Externalities: Market Failures and Public Policies

1. Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 10: Externalities M. Cary LeaheyManhattan CollegeFall 2012

2. Goals • This is (yet) another applications chapter looking at international trade. • This chapter reviews many of the concepts introduced in earlier classes, particularly the tradeoff between efficiency and equity. • We look at externalities and why they can make market outcomes inefficient (market “failures”). • We look at why private solutions may solve or not solve the problem, whether “internalizing the externality” can work. • We examine the kinds of public policies to solve the problem of externalities.

3. Defining one kind of market failure-externalities The competitive market outcome is efficient and maximizes total surplus, except when there are market failures. One kind of market failure is externalities, which is the uncompensated impact of one person’s action on another’s well-being. Externalities need not be solely negative, a bystander’s well-being could be enhanced by another's action. Some examples of externalities: Pollution Noise Driving and texting Flu shots (and the case for govt. subsidies) 3

4. Example 1: negative externality, gasoline The market for gasoline P $ 5 4 3 $2.50 2 1 0 Q(gallons) 25 0 10 20 30 The market eq. maximizes consumer + producer surplus. Supply curve shows private cost, the costs directly incurred by sellers. Demand curve shows private value, the value to buyers (the prices they are willing to pay).

5. Example 1: negative externality, gasoline The market for gasoline P $ 5 external cost 4 3 2 1 0 Q(gallons) 0 10 20 30 Social cost= private + external cost Supply (private cost) External cost = value of the negative impact on bystanders = $1 per gallon(value of harm from smog, greenhouse gases)

6. Example 1: negative externality, gasoline The market for gasoline P $ 5 4 3 2 1 0 Q(gallons) 0 10 20 30 The socially optimal quantity is 20 gallons. Social cost S At any Q < 20, value of additional gas exceeds social cost. At any Q > 20, social cost of the last gallon isgreater than its value to society. D 25

7. Example 1: negative externality, gasoline The market for gasoline P $ 5 4 3 2 1 0 Q(gallons) 0 10 20 30 Market eq. (Q = 25) is greater than social optimum (Q = 20). Social cost S One solution: tax sellers $1/gallon, would shift S curve up $1. D 25

8. Internalizing the externality Internalizing the externality means changing incentives to make people take accounts of the external effects of their actions. So not just market costs but “all” costs of actions are incorporated. In the gasoline example, the tax makes the market cost equal the social cost of gasoline consumption. The social optimum is when social costs are fully paid so market equilibrium = social optimum The socially optimal Q quantity maximizes social welfare. At a lower Q, the social value of additional units > social cost At a higher Q, the social value of additional units < social cost. 8

9. Example 2: positive externality, flu shots P 50 $ external benefit 40 30 20 10 Q 0 0 10 20 30 25 External benefit = $10/shot Socially optimal Q = 25 shots. To internalize the externality, use subsidy = $10/shot. The market for flu shots S Social value = private value + $10 external benefit D

10. Summary of effects of externalities Negative externality: market Q larger than socially desirable Q Positive externality: market Q less than socially desirable Q To remedy the problem, internalize the externality Tax goods with negative externalities Subsidize goods with positive externalities. 10

11. Public policies regarding externalities Two approaches have been adopted. Command and control Relegate behavior directly to “guarantee” the desired outcome. Limits on quantity of pollution Require adoption of specific technologies to solve the problem Market based policies Private sector solves problem on its own Corrective taxes/subsidies Tradable pollution permits Pay to pollute seems immoral to some. 11

12. Public policies regarding externalities: corrective taxes Corrective tax also called Pigovian taxes designed to make private decision makers take full account of the social costs that arise from a negative externality. Ideal corrective tax equals the external cost A corrective subsidy deals with positive externalities Ideal corrective subsidy equals external benefit. While other taxes and subsidies distort incentives, thereby moving outcomes away from the market ideal, corrective taxes and subsidies move market outcomes closer. They align social interests and private incentives and move the economy toward a more efficient allocation of resources. 12

13. Corrective taxes versus regulations; which is better? Corrective taxes promote the most efficient outcome to dealing with externalities of production. Different firms have different costs. The efficient outcome has firms with the lowest abatement costs reducing pollution the most. In the case pollution, a tax is efficient. Efficient firms (with low abatement costs) will reduce pollution to reduce their tax burden. Ineffecient firms (with high abatement costs) have a greater willingess to pay tax. In contrast, a regulation may mandate the socially desirable outcome but at a higher cost (ineffecient) since all firms are reuired to cut emissions. So the inefficient firms have to devote more resources to cleanup, which is inefficient. 13

14. Corrective taxes versus regulations; which is better? Corrective taxes are better for the environment They gives firms incentives to continuer educing pollution as long as the cost is less than the tax. Technological improvements are more likely to be adopted, since the tax gives them an incentive to adopt them. In the regulatory world, firms have no incentives go beyond the mandate. For example a gasoline tax attacks three negative externalities: Congestion – reducing “unneeded” driving Accidents – increasing demand for smaller vehicles (less damage) Pollution – reducing emissions by reducing consumption 14

15. Example 3: reducing greenhouse gases • Acme and US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month, total emissions = 80 tons/month. • Goal: Reduce SO2 emissions 25%, to 60 tons/month • Cost of reducing emissions: $100/ton for Acme, $200/ton for USE Policy option 1: RegulationEvery firm must cut its emissions 25% (10 tons). Cost to Acme: (10 tons) x ($100/ton) = $1000 Cost to USE: (10 tons) x ($200/ton) = $2000

16. Example 3: reducing greenhouse gases • Policy option 2: Tradable pollution permits • Issue 60 permits, each allows one ton SO2 emissions. Give 30 permits to each firm. Establish market for trading permits. • Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons. Compute cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each. Acme • sells 10 permits to USE for $150 each, gets $1500 • uses 20 permits, emits 20 tons SO2 • spends $2000 to reduce emissions by 20 tons • net cost to Acme: $2000 − $1500 = $500

17. Example 3: reducing greenhouse gases • Policy option 2: Tradable pollution permits USE • buys 10 permits from Acme, spends $1500 • uses these 10 plus original 30 permits, emits 40 tons • spends nothing on abatement • net cost to USE = $1500 Total cost of achieving goal = $500 + $1500 = $2000 Using tradable permits, goal is achieved at lower total cost and lower cost to each firm than using regulation. Pollution reduction is concentrated in the firms with the lowest abatement costs, promoting an efficient outcome. In the real world this has been going on since 1995 in the US.

18. Corrective taxes/tradable permits and morality In the pollution case, the demand for pollution has a downward slope, as the price of polluting declines, Q polluted goes up. Corrective taxes raise the price of polluting to reduce emissions (Q). Tradable permits restricts the supply of pollution rights and has the same effect as the tax. Tradable permits are to be preferred if policymakers do not know the demand curve for polluting very precisely. The position argues that it is immoral to pay to pollute but life involves tradeoffs-the value versus the cost of clean water. While moral solution can help internalize the externality, the Coase theorem argues that if parties can “costlessly bargain,” then the externality problem can be solved on its own. Example: cleaning dirty clothes-does the polluter or pollutee pay. In real life, transactions costs, stubbornness, and coordination problem can stymie private solutions, making the Coase theorem a nice academic discussion point but little more. 18