The economics of externalities

Today: Graphical analysis Private responses Public responses

Today

More on the externality problem Marginal damage will

not be constant Private responses

The Coase Theorem Mergers Social conventions

Public responses Taxes Subsidies Command-and-

control Cap-and-trade

programs

The externality problem

With externalities, quantity produced is typically not optimal

Finding optimal quantity when marginal damage is not constant

Deadweight loss of inefficient production

Graphical analysis of externalities

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

Actual outputSocially efficient output

ab

c

d

f

e

g

h

Graphical analysis of externalities

Producer surplus lost going from Q1 to Q*

Graphical analysis of externalities

Consumer surplus gained going from Q1 to Q*

Graphical analysis of externalities

Net social gain going from Q1 to Q*

Pollution

Pollution is one of the biggest negative externalities around

Multiple steps needed to try to find optimal amount of pollution Which pollutants actually do damage? Are there pollutants that indirectly cause damage?

Example: CFCs on the ozone layer How do we value the damage done?

Very difficult to do, due to lack of markets

Pollution and empirical studies Empirical studies have been done to try to

determine the damages caused by pollution Remember from Chapter 2 that we need to

use events that prevent bias

Pollution and empirical studies Chay and Greenstone (2003, 2005)

Pollution on health 1 percent reduction in total suspended particulates

resulted in a 0.35 percent reduction in infant mortality rate

Pollution on housing prices Improved air quality between 1970 and 1980 in pollution-

regulated cities led to property value increases of $45 billion

Costly negotiation

Negotiation is typically costly Remember, time is worth something

Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

Coase theorem

The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur People can negotiate costlessly The right can be purchased and sold

Property rights

Given the above conditions, efficient solutions can be negotiated

Ronald Coase

Coase theorem

Notice that the Coase theorem addresses efficiency

To get to efficiency, the quantity of most goods and services produced is still positive Example: It is not efficient to get rid of all pollution

If all pollution was gone, we could not live (since we exhale CO2)

Bargaining and the Coase Theorem

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

dg

h

MB exceeds MPC in this range Production will be Q1 without negotiation

Bargaining and the Coase Theorem

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

dg

h

MSC exceeds MB here With costless bargaining, consumers will pay to reduce production from Q1 to Q*

Other private responses to externalities Mergers

When negative externalities only affect other firms, two firms can merge to internalize the externalities

Social convention Social pressure to be nice can lower the amount

of certain negative externalities

Public responses to externalities Four public responses

Taxes Also known as emissions fee in markets with pollution

Subsidies Command-and-control

Government dictates standards without regard to cost Cap-and-trade policies

Also known as a permit system

Taxes

With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss Quantity is below the optimal amount with taxes

With negative externalities, taxes can improve efficiency The optimal tax is known as the Pigouvian tax

Pigouvian tax equals marginal damage at the efficient output Increased Pigouvian taxes can also lead to lower income

taxes without sacrificing overall tax revenue Double dividend hypothesis (More in Chapter 15)

Pigouvian taxes in action

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

Pigouviantax revenues

i

j

Emissions fee

One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output This kind of tax is known as an emissions fee

Emissions fee in action

0Abatement quantity

MSB of abatement

MC of abatement

e*

f*

$

Subsidies

An alternative to taxes is providing a subsidy to each firm for every unit that it abates

Problems with subsidies: Efficient outcome only with a fixed number of firms

Increased profits of firms in the industry will encourage new entrants into the industry Positive economic profits if new entry is not allowed

Revenue is needed to provide subsidies Taxing income reduces inefficiencies

Ethical issues: Who has the right to pollute?

Subsidies in action

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

i

jgk

h

f

e

Pigouviansubsidy

Command-and-control pollution reduction Two firms

Each would pollute 90 units if there are no pollution controls

Suppose each firm was forced to reduce pollution by 50 units Known as uniform pollution reduction Usually not efficient

Uniform pollution reductions

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

MC is for abatement on these graphs

Total abatement costs are in red for each firm

$ $

Inefficiencies of uniform reductions

Notice that MC of Homer’s last unit of abatement is higher than Bart’s D’oh

$ $

Inefficiencies of uniform reductionsOverall abatement costs

can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit

$ $

Command-and-control regulation Command-and-control regulations can take many

forms Uniform reductions Percentage reductions Technology standards

Each firm must use a certain type of technology This method may work best when emissions cannot be

monitored easily Performance standards

Government sets emissions goal for each polluter Firm can use any technology it wants Less expensive than technology standards

Lowering abatement costs

Going from command-and-control requirements to emissions fees can lower overall abatement costs

Marginal cost of abatement of the last unit is equal for each firm with an emissions fee

Emissions fees

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

Bart’s TaxPayment Homer’s Tax

Payment

MC is for abatement on these graphs

Cap-and-trade policies

Policy in which a permit is needed for each unit of pollution emitted

Permits can be traded Policy is efficient if

Bargaining costs are negligible Competitive permit markets exist Number of permits matches efficient pollution level

Initial allocation of permits does not affect efficiency as long as the above criteria are met

Cap-and-trade

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

10

a

b

Suppose Bart starts with 80 permits and Homer starts with none (see points a and b)

Bart and Homer will negotiate until they agree on a $50 price for permits

Bart sells 65 permits Homer buys 65 permits

Emissions fee versus cap-and-trade Given certain conditions,

we notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency $50 fee for each unit polluted

(implicit fee under permits) Bart reduces pollution by 75

units Homer reduces pollution by 25

units

The real world is more complicated We do not live in a world with perfect

economic assumptions Complicating factors

Inflation Cost changes Uncertainty Distributional effects

Inflation

If emissions fees do not represent real prices, the amount of pollution will change as real price changes

Cap-and-trade policies do not need inflation factored in, since quantity limits are used

Cost changes

Suppose cost to abate decreases every year Optimal amount of abatement will increase each

year If a new abatement technology is just being

developed, future cost changes could be small or large Potential solution: Impose a hybrid system

Permit market Offer a high tax for pollution emitted without a permit

Uncertainty

Costs and benefits are typically not known with certainty With uncertainty, too much or too little pollution

can be produced (relative to the efficient outcome) Two situations analyzed, with MC curve

uncertain Inelastic MSB Elastic MSB

Inelastic MSB curve

0Pollution reduction

MSB

MC*

e*

f*

$

MC’

ef e’

Too much pollution reduction with permitsToo little pollution reduction with fees

Assume best guess of marginal cost schedule is MC*

Marginal cost schedule could be as high as MC’

Permits are closer to efficient than fees in this case

Elastic MSB curve

0Pollution reduction

MC*

e*

f*

$

MC’

ef e’

MSB

Too much pollution reduction with permitsToo little pollution reduction with fees

Fees are closer to efficient than permits in this case

Distributional effects

Firms… Lose when they pay a tax Win when they are given permits

Government can generate revenue… If a tax is imposed If permits are sold

Double dividend hypothesis supports taxes or selling permits

Political pressure may encourage permit giveaways

Distributional effects

Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods

Displacement concerns Job losses from environmental regulation: Does

this increase income inequity? Who bears the cost of pollution control?

Depends on who uses the good that has the pollution control Example: Cars that are 15 or more years old

Externalities can be positive

Remember that not all externalities are negative

Some consumption leads to external benefits to others

Recall some examples Planting flowers in your front lawn Scientific research Vaccination

Prevents others from getting a disease from you

Positive externalities and subsidies Subsidies can be used to increase efficiency

in the presence of positive externalities Note that this money must be generated from

somewhere, probably taxes Recall that tax money used for subsidies has its

own deadweight loss Compare DWL with efficiency gains from the subsidy

Positive externality example

Researchper year

$

MPB

MC

MEB

MSB = MPB + MEB

R*R1

In what direction are we heading? Command-and-control policies often rely on

states to enforce States do not always comply with these measures Fees and permits can often be controlled on the

national level US policies have generally moved from

command-and-control to taxes and permits Exceptions do still apply: Emissions hot spots

Summary

Many methods are used to try to increase efficiency when externalities are present Negotiation Mergers between firms Social conventions Taxes, including emissions fees Subsidies Command-and-control policies Cap-and-trade programs using marketable

permits

Summary

Distributional concerns are important for someone that thinks that social welfare is important Who benefits and loses from taxes versus

permits? Firms? The government?

Who benefits most when pollution is abated High-income more than low-income?