Chapter 5: Externality policies

1. Chapter 5: Externality policies • Consumption Externalities • Regulating monopolies and middlemen • Positive externalities • Education and direct control • Externalities from Cigarette Smoking • The Economics of Illicit Drugs

2. Production Externalities:Example • Inverse demand (D) = Marginal Benefit (MB)= a - bQ • Marginal private cost (MPC)=C(Q) = c + dQ • Marginal externality cost (MEC) = e + fQ • Marginal social cost (MSC) = MPC + MEC = c + dQ + e + fQ = c + e + (d + f)Q

3. Outcomes: alternative institutions

4. Monopoly is polluting excessively High MSC Low MSC=small MEC High MSC=large MEC Unregulated competition=Qc Monopoly=Qm $ A MR Low MSC MPC B D Qc Q* High Qm Q*low Q

5. Regulating the monopoly- High MSC case Move to Q* where MB=MSC Using a tax,subsidy or standard The tax =MR-MPC at Q* High MSC $ A MR Low MSC TAX MPC B D Qc Q* High Qm Q*low Q

6. Regulating the monopoly- LOWMSC CASE Move to Q* where MB=MSC Using upper bound on price, or a standard The upper bound price is P* Minimum Quantity Q*low High MSC $ MR Low MSC P* MPC B D Qc Q* High Qm Q*low Q

7. Optimal policy: monopoly • If Q*<Qm monopoly is over polluting Regulation:Tax, subsidy,standard The tax=MR-MPC a-2bQ*-(c+dQ*) (2b+d)(a-c-e) MR minus MPC at Q* (a-c)- ------------------ (b+d+f) MSC D MPC TAX MR Qm Q*

8. Example-old numbers- Monopoly • if a=20,b=2,c=4,d=2,e=2 f=.5 • Qm=3.2<Q*=4 under production • intervention p=12 • Price is reduced from 13.60 to 12 • If f=3 Qm=3.20 > Q*=2.33 • Over production by monopoly A tax of 4.33 will lead the monopoly to reach optimal outcome (20-4-2.33*(2*2+1)-4.33=0)

9. Intervention for middle men IF middle men produces less than optimal • set upper bound on consumer price to be P* If Middle men produces more than optimal output: • set a tax MR-MO at Q* in case of example it is 2.00. • To check if that will lead to optimal Q with middle men • MR will be 20-2*2*Q-2 • MO will be 4+2*Q • Solution will be where 20-4-2-(4+2)Q=14-6Q • Q=Q*=2.33

10. Positive Externalities • We now turn to positiveexternalities. • Consumers benefit from conservation activities of producers-they generate environmental services

11. Positive externalities • MPC=Marginal privatel cost of production (0 production externality) • MPBcons=Marginal Private Benefit = Individual Demand • MSBcons=Marginal Social Benefit = MPBcons + MECbenefits • Socially optimal outcome = Q*, P*, • Inefficient outcome under unregulated competition=Qc,Pc $ MPC P*+subsidy Pc MSB cons P* MPB cons Qc Q * Q

12. Positive externalityCase with a=20,b=2,c=4,d=1 ,e=-2 f=-1 • Competition Pm=9.33,Qm=5.33 • CS=28.44,PS=14.22,ES=24.89,SS=67.56 • Optimal Q*=9 Sub=11 • Consumer price P*=2.0 Producer price=13 • CS=9*(20-2)/2=81 • PS=9*((11+2)-(4+13)/2)=40.5 • ES=9*(2+11)/2=58.5 • Government expense=9*11=99 • Social welfare=81+99-99=81

13. Positive Basic principle- beneficiary pays -subsidy If government does not pay subsidy- private parties may Negative Basic principle-polluter pay-pollution tax Subsidy liked by industry Tradable permits leads to compromise Positive vs negative externality

14. Policy tools • Incentives ( taxes, subsidies) • Cap and trade • Direct controls • Property rights • Voluntary agreements • Education

15. Voluntary agreement • Government or NGO reach an agreement with a polluter to reduce pollution. • It can be motivated by need to project a “green image” • It may occur when government does not have sufficient power to control gains

16. Education& communication • Education can inform people of consequences of their activities. (e.g., farmers may modify waste management practices if they learn that these practices contaminate a lake they use). • Education can modify preferences and lead to change in behavior. (e.g., people may learn to appreciate the environment, value the preservation of natural resources, and thus behave in a more environmentally friendly way). • Education can inform the public of the firms that generate the most pollution. This may induce some of these firms to change their practices because this information may reduce the demand for their products.

17. Externalities from Smoking • Health Costs Associated with Smoking:  Smokers' health costs shared by society.  Cost of family support (in case of early death).  Risk to nonsmokers (second-hand smoke). • Estimated Death Toll (1989): • Estimated Annual external costs of smoking: $ 35 billion (medical cost) $ 20 billion (lost work) $ 5 billion (fires, smoke, odor damage) $ 60 billion (total cost)

18. Policies to control cigarettes • A cigarette tax or tobacco tax. • A standard/quota to restrict quantities of cigarettes and tobacco. • Approximately 30 billion packs of cigarettes are smoked annually. • If marginal externality cost = average externality cost, then the tax should be $2.00 per pack ($60 billion of externality cost / 30 billion packs).

19. Policy consequences • Producers: Restriction on quantities may benefit producers or distributors if elasticity of demand is smaller than 1. • Government: Tax revenues can be used to compensate victims of smoking damages, or it can be used in lieu of other distortionary taxes (such as income taxes and sales taxes) to support government programs. • Unintended Consequences: May strengthen the case for the legalization of drugs.

20. The Economics of Illicit Drugs • Should there be a drug legalization policy similar to the one for cigarettes? • Proposals  Legalize illicit drugs.  Ban advertisement and sale to minors.  Institute a tax on drugs. • Benefits:  Increased government revenue.  Reduced government costs (fewer prisoners and less drug enforcement).  Reduced crime. • Costs:  Increased addiction.  Legalization may induce more to try.

21. Economic impacts of drug policy 1. Legalization of drugs would shift income from the illegal network of drug traffickers to government (taxes) and legal marketers (pharmacies). 2. Drug producers may be better off if drug cartels behave like the middlemen, since eliminating drug trafficker middlemen may result in increased quantity and higher producer prices. 3. Costs of crime enforcement may go down. 4. Consumer prices (inclusive of taxes) may go down and quantity may go up. There may be higher health costs associated with drug addiction.