MODULE 39 (75) Externalities and Public Policy

2. MODULE 39 (75)Externalities and Public Policy

3. How external benefits and costs cause inefficiency in the markets for goods • Why some government policies to deal with externalities, such as emissions taxes, tradable permits, or Pigouvian subsidies, are efficient, although others, like environmental standards, are inefficient

4. Policies Toward Pollution • Environmental standards are rules that protect the environment by specifying actions by producers and consumers. Generally such standards are inefficient because they are inflexible. • An emissions tax is a tax that depends on the amount of pollution a firm produces.

5. Policies Toward Pollution

6. Environmental Standards Versus Emissions Taxes (a) Environmental Standard (b) Emissions Taxes Marginal benefit to individual polluter Marginal benefit to individual polluter MB MB $600 $600 B B S MB MB B A A 300 T T A B 200 S A 150 Emissions tax Quantity of pollution emissions (tons) Quantity of pollution emissions (tons) 0 300 600 0 200 400 600 Environmental standards forces both plants to cut emission by half Without government action, each plant emits 600 tons. Plant B has a higher marginal benefit of pollution and reduces emissions by only 200 tons Plant A has a lower marginal benefit of pollution and reduces emissions by 400 tons

7. Policies Toward Pollution • When the quantity of pollution emitted can be directly observed and controlled, environmental goals can be achieved efficiently in two ways: emissions taxes and tradable emissions permits. • These methods are efficient because they are flexible, allocating more pollution reduction to those who can do it more cheaply.

8. Policies Toward Pollution • Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. • Taxes designed to reduce external costs are known as Pigouvian taxes.

9. Policies Toward Pollution • An emissions tax is a form of Pigouvian tax, a tax designed to reduce external costs. • The optimal Pigouvian tax is equal to the marginal social cost of pollution at the socially optimal quantity of pollution.

10. Cap and Trade • The tradable emissions permit systems for acid rain in the US and greenhouse gases in the European Union are examples of cap and trade programs. • In cap and trade, the government: • sets a cap. • issues tradable emissions permits. • enforces a yearly rule that a polluter must hold a number of permits equal to the amount of pollution emitted. • Cap and trade doesn’t work for localized pollution. • Policy makers can face pressure from industry. • Cap and trade requires vigilant monitoring.

11. Production, Consumption, and Externalities • When there are external costs, the marginal social cost of a good or activity exceeds the industry’s marginal cost of producing the good. • In the absence of government intervention, the industry typically produces too much of the good. • The socially optimal quantity can be achieved by an optimal Pigouvian tax, equal to the marginal external cost, or by a system of tradable production permits.

12. Positive Externalities and Consumption (a) Positive Externality (b) Optimal Pigouvian Subsidy Price, marginal social benefit of flu shot Price of flu shot Marginal external benefit S S Price to producers after subsidy P MSB O O P OPT Optimal Pigouvian subsidy P E E MKT MKT MKT MSB of flu shots Price to consumers after subsidy D D Q Q Q Q Quantity of flu shots Quantity of flu shots MKT OPT MKT OPT

13. Private Versus Social Benefits • The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to consumers plus its marginal external benefit. MSB = MPB + MEB

14. Private Versus Social Benefits • A Pigouvian subsidy is a payment designed to encourage activities that yield external benefits. • A technology spillover is an external benefit that results when knowledge spreads among individuals and firms. • The socially optimal quantity can be achieved by an optimal Pigouvian subsidy equal to the marginal external benefit.

15. Private Versus Social Costs • The marginal social cost of a good or activity is equal to the marginal cost of production plus its marginal external cost. MSC = MPC + MEC

16. P MSC P OPT Negative Externalities and Production (a) Negative Externality (b) Optimal Pigouvian Subsidy Price of livestock Price, marginal social cost of livestock Marginal external cost MSC of livestock Price to consumers after tax S S O O Optimal Pigouvian subsidy P E E MKT MKT MKT Price to producers after tax D D Quantity of livestock Quantity of livestock Q Q Q Q OPT OPT MKT MKT

17. Network Externalities • Any way in which another people’s consumption of a good increases your own marginal benefit from consumption of that good can give rise to network effects. • e.g. computer operating systems like Windows.

18. When a good or activity yields external benefits, such astechnology spillovers,the marginal social benefit ofthe good or activity is equal to the marginal benefitaccruing to consumers plus its marginal external benefit. • Without government intervention, the market producestoo little of the good or activity. • An optimal Pigouviansubsidy to producers, equal to the marginal externalbenefit, moves the market to the socially optimal quantityof production. • When there are externalcosts from production, the marginal social cost of agood or activity exceeds its marginal cost to producers,the difference being the marginal external cost.

19. Withoutgovernment action, the market produces too much of thegood or activity. • The optimal Pigouvian tax on productionof the good or activity is equal to its marginal externalcost, yielding lower output and a higher price to consumers. • A system of tradable production permits for the right to produce the good or activity can also achieve efficiency at minimum cost. • Network externalitiesarise when the value of the good to an individualis greater when a large number of people use the good.