Understanding Externalities: Impact on Resource Efficiency

1. Externalities Definition: An externality exists whenever consumers or firms do not account fully for all the ramifications of their actions. The effect that is not accounted for is called the external effect. Negative externalities: Situations in which the external effect damages others; Positive externalities: Situations in which the external effect helps others. Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? No Yes Is the state of affairs getting the most from the economy’s resources? No. Is the state of affairs getting the most from the economy’s resources? Yes. State of affairs inefficient. State of affairs efficient. Preview Externalities cause inefficiency. Remedies for Externalities Fees (Taxes) or Bonuses (Subsidies) Coase Approach (Private Solution) Command and Control Cap and Trade

2. Pollution and Efficiency First, focus on the chemical firm Farmer’s Clean-up Costs = C  F where C = Quantity of chemicals producedF = quantity of food produced Both industries are perfectly competitive. PC = 1,000 PF = 800 Question: Does 399 units of chemicals maximize the chemical firm’s profit? Answer: No. Chemical Firm MC of Chemicals MRC = PC = 1,000 MCC 1,200 MCC = 200 + 2C C = 399 = 200 + 2×399 1,000 MRC = 1,000 = 200 + 798 MCC = 998 800 C = 399C = 400 TR  TC Profit = 600 Up by $1,000 Up by $998 Up by $2 400 MCC = 200 + 2C Question: Does 400 units of chemicals maximize the chemical firm’s profit? 200 = 200 + 2×400 = 200 + 800 Answer: Yes C MCC = 1,000 C* = 400

3. Pollution and Efficiency Next, focus on the farmer. Clean-up Costs = C  F where C = Quantity of chemicals producedF = quantity of food produced Both industries are perfectly competitive. PC = 1,000 PF = 800 C* = 400 Question: How much food will the farmer produce? Farm C = 400 C = 800 MC of Food MRF = PF = 800 C = 0 1,200 F* = 100 1,000 The farmer must clean up the water before he can use it to irrigate his fields. MRF = 800 800 600 Farmer’s Clean-up Costs = C  F = 400  100 400 Farmer’s Clean-up Costs =$40,000 200 F 100 200 300

4. State of Affairs: Each firm maximizes its individual profit: Chemical Firm: C* = 400 Farm: F* = 100 Farmer’s Clean-up Costs = C  F = 400  100 Claim: This state of affairs is inefficient. =$40,000 Question:How would the farmer and the chemical firm be affected if the chemical firm produced 1 fewer unit of chemicals; that is, what if the chemical firm produced 399 units rather than 400? Claim: Farmer’s clean-up costs fall by $100. Farmer’s Clean-up Costs = 399 100 =$39,900 Claim: Chemical firm profit falls by $2. Review: Chemical firm profit rises by $2 when production rises from 399 to 400 Profit C = 399C = 400 Up by $2 Chemical firm profit falls by $2 when production falls from 400 to 399. Question: Can you devise a special deal between the owner of the chemical firm and the farmer that would make both better off?

5. State of Affairs: Each firm maximizes its profit: C=400 F=100 Farmer’s Clean-up Costs = 40,000 When chemical production falls from 400 to 399. Chemical firm profit falls by $2. Farmer’s clean-up costs fall by $100. Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? No Yes Is the state of affairs getting the most from the economy’s resources? No. Is the state of affairs getting the most from the economy’s resources? Yes. State of affairs inefficient. State of affairs efficient. Side payment Farmer Chemical Firm Special Deal: The farmer gives the owner of the chemical firm a “side payment” of $50 on the condition that the owner of the chemical firm reduces chemical production by 1 unit. $50 Chemical Production down by 1 unit Clean up costs down by $100  Profit down by $2 $50 ahead $48 ahead Conclusion: The state of affairs in question results in an inefficient high level of chemical production.

6. Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most does not from the economy’s resources? No. Is the state of affairs getting the most does not from the economy’s resources? Yes. State of affairs inefficient. State of affairs efficient. Intuition: When each firm maximizes its profit are decisions based on misleading or accurate information? Misleading information Accurate information  Inefficiency results Efficiency results Question: Why does the market fail to operate efficiency in the presence of a negative externality? Social Costs of Chemical Production Private Costs of Chemical Production > Costs that the chemical firm incurs plusthe costs the chemical firm imposes on others, the farmer. Costs that the chemical firm incurs. Difference: External Effect Answer: The chemical firm does not fully account for all the costs it is imposing.

7. EPA Prohibits the Chemical Firm from Polluting PC = 1,000 Claim: This state of affairs is inefficient. PF = 800 C** = 0 MRF = PF = 800 Question:How would the chemical firm and the farmer be affected if the chemical firm were allowed to produce 1 unit of chemicals? F** = 200 Farm C = 400 C = 800 MC of Food MRC = PC = 1,000 C = 0 MCC = 200 + 2C 1,200 = 200 + 2×0 C = 0 MCC = 200 1,000 TR  TC Profit = MRF = 800 800 C = 0C = 1 Up by $1,000 Up by $200 Up by $800 600 400 Chemical firm’s profit rises by $800 200 Farmer’s Clean-up Costs = C  F = 1  200 F = $200 100 200 300 Farmer’s clean-up costs rise by $200. Farmer’s Clean-up Costs = C  F = 0  200 Question: Can you devise a special deal to make both better off? Farmer’s Clean-up Costs = $0

8. State of Affairs: EPA prohibits pollution: C = 0 F = 200 Farmer’s Clean-up Costs = 0 When chemical production rises from 0 to 1 Farmer’s clean-up costs rise by $200 Chemical firm’s profit rises by $800 Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? No Yes Is the state of affairs getting the most from the economy’s resources? No. Is the state of affairs getting the most from the economy’s resources? Yes. State of affairs inefficient. State of affairs efficient. Special Deal: The owner of the chemical firm gives the farmer a “side payment” of $400 on the condition that the owner of the chemical firm can increase chemical production by 1 unit. Side payment Farmer Chemical Firm $400 Chemical Production up by 1 unit Clean up costs up by $200  Profit up by $800 $200 ahead $400 ahead

9. Summary of Externalities An externality is present whenever consumers or firms do not account for the full ramifications of their actions. In such a situation, the markets fail because decisions are based on erroneous information. A market failure occurs. More specifically when one party does not account for all the costs of its actions, a negative externality exists. In such a case, • An unfettered market when each firm independently maximizes its own profit results in an inefficiently high level of production. Complete elimination of the negative externality is typically inefficient also. The challenge: Efficiency calls for something in the middle. How can we get there? Remedies for Externalities Fees (Taxes) or Bonuses (Subsidies) Coase Approach (Private Solution) Command and Control Cap and Trade

10. Fees (Taxes) or Bonuses (Subsidies) Question: Consider the chemical firm and farm. What is the basic problem when each maximize profit? Chemical Firm MC of Chemicals MCSocial Answer: The chemical firm is not accounting for all the ramifications of its actions. It is not accounting for the fact that when it produces chemicals it is imposing a cost on the farmer. MCPrivate 1,200 1,000 800 Social Costs of Chemical Production Private Costs of Chemical Production 600 > External Effect: Costs the chemical firm imposes on the farmer. 400 The government charges the owner of the chemical firm a fee for each unit of pollution the chemical firm dumps into the lake. 200 C Question: What should the pollution fee equal? Answer: The cost of the external effect. Intuition: Are decisions based on misleading or accurate information? Misleading Accurate  Inefficiency results Efficiency results

11. Coase Approach Bargaining and deal making are the central ideas behind the Coase approach. When it is possible to strike a deal be struck and when it would be impossible to strike a deal? Question: What must be true if two (or more) individuals voluntarily agree to a deal? Answer: The deal must make at least one individual better off. and make no individual worse off. Question: What must be true if it is IMPOSSIBLE for two (or more) individuals to AGREE voluntarily to a deal? Answer: It must be impossible to find a way to make at least one individual better off and make no individual worse off. Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most does not from the economy’s resources? No. Is the state of affairs getting the most does not from the economy’s resources? Yes. State of affairs inefficient. State of affairs efficient.

12. CoaseApproach CoaseTheorem: When bargaining costs are negligible Get the affected parties together. Bargaining leads to efficiency. Encourage them to bargain and make deals. Furthermore, the assignment of property rights: does not affect the allocation of resources. Continue this bargaining and deal making process until it is impossible for the parties to make any more deals. does affect the distribution of income. Simple Illustration of the CoaseTheorem: Mr. Smith, Ms. Jones, and a Wood Stove Mr. Smith, who suffers from asthma, is getting a new neighbor; Ms. Jones is building a house near Mr. Smith. Ms. Jones is deciding how to heat her house and has narrowed the options to two: electricity or wood. Electricity would cost her $5,000 per year and wood $2,000 a year. Ms. Jones does not suffer from any respiratory problems; consequently, the fact that wood burning will pollute the atmosphere does not concern her. Since Mr. Smith suffers from asthma, his lungs cannot tolerate the pollution produced by wood burning stoves. If the air were polluted by Ms. Jones’ wood smoke, he would have to install a climate control system in his home which would filter the air. Such a system costs $2,500 per year.

13. Wood: $2,000 Electricity: $5000 Cost of Mr. Smith’s climate control system: $2,500 Heating Costs for Ms. Jones: A difference of $3,000 Scenario #1: Ms. Jones has the right to pollute the air. Ms. JonesHeats with wood Spends $2,000 on heat Mr. SmithInstalls climate control system Spends $2,500 on the climate control system Would Ms. Jones choose, wood or electricity? Question: Could Mr. Smith offer Ms. Jones a “side payment” to induce her to heat with electricity? No $2,500 What is the largest side payment Mr. Smith would be willing to offer? $3,000 What is the smallest side payment Ms. Jones would find acceptable? Ms. JonesHeats with wood Spends $2,000 on heat Mr. SmithInstalls climate control system Spends $2,500 on the climate control system Outcome: Question: Does this outcome make economic sense from the perspective of society as a whole? Provide Mr. Smith with clean air. Provide Ms. Jones with heat. From society’s perspective there are two goals: There are two ways to achieve the goals: Ms. Jones heats with electricity Ms. Jones heats with woodand Mr. Smith installs the climate control system  Jones costs = $5,000 Smith costs = $0 Jones costs = $2,000 Smith costs = $2,500 Costs to Society = $5,000 Costs to Society = $4,500