taxation
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Public-Sector Remedies for Externalities5 . 3
Subsidies
subsidy Government payment to an individual or firm that lowersthe cost of consumption or production, respectively.
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Public Responses to Externalities - Subsidies
Q per year
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MD
MPC
MSC = MPC + MD
Q1Q*
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Pigouviansubsidy
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Public-Sector Remedies for Externalities5 . 3
Subsidies
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Externality Problem
The private marginal benefit associated with a product’s consumption is PMB = 360 –4Q
and the private marginal cost associated with its production is PMC = 6Q.
The marginal external damage associated with this good’s production is MD =2Q.
To correct the externality, the government decides to impose a tax of T per unit sold.
What tax T should it set to achieve the social optimum?
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Public-Sector Remedies for Externalities5 . 3
Regulation
In an ideal world, Pigouvian taxation and regulation would be identical. Because regulation appears much more straightforward, however, it has been the traditional choice for addressing environmental externalities in the United States and around the world.
In practice, there are complications that may make taxes a more effective means of addressing externalities.
Taxation doe not provide incentive for innovation of pollution reducing technologies
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Emissions Fee
0Pollution reduction
MSB
MC
e*
f*
$
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Uniform Pollution Reductions
Bart’spollutionreduction
Homer’spollutionreduction
50 75 90 50 75 90
MCB
MCH
25
f = $50
f = $50
Bart’s TaxPayment Homer’s Tax
Payment
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Cap-and-Trade
Bart’spollutionreduction
Homer’spollutionreduction
50 75 90 50 75 90
MCB
MCH
25
f = $50
f = $50
10
a
b
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Cap-and-Trade v Emissions Fee
0Pollution reduction
MSB
MC*
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f*
$
MC’
ef e’
Too much pollution reductionToo little pollution reduction
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Cap-and-Trade v Emissions Fee
0Pollution reduction
MC*
e*
f*
$
MC’
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MSB
Too much pollution reductionToo little pollution reduction
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Emissions Fee v Cap-and-Trade
Responsiveness to InflationResponsiveness to Cost ChangesResponsiveness to Uncertainty
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Distinctions Between Price and Quantity Approaches to Addressing Externalities
5 . 4
Uncertainty About Costs of Reduction
Implications for Effect of Price and Quantity Interventions
The uncertainty over costs has important implications for the type of intervention that reduces pollution most efficiently.
Implications for Instrument Choice
The central intuition here is that the instrument choice depends on whether the government wants to get the amount of pollution reduction right or whether it wants to minimize costs.
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Distributional Effects
Emissions feeCap-and-Trade
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Command-and-Control Regulation
Incentive-based regulationsCommand-and-control regulations
technology standardperformance standard
Is command-and-control ever better?hot spots
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The U.S. Response
Clean Air Act1970 amendmentsCommand-and-control in the 70sHow well did it work?
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Conclusion5 . 5
Externalities are the classic answer to the “when” question of public finance: when one party’s actions affect another party, and the first party doesn’t fully compensate (or get compensated by) the other for this effect, then the market has failed and government intervention is potentially justified.
This naturally leads to the “how” question of public finance. There are two classes of tools in the government’s arsenal for dealing with externalities: price-based measures (taxes and subsidies) and quantity-based measures (regulation).
Which of these methods will lead to the most efficient regulatory outcome depends on factors such as the heterogeneity of the firms being regulated, the flexibility embedded in quantity regulation, and the uncertainty over the costs of externality reduction.
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Distinctions Between Price and Quantity Approaches to Addressing Externalities
5 . 4
Basic Model
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Distinctions Between Price and Quantity Approaches to Addressing Externalities
5 . 4
Multiple Plants with Different Reduction Costs
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Distinctions Between Price and Quantity Approaches to Addressing Externalities
5 . 4
Multiple Plants with Different Reduction Costs
Policy Option 1: Quantity Regulation
Policy Option 2: Price Regulation Through a Corrective Tax
Policy Option 3: Quantity Regulation with Tradable Permits
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Distinctions Between Price and Quantity Approaches to Addressing Externalities
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Uncertainty About Costs of Reduction
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Distinctions Between Price and Quantity Approaches to Addressing Externalities
5 . 4
Uncertainty About Costs of Reduction