Externalities

1. Externalities Today: The fundamentals of externality theory

2. Externalities • Markets are well functioning for most private goods • Many buyers and sellers • Little or no market power by anybody • Example: When demand shifts right for a good, new equilibrium will have higher price and quantity • Some markets do not have good mechanisms to account for everything in a market • Example: Talking on a cell phone in an airplane

3. Externalities • Externalities are effects that are not incorporated into market quantities and prices • R/G (p.73) define an externality as “an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism” • When markets have externalities, they are typically not efficient • This is the topic of Chapter 5

4. Public good versus externality • Although public goods are often looked at as goods with externalities, we study the two topics separately • Know which analysis applies when you solve a problem

5. Negative externalities • Some examples of negative externalities • Air pollution • Water pollution • Sometimes you do not even think about polluting the water: Washing a car in your driveway • Noise pollution • Highway congestion • Standing at a concert or sporting event

6. Positive externalities • Some externalities are benefits • Planting flowers in your front lawn • Scientific research • Vaccination • Prevents others from getting a disease from you • Exercise? • Yes, if it leads to lower health care insurance premiums for others • More on the private health care market in Chapter 9

7. More externalities: Benefit or cost? • Christmas decorations • Enjoyment or nuisance? • A fan blowing in a warm office building • Cooling breeze or blowing your important papers? • Use of perfume or cologne • Nice smell or allergen?

8. A simple example with externalities • Suppose private MC equals quantity • MPC = Q • Let demand be denoted by P = 100 – Q • Let marginal damage be $10 per unit

9. A simple example with externalities • Translate equations and external cost to our graphical example MSC = Q + 10 MPC = Q marginal damage per unit of $10 P = 100 – Q

10. A simple example: Private equilibrium • Inefficient equilibrium w/o controls: Set Q = 100 – Q  Q = 50 (quantity F) MPC = Q P = 100 – Q

11. A simple example: Optimal equilibrium MSC = Q + 10 P = 100 – Q • Socially optimal quantity • Q + 10 = 100 – Q  Q = 45 (quantity E)

12. An algebraic example: Price • Inefficient equilibrium, P = Q  P = 50 • Socially optimal quantity, P = Q + 10  P = 55 MSC = Q + 10 MPC = Q Price B = 55 marginal damage per unit of $10 Price C = 50 P = 100 – Q Recall E = 45 and F = 50

13. 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

14. Next… • A more general analysis of externalities • External cost per unit does not have to be constant

15. Graphical analysis of externalities MSC = MPC + MD $ MPC h d g c MD f b MB a e 0 Q* Q1 Q per year Socially efficient output Actual output

16. Graphical analysis of externalities Producer surplus lost going from Q1 to Q*

17. Graphical analysis of externalities Consumer surplus gained going from Q1 to Q*

18. Graphical analysis of externalities Net social gain going from Q1 to Q*

19. Graphical analysis of externalities This is also the deadweight loss (or excess burden) when Q1 is produced

20. 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

21. 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

22. 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

23. The externalities of smoking • Increased health care costs • Affects others through increased health care insurance premiums • Lower workplace productivity due to smoking • Lowers non-smoker wages also if firms cannot discriminate against smokers • Increased fires • Additional fire fighting cost on society • The death benefit: A positive externality • Secondhand smoke

24. The externalities of smoking • All together, the externalities due to smoking lead to a net cost on society • Empirical estimates lead to a total cost that is probably somewhere between $0.50-$1.50 per pack • Estimates can vary depending on factors such as discount rate, assumptions in a model, and value of life • Current cigarette taxes in the US average about $2 per pack

25. Why don’t we just negotiate? • 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

26. 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

27. 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)

28. Bargaining and the Coase Theorem MB exceeds MPC in this range  Production will be Q1 without negotiation MSC = MPC + MD $ MPC h d g c MD MB 0 Q* Q1 Q per year

29. Bargaining and the Coase Theorem MSC exceeds MB here  With costless bargaining, consumers will pay to reduce production from Q1 to Q* MSC = MPC + MD $ MPC h d g c MD MB 0 Q* Q1 Q per year

30. 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

31. 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

32. 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)

33. Pigouvian taxes in action MSC = MPC + MD $ (MPC + cd) Pigouviantax revenues MPC d i j c MD MB 0 Q* Q1 Q per year

34. 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

35. Emissions fee in action $ MC of abatement f* MSB of abatement 0 e* Abatement quantity

36. 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?

37. Subsidies in action MSC = MPC + MD $ (MPC + cd) MPC Pigouviansubsidy d k i f g j h c MD MB e 0 Q* Q1 Q per year

38. 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

39. 50 50 75 75 90 90 Uniform pollution reductions MC is for abatement on these graphs Total abatement costs are in red for each firm MCH $ $ MCB 25 Bart’spollutionreduction Homer’spollutionreduction

40. Inefficiencies of uniform reductions Notice that MC of Homer’s last unit of abatement is higher than Bart’s $ $

41. Inefficiencies of uniform reductions Notice that MC of Homer’s last unit of abatement is higher than Bart’s  D’oh $ $

42. Inefficiencies of uniform reductions Overall abatement costs can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit $ $

43. 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

44. 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

45. 50 50 75 75 90 90 Emissions fees MC is for abatement on these graphs MCH Bart’s TaxPayment Homer’s TaxPayment MCB f = $50 f = $50 25 Bart’spollutionreduction Homer’spollutionreduction

46. 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

47. 50 50 75 75 90 90 Cap-and-trade Bart and Homer will negotiate until they agree on a $50 price for permits Suppose Bart starts with 80 permits and Homer starts with none (see points a and b) MCH b MCB f = $50 f = $50 a 10 25 Bart’spollutionreduction Homer’spollutionreduction Bart sells 65 permits Homer buys 65 permits

48. 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

49. 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

50. In a perfect world… • …we would know everything with certainty • The real world is not perfect • How does this complicate our analysis?