Introduction to Externalities

8/12/2019 Introduction to Externalities

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Externalities, Market Failures, and Policy

Interventions

Evaluate positive and negative externalities

in the context of an otherwise well-

functioning competitive market.

Identify inefficiencies caused by externalities

& possible policy interventions.


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Positive Externalities

Illustrative example: Open space, viewshed,

wildlife habitat, watershed benefits of

pastureland

Suppose that pastureland is bought and sold inotherwise well-functioning competitive markets

for land

What happens if market demand only reflects

the benefits to the private landowner?


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What is a positive externality?

An unpaid-for benefit to other members of society

generated as a side effect or consequence of an

economic exchange, such as between a buyer and aseller


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How might there be unpaid-for benefits to societyin the previous agricultural land example?

Nearby residents and visitors enjoy the open space,

views, wildlife, and watershed benefits but do not

have to pay for them

Why is this a problem?


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Unpaid for benefits are wonderful things.

That isnt the problem

The problem is that the market will not allocate

enough resources to produce the socially optimal

quantity of the thing (pastureland) if only thefarmers benefits are reflected in willingness-to-

pay


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Market Supply and Demand

0100200300400500600700800900

1,0001,100

1,2001,3001,4001,5001,600

0

1,

000

2,

000

3,

000

4,

000

5,

000

6,

000

7,

000

8,

000

9,

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10,

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Quantity

Price

Demand, Private

Benefits

Demand, Social

Benefits

Q too small

MEB

Note:

MEB is

marginal

external

benefit,

theexternal

benefit

per acre

of land in

this case


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Thus too much ag. land gets allocated to housingand commercial development rather than kept aspastureland under market allocation becauseexternal benefits are not internalized into themarket demand curve

What are some possible interventions that could

help secure the socially optimal quantity of

pastureland in a market process?


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One common government intervention is to

provide subsidies to those who provide society

with positive externalities

Williamson Act tax credits for preserving ag. land, publicfunding to acquire conservation easements

Subsidized vaccinationsOther examples?

Note that altruistic non-government groups like land trusts or

public health organizations can fulfill some of this intervention

function


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Property Rights and Externalities

Society can also decide that neighboringresidents have a property right to some of the

external benefits described previously, and thusthat landowners do not have an unlimited rightto develop their land

How does this tie in with the 5thConstitutional

Amendment concerning takings?


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One can see that the way that property

rights are allocated has a huge impact on

the way that externalities are addressedby social policy

What are the five key categories of property right

and the four ownership regimes?


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Access: Non-extractive right to enjoy benefits of

property. Authorized entrants have access

rights, such as permission to bike on timber

company roads.

Withdrawal: Right to extract or remove some or

all of the product of the property. Authorizedusers have access and withdrawal rights, such asthose with valid CA fishing licenses.


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Management: Right to regulate use (access,

withdrawal) and improvements. Claimants such

as farmers who participate in the management

of government-owned irrigation systems hold

these rights.

Exclusion: Right to exclude others from access,withdrawal, and management. Proprietors whocollectively govern common-property (ex: condoswimming pool) hold exclusion rights.


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Alienation: Right to sell (alienate) property to

someone else. Owners of cars have the right to

sell their cars to someone else.

Frequently, we hold limited property rights tomany different things. Usufructuary rights, forexample, are open-ended withdrawal rights thatmay run with the land (riparian law) or maycover treaty rights (ex: Indian fishing rights).State may be owner in public trust capacity.


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Ownership Regimes:

Private property

Common property

Government (state) property

Open access (no propertyres nullius[nullis?]


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The issue of who holds what property rightdetermines how law and public policyaddresses externalities

What is the common law, and what is it

designed to protect and enforce?

The term common law refers to the body of legal

principles which evolve through the interpretation of law byjudges, as distinct from the body of law created through

legislation. The term originally referred to the common law

of England -- general rules applicable to the whole country,

as distinct from local customs.


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The common law evolved to protect life,

property, contractual rights and

responsibilities, etc.


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Thus we might ask, did common law

adequately address + orexternalities?

Key problem: If harms are done to an open-access resource, who has legal standing to sue

under common-law, which protects property?

Moreover, even if it is clear that you were harmedby pollution to an open-access resource, it may

not be possible to assign liability to a particular

source of emissions if there are many sources.


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In a few rare cases, 19thcentury judges recognized

that water pollution impacted downstream

usufructuary rights holders. Until theMineral Kingdecision, users of open access natural resources were

not widely recognized as having the necessary legal

standing to sue. Thus common law was largely

ineffectual in protecting the environment.


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Note: Environmental regulations essentiallymake the government a proprietor of air, water,fisheries, wildlife, and other former open-access

resources in a public trust capacity.

Alternatively, land and other non-fugitive

resources can become private property and be

protected under the common law

Alternatively, many resources can become common

property and be protected under common law


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Negative Externalities

What is a negative externality?

An uncompensated cost borne by members ofsociety (or the aspects of the natural world they

care about) that comes about as a byproduct of

economic exchange, such as through market

transactions.

Examples?


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Assertion: When production of a good or

service generates significant negative

externalities, profit-maximizing firms ina competitive market will supply too

much of that good or service. Consumers

will pay a subsidized price and so willconsume too much.


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In a well-functioning competitive marketthe firms marginal cost curve is its

supply curve.

So, why should we care about all of this cost curve

analysis?

Because in an unregulated competitive marketexternal costs are not accounted for in the firms

marginal cost, which means that the firms supply

decision ignores external costs.


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Marginal social cost =

Marginal private cost (borne by the firm)

Marginal external cost (borne by the environment

and society)

+


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Thus there are two supply curves

The supply curve based on marginal private cost.

This is the supply curve that firms supply along inthe absence of environmental regulation or

reputational enforcement.

The supply curve based on marginal social cost.

This is the supply curve that reflects the full social

cost of production.


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Market Supply and Demand

0

100200

300

400

500

600

700

800

900

1,000

1,100

1,200

0

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2,

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Quantity

Price

Supply, PrivateCost

Supply, Social

CostA

B

C

D

E

F

Area ABC:

Gross gainsfrom trade to

buyers and

sellers

Area BCDE:

Total external

cost

Area ABC

Area BCDE:

True net gains

from trade to

all who are

affected

Area AFD:

Max. avail.

gains from

trade w/

Pigouvian tax


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Theory of Efficiency-Enhancing Policy

Interventions

Pigouvian (aka Pigovian) tax (named after English

economist A.C. Pigou): Tax per unit of output (e.g.,

electricity) equal to marginal external cost, with tax

revenues being used to compensate those harmedand/or fix environmental harms.


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Theory of Effic iency-Enhancing Pol icy Intervent ions

What happens if the Pigouvian tax is less than the

cost per unit of reducing emissions? Relate to

benefit/cost analysis.

What happens if the Pigouvian tax is greater thanthe cost per unit of reducing emissions? Relate to

benefit/cost analysis.

How does a Pigouvian tax (or environmental tax ingeneral) affect the market viability of less polluting

alternatives, and research and development to find

clean alternatives?


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For a Pigouvian tax to fully resolve the inefficiency

due to negative externalities, the following must

hold:

Ability to accurately measure marginal external

cost

Ability of the political system to produce anefficient environmental policy

Ability to monitor emissions, charge appropriate

tax, and enforce this system


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In Chapter 8 we will investigate political economy,

an area of study that uses economic methods to

analyze political (legislative, administrative)outcomes.

In Chapter 9 we will look at economic issues

associated with promoting compliance with

environmental and NR law.


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Pract ice Prob lem, Negative External i t ies

Demand: P = 15000.1Q

Private-cost supply: P = 100 + 0.1Q

Marginal external cost: $200

Social-cost supply: P = 300 + 0.1Q

1. Solve for equilibrium P, Q, and total gross gains from trade

assuming no regulation (use private-cost supply)

2. Solve for total external cost under #1 above

3. Solve for the true or net gains from trade under #1 above (totalgross gains from tradetotal external cost)

4. Solve for equilibrium P, Q, and total gains from trade assuming a

Pigouvian tax (use the social-cost supply). Compare with #3 above.

By how much does the Pigouvian tax enhance efficiency (net gains

from trade)?


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1. Solve for equilibrium P, Q, and total gross gains from trade

assuming no regulation (use private-cost supply)

15000.1Q = 100 + 0.1Q Q = 7000, P = $800

CS = $(1500-800)*7000/2 = $2,450,000PS = $(800-100)*7000/2 = $2,450,000

Total gross gains from trade = CS+PS = $4,900,000


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2. Solve for total external cost under #1 above

Since marginal external cost is a constant $200,

Total external cost = $200*Q = $200*7000 = $1,400,000


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Pigouvian tax (use the social-cost supply). Compare with #3 above. By

how much does the Pigouvian tax enhance efficiency (net gains from

trade)?

15000.1Q = 300 + 0.1Q Q = 6,000, P = $900

CS = $(1500-900)*6,000/2 = $1,800,000

PS = $(900-300)*6000/2 = $1,800,000

Total gains from trade = $3,600,000, which is $100,000 larger than

in the free market without the Pigouvian tax.


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Pigouvian tax (use the social-cost supply). Compare with #3 above. By

how much does the Pigouvian tax enhance efficiency (net gains from

trade)?

Also note that in the free market without the Pigouvian tax,consumers are pay a subsidized price of $800, which is $100 below

the price that is based on the full marginal social cost of production.


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Pract ice Problem , Pos it ive External i t ies

Second problem:

Suppose that supply is given by the equation p = 100 + 2q

Private-benefit demand is given by the equation p = 1000q

Social-benefit demand is given by the equation p = 2000q

1. Derive the free market equilibrium values for p and q, andcalculate gross gains from trade.

2. Calculate total external benefits under the free market equilibrium

above.

3. Calculate true net gains from trade and deadweight loss.

4. Derive the socially optimal equilibrium values for p and q,under the assumption that all externalities are internalized, and

calculate total gains from trade.

5. How much would society have to subsidize each unit of this good

in order to fully internalize the positive externality?


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Third problem:

Suppose that private-cost supply is given by the equation p =

100 + 2q

Social-cost supply is given by the equation p = 500 + 2q

Suppose that the supply curve based on the use of clean, non-polluting technology is given by the equation p = 400 + 2q

Suppose that demand is given by the equation p = 2000q.

1. What is the dollar value for marginal external cost?

2. If regulators charge firms that pollute a Pigouvian tax, whichof the supply curves above will prevail in the market? What

will be the equilibrium p and q?

3. How would this change if the supply curve based on the use

of clean, non-polluting technology was given by the equation p

600 2 ?

Introduction to Externalities

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