Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 5 : Externalities and Public Policy (Contd…)

Public Finance

4- Property rights & Coase theorem

• Property rights of some resource users are not identified.

• Government can change property rights• Example: Pollution of a stream• Small-number externalities• Parties: Emitters & Receptors

4- Property rights & Coase theorem

• The theorem• An example• The significance of Coase Theorem• Application : Pollution rights

Coase's Theorem

• By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.

An example. Figure 3.7 Coase’s Theorem

B A

MCW MC*

W

MPCB + MEC = MSC

MPCB

Pri

ce o

f B

eef

(Do

llar

s)

Pri

ce o

f W

hea

t (D

oll

ars)

Wheat Output per Year

PW

Q* W QW1

Beef Output per Year Q*

B QB1

PB

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. –Plight of American Farmer

• Agriculture Run-off–Problem of Urban Flooding

• New land development

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.

Figure 3.8 Pollution Rights and Emissions

S = Supply of Pollution Rights

D = MSB of Emitting Wastes

Pri

ce

an

d M

arg

ina

l So

cia

l Be

ne

fit

Tons of Annual Emissions and Number of Pollution Rights

0

$20

75,000 100,000

Figure 3.9 The Efficient Amount of Pollution Abatement

E

MSB

MSC M

arg

ina

l So

cia

l Co

st

an

d B

en

efi

t

Percent Reduction in Wastes Emitted per Year 0 A* 100

6- Regulatory Solutions

• Instead of using market forces to cause firms to internalize externalities we can use emission standards and apply these to all.

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

DQRB

DQRA

G

H

0 QR

10

Firm A

10 Co

st a

nd

Ben

efit

(D

oll

ars)

Firm B

Q* A

Q* B

QB1

QA1

Tons of Emissions per Year

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

DQRD

DQRC

Firm C

Tons of Emissions per Year

Firm D

20

Q* C

QR

Q* D

QRC

ost

an

d B

enef

it (

Do

llar

s)

Theory in Practice

• Command and control Policies– Environmental Production Agency (EPA)– Discourages Innovation– Administrative Burden

• Markets for Pollution Rights– Clean Air Act of 1990 tradable on Chicago

Board of Exchange• Tradable Emission Permits (Allowances)

– Option of cleaner burning fuels or Scrubbers

Theory in Practice

• Cap & Trade Policies• Emission Offset Policy• Bubble Scheme• Banking of Emission Reduction

– Self use– Sell to other firms

Global Externalities

• CFC’s• Deforestation• Global Warming