Externalities

1. Externalities Public Finance - Introductory

2. Definition • An externality occurs when the activity of an ind affects the utility of another ind in a way not accounted by the price system • externality = external to the P mechanism • E.g. pollution • So called “pecuniary externalities” are reflected in the P mechanism → not an externality, no market inefficiency involved • Very important concept, fundamental for economic analysis of the law, environmental economics etc. Public Finance - Introductory

3. Nature of externalities • Firm A (paper producer) throws waste in a river upon which there are no property rights → negatively affects ind B (fisherman) → negative externality • River water is input for firm A but has also alternative uses→ e.g. input for fisherman • Input s are efficiently used if paid to owners on the basis of opportunity costs (e.g. wage is opportunity cost of leisure time of worker) • P of water in example is 0 → nobody owns river→ no incentive to use it efficiently • → Externality is consequence of lack of property rights Public Finance - Introductory

4. Features of externalities • Produced by consumers and producers • E. in consumption → affects utility • E. in production → affects profits • Reciprocal: firm A pollutes river, but also fisherman produces externalities → raises costs of polluting • Negative and positive (e.g.. neighbor’s well tendered garden) • PG are source of externalities Public Finance - Introductory

5. Picture of negative externality in consumption Public Finance - Introductory

6. The Nature of Externalities-Graphical Analysis MSC = MPC + MD Reduction from Q1 to Q* means dcg profit loss for Supplier and dchg welfare gain for Demander. $ MPC h d g c MD f b MB a e 0 Q* Q1 Q per year Actual output Socially efficient output Public Finance - Introductory

7. Description • Firm produces up to Q1 whereπmax(Mπ=0) • From the point of view of society → production must be up to MB=MSC (social costs, not firm’s private costs) → point Q* • If there is an externality FTWE does not hold • MB=MPC holds, not MB=MSC • → if negative externality → excessive production wrt efficient quantity Public Finance - Introductory

8. Description of diagrams-2 • Efficiency increases by moving from Q1 to Q* • → Firm profits lowered (area dcg) • → Fishermen’s welfare increases → every unit of output less increases fisherman welfare by MC of externality (abfe=cdgh because MSC=MPC+MD) • If U functions of firm and of fisherman equivalent → society’s welfare increases by dgh • 0 pollution is NOT socially desirable → both activity affect each other (“reciprocal externality”) • → 0 pollution=0 production=0 profits Public Finance - Introductory

9. Limits of analysis • 4 main limits → analysis assumes • Knowledge of functional forms that generate curves • Quite unlikely • Identification of polluter • Who’s responsible for acid rainfalls? • Identification of pollutant agents • Often disagreements about this (e.g.. ozone hole) • Identification of damage • What’s the cost of being polluted? Who decides it? Public Finance - Introductory

10. Remedies to externalities • Mergers • Social rules • Pigouvian taxes • Creation of markets • Assignment of property rights • Regulation • Nothing Public Finance - Introductory

11. Mergers and social rules • Mergers → externalities are internalized by merging the affected parties • Agents coordinate to make joint π superior to sum of individual π • → Damage (externality) eliminated • e.g. Bank mergers where competition is externality → pooling of risks, as in financial crisis of 2008 • Social rules → Education plays an important role in reduction of externalities Public Finance - Introductory

12. Pigouvian tax • Externality inefficient because production costs do not reflect social costs • → Pigouvian tax (by name of Arthur Pigou) aims at correcting such difference → increaseP of underpriced inputs(e.g. P=0 in previous example) because of property rights not assigned • Tax = externality = ij • P=0j+ij • New cost structure for firm is MPC+cd • Firm produces Q* where MB=MPC+cd • Revenue is cd*0Q* Public Finance - Introductory

13. Diagram of a Pigouvian tax MSC = MPC + MD $ (MPC + cd) Pigouviantax revenues MPC d i j c MD MB 0 Q* Q1 Q per year Public Finance - Introductory

14. Pigouvian tax - limits • Pigouvian tax revenues must not go to people affected by externality • Incentive to declare damage • → Compensation of victims not needed to attain efficient production • Identification of value of externality (MD function) • Identification of who pollutes and how much • Point is not whether Pigouvian tax is perfect, but whether it is better than the alternatives Public Finance - Introductory

15. Creation of markets - 1 • Eternality due to lack of a market for it → state can create the market • E.g. Trade of emission permits → market for non polluted air → air becomes economically valuable (=with a price) • Aka “Cap and trade” • State first sets (“caps”) the quantity of acceptable emissions (e.g. Z*), then auction off the right to pollute up to Z* (“trade”) • P offered by best bidder is market equilibrium price P1→ efficient • Those who do not want to pay P1 either reduce production or chooses cleaner technologies • P1 = effluent fee Public Finance - Introductory

16. Diagram of market creation Public Finance - Introductory

17. Creation of markets - 2 • Government can also distribute emission permits and let firm do the distribution in a secondary market • Equilibrium not affected → firms sell rights only if value them less than P1 • Distribution changes → gov. does not cash any revenues • Main advantage is reduction of uncertainty about pollution level → this system works best when knowing the curves of the Pigouvian tax diagram is costly • Markets for emission permits exist in USA and now in Europe as well Public Finance - Introductory

18. Attribution of property rights • In certain conditions government can assign property rights on the resource that generates the externality → creating a market for externalities and then stay out of it • → Coase Theorem (Coase, 1963): parties affected in an externality will always agree on a pareto-otpimal solution (Q*), regardless the prior attribution of property rights, provided that the transaction costs be 0 (or sufficiently low ) • If firm owns river but MB of production is below MD (externality) → exchange opportunity → fishermen pay firm to produce up to Q* where MD=MB-MPC • If fishermen own the river (opposite attribution of property rights) firms will pay to produce until MB=MPC, fishermen will demand MD → back to Q* Public Finance - Introductory

19. Coase theorem Public Finance - Introductory

20. Commentaries to Coase theorem • No need for the state to intervene • Within conditions where theorem applies, ind solve externalities through voluntary exchange • Base for modern law and economics (e.g. extra trial negotiations and deals) • 3 problems: • Transaction costs 0 • Identification of polluter and costs to enforce deal • Few parties must be involved in externality and externality must be well defined (but experimental economics shows that range of deals is larger than expected; Mueller 2003) • Government often increases transaction costs to be part of the deal (supply side) Public Finance - Introductory

21. Regulation • Government establish rule not to pollute beyond a certain threshold → otherwise sanctions • Kyoto protocol is regulation with weak sanctions • Inefficient when involved firms are numerous and heterogeneous • Firms X and Z have same fixed costs → their technology is potentially polluting → but face different demand curves • Damage is d: with regulation, efficient production is where MB=MPC+d • Firm with more elastic demand curve Z reduces Q more → made worse off by regulation to a larger degree than X • → Not all firms that pollute in the same way pay the same amount • e.g. Catalytic converters more useful in Paris traffic than in Rennes, but price is the same • Firms use regulation strategically Public Finance - Introductory

22. Diagram of regulation Public Finance - Introductory

23. Which is best remedy? • Choice of solution depends from circumstances • Verify hypotheses that condition the efficiency of alternative solutions • No best unique solution • Economists generally prefer Pigouvian taxes, trade of emission permits and/or voluntary solutions • Governments generally use taxes (revenues) or regulation to show that they are acting (visible action) • Regulation has high costs → even if firm pollutes beyond thresholds sanctions are often not applied because if firms goes bankrupt unemployment is itself a cost → strategic use of regulation, which politicians use precisely because it is inefficient (e.g. Kyoto) • Gradual move towards use of tradable emission permits • Ideology makes finding solutions harder Public Finance - Introductory

24. Distributive consequences • Who actually pays reduction of pollution? • Evaluating distributional consequences is difficult • Many parties involved, in different ways • Empirical evidence • Unemployment increases→ production costs increase, output goes down → environmental regulation responsible for lower growth rates of western economies since the 1970s (Mankiw, 2004) • Prices go up→ consumers bear the costs of environmental friendly technologies (costs shifted onto final products) • It seems that low income people face worst distributional consequences (e.g., having to buy a new car, with lower polluting emissions is a heavier financial sacrifice for low income families) Public Finance - Introductory

25. The impact of the Kyoto Protocol Other high income countries Eastern Europe Rest of the World Source William Nordhaus and Joseph Boyer, Warming the World: Economic Models of Global Warming, MIT Press, 2000 Public Finance - Introductory

26. Differences in polluting emissions Efficient policy: curve where costs and benefits of reduction of emissions are balanced Public Finance - Introductory

27. Differences in energy and primary inputs prices Public Finance - Introductory