Externalities

1. 10 Externalities

2. Market Failure • Market Failure • When the free market may not provide economically efficient (ideal) outcome • Sources • Too little competition • Monopoly/Cartels • Asymmetric Information Financial Markets (insider trading – Facebook IPO) • Externalities (positive and negative)

3. Externalities • Externality • The uncompensated impact of one person’s actions on the well-being of a bystander • Negative externality • Impact on the bystander is adverse • Positive externality • Impact on the bystander is beneficial

4. Externalities • A more technical definition A cost that is suffered by a third party as a result of an economic transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organization, property owner, or resource that is indirectly affectedby the production or consumption of the good by first/second parties.

5. Externalities and Market Inefficiency • Externalities • Cause markets to allocate resources inefficiently • Welfare economics: a recap • Demand curve – value to consumers • Prices they are willing to pay • Supply curve – cost to suppliers • Equilibrium quantity and price • Efficient • Maximizes sum of producer & consumer surplus • Without externalities present

6. Negative Externalities – A Graph A Cost Which is Incurred by Society That Should Be Accounted For But those in the Market (1st and 2nd Parties) Don’t Have to Pay For It

7. Market Failure Negative Externality – Not Accounted For in the Market’s Pricing/Costing of the Good Creates Deadweight Loss – Inefficient Use of Resources

8. Increased Health Care Costs • Harvard Study: Coal Costs America $330-500 Billion Annually • A Harvard University study published on Feb 17, 2011, has determined that the true costs of using coal to generate electricity in America are between $330 and $500 billion dollars annually. The study, "Mining Coal, Mounting Costs -- The Life Cycle Consequences of Coal" by the Harvard Medical School's Center for Health and the Global Environment examines the costs for so-called "cheap coal" that don't show up on the monthly electric bill: the so-called "externalities" or hidden costs.

9. Graphically

10. Externalities and Market Inefficiency • Negative externalities - Pollution • Cost to society (of producing electricity from coal) • Larger than the cost to the electric utilities • Does not include damage from acid rain • Social cost - supply • Private costs of the producers • Plus the costs to those bystanders affected adversely by the negative externality • Social cost curve – above the supply curve (private costs)

11. 2 Pollution and the social optimum Price of Electricity Equilibrium External Cost Optimum Social cost (private cost and external cost) QOPTIMUM QMARKET Supply (private cost) 0 Megawattsof Electricity Demand (private value) In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET.

12. Externalities and Market Inefficiency • Negative externalities • Markets - produce a larger quantity than is socially desirable • Positive externalities • Markets - produce a smaller quantity than is socially desirable • Government: “internalize” the externality • Taxing goods that have negative externalities • Subsidizing goods that have positive externalities

14. Public Policies Toward Externalities • Command-and-control policies: regulation • Regulate behavior directly • Making certain behaviors either required or forbidden • Cannot eradicate pollution • Environmental Protection Agency (EPA) • Develop and enforce regulations • Protecting the environment • Dictates maximum level of pollution • Requires that firms adopt a particular technology to reduce emissions

15. Public Policies Toward Externalities • Market-based policies • Provide incentives • Private decision makers - choose to solve the problem on their own 1. Corrective taxes and subsidies • Corrective tax • Induce private decision makers to take account of the social costs that arise from a negative externality • Places a price on the right to pollute • Reduce pollution at a lower cost to society

16. Why is gasoline taxed so heavily? • The gas tax = corrective tax • Three negative externalities • Congestion • Accidents • Pollution • Doesn’t cause deadweight losses • Makes the economy more efficient • Less traffic congestion, safer roads, and cleaner environment

17. Why is gasoline taxed so heavily? • How high should the tax on gasoline be? • Most European countries • Gasoline taxes - much higher than those in the U.S. • 2007 study, Journal of Economic Literature • Optimal corrective tax on gasoline was $2.10 per gallon • Actual tax in the United States: 40 cents • Tax revenue from a gasoline tax • Lower taxes that distort incentives and cause deadweight losses • Some government regulations • Production of fuel-efficient cars – unnecessary

18. Public Policies Toward Externalities • Market-based policies 2. Tradable pollution permits • Voluntary transfer of the right to pollute from one firm to another • New scarce resource: pollution permits • Market to trade permits • Firm’s willingness to pay • Depend on its cost of reducing pollution

19. Public Policies Toward Externalities 2. Tradable pollution permits • Advantage of free market for pollution permits • Initial allocation of pollution permits • Doesn't matter • Firms - reduce pollution at a low cost • Sell whatever permits they get • Firms - reduce pollution only at a high cost • Buy whatever permits they need • Efficient final allocation

20. Controlling Pollution The following table shows the marginal costs for each of four firms (A, B, C, and D) to eliminate units of pollution from their production processes. For example, for Firm A to eliminate one unit of pollution, it would cost $54, and for Firm A to eliminate a second unit of pollution it would cost an additional $67.

21. Three Policy Approaches • Suppose that the government determines that the optimal level of pollution is 8 total units for the entire industry • A) If the government requires each firm to reduce its current level of pollution (4 units) by 50% (2 units each), what would be the total cost of the industry (and to society) of reducing pollution? • B) What per-unit tax on emissions could the government set to reduce pollution by 50%? • C) Suppose that the government issues 2 tradable (can be sold to another firm) to each firm. The firm can either use it to reduce pollution by 50% (2 units) or can resell the permit to another firm. But then will have to pay the marginal cost of treating the unit for which the permit would have been used. What would be the market price for the permit and how many would be sold?

22. Public Policies Toward Externalities • Reducing pollution using pollution permits or corrective taxes • Firms pay for their pollution • Corrective taxes - to the government • Pollution permits, - buy permits • Internalize the externality of pollution

23. 4 The equivalence of corrective taxes & pollution permits Price of pollution Price of pollution (a) Corrective tax (b) Pollution permits 1. Pollution permits set the quantity of pollution . . . Supply of pollution permits 1. A corrective tax sets the price of pollution . . . 2. . . . which, together with the demand curve, determines the quantity of pollution. Corrective tax P Demand for pollution rights P Demand for pollution rights Quantity of pollution Quantity of pollution 0 0 2. . . . which, together with the demand curve, determines the price of pollution. Q Q In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand curve determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by limiting the number of pollution permits, and the demand curve determines the price of pollution. The price and quantity of pollution are the same in the two cases.

24. Public Policies Toward Externalities • Objections to the economic analysis of pollution • “We cannot give anyone the option of polluting for a fee.” - former Senator Edmund Muskie • People face trade-offs • Eliminating all pollution is impossible • Clean water and clean air – opportunity cost • Lower standard of living

25. Public Policies Toward Externalities • Clean environment - is a normal good • Positive income elasticity • Rich countries can afford a cleaner environment • More rigorous environmental protection • Clean air and clean water - law of demand • The lower the price of environmental protection • The more the public will want • Economic approach • Pollution permits and corrective taxes • Reduces the cost of environmental protection • Increase demand for a clean environment

26. Private Solutions to Externalities • The Coase theorem • If private parties can bargain without cost over the allocation of resources • They can solve the problem of externalities on their own • Private economic actors • Can solve the problem of externalities among themselves • Whatever the initial distribution of rights • Interested parties - reach a bargain: • Everyone is better off & Outcome is efficient

27. Private Solutions to Externalities • Why private solutions do not always work • High transaction costs • Costs that parties incur in the process of agreeing to and following through on a bargain • Bargaining simply breaks down • Large number of interested parties

28. Technology spillovers, industrial policy, and patent protection • Technology spillover = Positive externality • Impact of one firm’s research and production efforts on other firms’ access to technological advance • Government: internalize the externality • Subsidy = value of the technology spillover • Industrial policy • Government intervention in the economy that aims to promote technology-enhancing industries • Patent law • Protect the rights of inventors by giving them exclusive use of their inventions for a period of time