Public Responses to Externalities

1. Public Responses to Externalities If private responses to externalities don’t work or don’t occur, there are a variety of ways the government can intervene, including: • Taxes • Subsidies • Creating a Market (emission standards) • Regulation

2. 1) Public Response: Taxes Since actions with externalities have SMC>PMC, one way to raise PMC is through taxation -a PIGOUVIAN TAX is a per-unit tax on output equal to the marginal external cost at the efficient level of output, Q* -If administrated correctly, the can move production to the efficient level of output:

3. Pigouvian Tax $ MSC MPC+Tax MPC MEC Tax Tax Revenue Tax MB Movie Downloads Q* A per-unit tax shifts up the MPC curve by the amount of the tax.

4. Calculating an optimal Pigouvian Tax • Calculate optimal Q* • Calculate MPC(Q*) • Calculate MSC(Q*) • Tax= MSC(Q*)- MPC(Q*) • Conclude OR • Calculate optimal Q* • Tax=MEC(Q*) • Conclude

5. Numerical Example Consider a bar near a residential neighborhood on a Friday night. Every hour the bar is open past 5pm has a negative impact on the neighborhood (due to noise, etc). Calculate private production and an ideal tax based on the following:

6. Numerical Example

7. Numerical Example

8. Numerical Example An hourly tax of $8 would cause the bar to be open until the social optimum of 1 am (8 hours) instead of the private optimum of 3 am (10 hours).

9. Check:

10. Pigouvian Tax MPC+Tax=2Q+8 $ MSC=3Q MPC=2Q Tax 24 MEC=Q Tax Revenue 16 Tax MB=40-Q Bar Hours 8 The tax moves the bar from the private to the social optimum.

11. 1) Public Response: Taxes -The Pigouvian tax also yields tax revenue -It may be tempting to give this tax revenue to the victims of the externality, but this distorts the market, and encourages others to experience the negative externality in order to get the payment Pigouvian Taxes have 2 concerns: • Estimation – one needs to know the exact MEC and MPC in order to calculate the tax • Efficiency – sometimes a similar tax is more efficient (tax on cars vs. tax on kilometers), but less transparent

12. 2) Public Response: Subsidies Since actions with externalities have MSC>MPC, another way to raise PMC is through subsidy -a PIGOUVIAN SUBSIDY is a per-unit subsidy on REDUCED output equal to the marginal damage at the efficient level of output, Q* -Therefore choosing to produce has the added MPC of giving up the subsidy -If administrated correctly, the can move production to the efficient level of output:

13. Pigouvian Subsidy $ MSC MPC+Subsidy MPC MEC Subsidy Cost Subsidy MB Movie Downloads Q* Choosing to produce increases the MPC by the amount of the subsidy given up

14. 2) Public Response: Subsidies In addition to the the Pigouvian Tax issues, the Pigouvian Subsidy has 3 additional problems: • The subsidy raises profits, encouraging other firms to join the market and produce externalities • The financing of the subsidy cost often comes from additional distortionary taxation that further restricts the economy -The externality may be less costly 3) Paying a firm not to pollute is often unpopular

15. 3) Public Response: Creating a Market Another way for the government to control externalities (ie: pollution) is to sell a set supply of externality permits -A competitive auction will automatically find an equilibrium price for these permits -An EFFLUENT FEE is the price charged for the right to pollute -Note that alternately, the government could freely distribute these permits. The equilibrium price would arise from trading among firms, only equity would be affected

16. Externality Rights Market $ Selling the licences or distributing them for free and allowing trading causes the same equilibrium price. P D Movie Downloads Q* Download Licences Bigger and less efficient firms will buy more permits, while smaller and more efficient firms will buy less or none.

17. 3) Public Response: Creating a Market Like Pigouvian taxes, we need information on optimal MEC, pollution and the relation between pollution and MEC to accurately issue permits. Permits do, however, have advantages over Pigouvian taxes: • Permits directly chose the amount of pollution, instead of indirectly (and possibly incorrectly) determining it with taxes • Permit prices automatically move with inflation, whereas a tax needs to be constantly re-assessed

18. Creating a Market=Creating Market Power? In theory, one firm could over purchase permits in an attempt to keep other firms out of the market. The feasibility of such a policy is difficult to predict. If it did occur, new market power would harm efficiency.

19. 4) Public Response: Regulation The government can force a firm to produce at Q* or face legal sanctions. Unfortunately, regulation is likely to be inefficient in a market with more than one firm. -Firms have different sizes and curves -Can one production level satisfy all firms? -Can one production reduction amount satisfy all firms? -Examine the simple case where two firms (A and B) differ only in MB schedules:

20. Regulation Difficulties: $ MSC=MPC+MEC MPC MEC MBB MBA Movie Downloads B* A* A1=B1 These two firms have different optimal production, therefore cannot be given the same production goal.

21. Public Response Issues Externalities also differ across locations. A driver in the middle of the wilderness has less effect than an Edmontonian driver, who may have less effect than a driver in Toronto -should Edmontonian drivers be punished according to Toronto standards? -Differing standards increases administration costs

22. Public Response Conclusion When externalities are large, there is room for government involvement -Due to lack of information, correct involvement can be difficult -No policy is perfect

23. Public Response Issues -Typically, economic incentives (tax, subsidy, permits) to reduce pollution have the best impact, as they encourage greener practices -Efficiency typically puts taxes and permits above subsidies and regulations Preference order is often: • Creating a Market (Permits) • Taxes • Subsidies • Regulation

24. Theory - Income Distribution Effects Although government is responsible to ensure efficiency in the case of externalities, it is also responsible to take into account the distribution effects of its policies In short, when dealing with externalities the government has to ask: • Who benefits? • Who bears the cost

25. 1) Who Benefits? If dealing with externalities favors the rich over the poor, the policy has distribution issues. Examples: -If poorer areas are more polluted that rich areas, reducing pollution (an externality) has a good distributional effect -If richer people care more about the externality than poorer people (ie: litter in national parks, noise pollution), removing the externality has a bad distributional effect

26. 2) Who Bears the Cost? For negative externalities, the optimal output is LOWER Lower output => more unemployment and reduced wages, generally landing on low-income households As seen in the previous graphs, forcing firms to realize MSC increases prices, which can be bad if the good is more used by lower-incomes ie: Is regulating a Kraft Dinner factory good if the price of Kraft Dinner doubles?

27. 2) Who Bears the Cost? Some studies have shown pollution control to have bad distributional (regressive) effects: -Hamilton and Cameron (1994) conclude that a carbon tax would reduce the lowest 20% of incomes by 3.4% and the highest 20% of incomes by only 2.7% -Many energy taxes in US and Europe have regressive impacts -One must also consider equity across locations -Toronto may favor an oil tax, but Edmonton would be more in favor of a big city tax

28. Theory - Positive Externalities An POSITIVE EXTERNALITY occurs when: 1) The activity of one agent directly BENEFITS another agent And 2) This affect is not transmitted by market prices Examples: -Getting the flu shot prevents others from getting sick -Writing your exam version on your exam speeds up marking, so everyone gets their exams back faster

29. Theory - Positive Externalities Although negative externalities are most often discussed, positive externalities can also lead to inefficiency -When an economic activity has an Marginal External Benefit (MEB), it causes the Marginal Social Benefit (MSB) to be greater than the Marginal Private Benefit (MPB), causing underproduction:

30. Positive Externality: $ MC=Supply MSB=MPB+MEB MPB MEB Security Q1 Q* With a positive externality, an product is underconsumed.

31. Graphical Example Assume family flu shots are available at the local medical center in a small town. Let: MC=50+Q MPB=350-Q MEB=200-Q Therefore: MSB=MPB+MEB MSB=350-Q+200-Q MSB=550-2Q

32. Graphical Example MEB=200-Q MSB=550-2Q MPB=350-Q MC=50+Q Individual: MPB=MC 350-Q=50+Q 300=2Q 150=Q1 P1=50+Q P1=50+150 P1=200 Society: MSB=MC 550-2Q=50+Q 500=3Q 167=Q* P*=50+Q P*=50+167 P*=217

33. Positive Externality: $ MC=50+Q 217 200 MSB=550-2Q MEB=200-Q MPB=350-Q Security 150 167 With a positive externality, an product is underconsumed.

34. Positive Externalities This positive externality activity can be made efficient by using a Pigouvian subsidy: This has three issues: • The amount of the subsidy is difficult to measure • Funding the subsidy redistributes taxes from taxpayers to the recipients • The benefits of the externality may be regressive, (such as funding liposuction research benefiting the rich over the poor)

35. Positive Externality: $ SMB=PMB+EMB MC MC-Subsidy Subsidy PMB EMB Security Q1 Q* The subsidy is related to the external marginal benefit.

36. Calculating an optimal Pigouvian Subsidy • Calculate optimal Q* • Calculate MC(Q*) • Calculate PMB(Q*) • Tax= MC(Q*)- PMB(Q*) • Conclude OR • Calculate optimal Q* • Subsidy=MEB(Q*) • Conclude

37. Graphical Example MEB=200-Q MSB=550-2Q MPB=350-Q MC=50+Q 1) Calculate Q* MSB=MC 550-2Q=50+Q 500=3Q 167=Q* 2) Subsidy =MEB(Q*) MEB(Q*) = 200-167 MEB(Q*) = 33

38. Check MEB=200-Q MSB=550-2Q MPB=350-Q MC=50+Q SUBSIDY=$33 New Equilibrium: MPB=MC-Subsidy 350-Q=50+Q-33 333=2Q 167=Q1 Society: P1=50+Q-33 P1=50+167-33 P1=184 A $33 subsidy causes the optimal number of family flu vaccines (167) to be purchased at a lower price ($184 per family).

39. Positive Externality: $ SMB=PMB+EMB MC MC-33 250 200 Subsidy 187 PMB EMB Security 150 167 With a subsidy, equilibrium quantity is increased.

40. Original Surplus and Benefits $ SMB=PMB+EMB MC Externality Benefit MC Consumer Surplus Subsidy Producer Surplus PMB EMB Security 150 167 Externality benefits exist regardless of Q

41. Consumer Surplus with Subsidy $ SMB=PMB+EMB MC MC Consumer Surplus Subsidy PMB EMB Security 150 167 Consumer Surplus Increases

42. Producer Surplus with Subsidy $ SMB=PMB+EMB MC MC Subsidy Producer Surplus PMB EMB Security 150 167 Producer Surplus Increases

43. Externality Benefit with Subsidy $ SMB=PMB+EMB MC Externality Benefit MC Subsidy PMB EMB Security 150 167 Externality Benefits Increase

44. Cost of Subsidy $ SMB=PMB+EMB MC MC Gov. Subsidy Cost Subsidy PMB EMB Security 150 167 The Subsidy Has a Large Cost

45. Net Subsidy Benefit $ SMB=PMB+EMB MC MC Gov. Subsidy Cost Subsidy PMB EMB Security 150 167 There is a net benefit

46. Positive Externalities Finally, note that just because an activity is beneficial does not mean it has a positive externality -Not all good activities need be subsidized Examples: -Many great workers (surgeons, firemen, kind insurance adjusters, emergency plumbers) are already compensated through a high wage (Econ profs aren’t, so please petition your government for Econ prof subsidies)