Externalities and the Environment

Externalities and the Environment

What is an Externality? When a person/firm does something that affects the interests of another person or firm without affecting prices. Examples: • Traffic/telephone/internet congestion • Over grazing • New fences • Building a road

Does not Affect Prices? This means: • You cannot use markets to give people incentives to do the right thing. Called: “A Missing Market” Or “Market Failure”

Kinds of Externality Beneficial Harmful Consumption Production 2-person Many person Stock Flow Affecting Utility Affecting Production Public Private

Why this presents a problem An externality implies: Social Cost = Individual Cost Social Benefit = Individual Benefit The incentives for the individual are not what society wants them to do. As a result: • too much of socially costly goods are produced • too little of socially beneficial goods are produced.

An Example : One Polluting Supplier of Coffee Demand for Cups of Coffee = Marginal Social Value for Coffee Price Quantity of Coffee

Private Equilibrium determined by private costs and demand Marginal Private Cost Price Marginal Social Value Quantity of Coffee

Suppose the social costs of coffee production were higher than the private costs (a negative externality) Marginal Social Cost Price Marginal Private Cost Marg Social Value Quantity of Coffee

Consequences • Too much coffee is produced. • The price so coffee is too low and does not reflect its true costs of production. • Who gains here? • What are the £ values of the costs imposed on society?

Consumers’ Value For Unregulated MSC Price MPC MSV/Demand Quantity of Coffee

Consumers’ Value at social optimum MSC Price MPC MSV/Demand Quantity of Coffee

Consumers’ Gain MSC Price MPC MSV/Demand Quantity of Coffee

Society’s Net Loss: Consumers are not paying the true Social Cost of Production MSC Price MPC MSV/Demand Quantity of Coffee

Some Solutions to the Pollution/Externality Problem Private Solutions (No Government) • Internalize the Externality: Somehow get the social cost to equal the private cost by enlarging the organization. e.g. Make the coffee store own a street cleaning company. • Assign Property Rights: Allow neighbours to sue the store for violating their rights to clean streets. (See Coase discussion below) • Common Law: Allow injuries to be compensated without property rights being invoked.

Public Solutions: Fines or Taxes? There are 2 alternatives: • Tax polluters to raise their private costs to the social cost. “Pigouvian tax”. Question: What kind of tax does this? 2. Subsidize abatement technology so the social costs of production are lowered.

Supply Curve = Marginal Private Cost Price MPC Quantity of Coffee

The Problem: Pollution => Social Cost > Private Cost MSC Price MPC Quantity of Coffee

Individuals’ Choices Compare Private Cost with Their Individual Value How much individuals choose to consume. Price MPC Marginal Social Value Quantity of Coffee

But it is Optimal for Society to have less produced MSC Price MPC Marginal Social Value Quantity of Coffee

Pigou’s Solution: Taxes Increase the Price at which the Good is Supplied MPC+tax Price MPC Tax Quantity of Coffee

This increases the Price and Reduces the Quantity Consumed MPC+tax Price MPC Tax Marginal Social Value Quantity of Coffee

If you choose the tax just right then we get to the same place: And the government raises revenue. MSC MPC+tax Price MPC Marginal Social Value Quantity of Coffee

An Alternative Route the Producers like Provide subsidies to reduce polluters’ costs of being clean.

Subsidize Abatement: The Original Position how much abatement gets provided £ Costs/Benefits Marginal abatement cost Marginal Private Damage Cost Quantity of Abatement

The Problem= Costs of Damage for Society > Individual polluters’ Cost=>Not enough abatement Marginal Social Damage Cost £ Costs/Benefits Marginal abatement cost Marginal Private Damage Cost Quantity of Abatement

Subsidize Abatement: Reduces Abatement cost £ Costs/Benefits Marginal abatement cost Subsidy Quantity of Abatement

Subsidizing Abatement => More Abatement is provided Marginal abatement cost Subsidized Cost Marginal Private Damage Cost Quantity of Abatement

If you get the subsidy just right you can get to the social optimum. Marginal abatement cost MSDC Marginal Private Damage Cost Quantity of Abatement

This is has distributional and welfare effects Abatement subsidies: • Benefit producers and do not raise the prices of the polluting products. • They raise government spending and increase general taxes. • As a consequence consumers do not bear the full social cost of the product they are consuming – everyone bears it. • Too much is consumed and produced. This is not the case with Pigouvian taxes.

Other Governmental Solutions Command and Control Just tell the producer how much they are allowed to produce (quota). Performance based regulation – how much can be emitted. Input regulation – what kind of production processes can be used…

Government can impose a market 1998 BP committed to reduce greenhouse gas emissions 10% below 1990 levels by 2010.

Internal Markets for Coordination : BP 1998 BP committed to reduce greenhouse gas emissions 10% below 1990 levels by 2010. Usual process would be: • Senior managers set targets for divisions. • Complaints, bargaining and negotiation by divisions (some would find targets difficult and very expensive to meet others would find them very easy). • Slow inefficient and uncoordinated reductions or maybe none at all.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol).

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: • Senior managers set targets for divisions.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: • Senior managers set targets for divisions. • Target implemented by allocating that division permits to emit targeted amount of GG.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: • Senior managers set targets for divisions. • Target implemented by allocating that division permits to emit targeted amount of GG. • Set up an internal electronic trading system.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: • Senior managers set targets for divisions. • Target implemented by allocating that division permits to emit targeted amount of GG. • Set up an internal electronic trading system. • Business managers could then either • Meet their target. • Reduce their emissions by less and buy extra credits. • Reduce their emissions by more and sell surplus credits.

Internal Markets for Coordination : BP Instead used an internal market (mimicking external market introduced under Kyoto protocol). New process: • Senior managers set targets for divisions. • Target implemented by allocating that division permits to emit targeted amount of GG. • Set up an internal electronic trading system. • Business managers could then either • Meet their target. • Reduce their emissions by less and buy extra credits. • Reduce their emissions by more and sell surplus credits. In 2001 4.5 million tons of rights were traded within the company @ average price of $40 per ton.

BP : Key Outcomes BP met its goal 9 years early.

BP : Key Outcomes BP met its goal 9 years early. The decisions across the organization were consistent and coordinated: • In parts of the organization where reduced GG was cheap <$40 they make big reductions and sell permits.

BP : Key Outcomes BP met its goal 9 years early. The decisions across the organization were consistent and coordinated: • In parts of the organization where reduced GG was cheap <$40 they make big reductions and sell permits. • In parts of the organization where reduced GG was expensive >$40 they buy permits.

BP : Key Outcomes BP met its goal 9 years early. The decisions across the organization were consistent and coordinated: • In parts of the organization where reduced GG was cheap <$40 they make big reductions and sell permits. • In parts of the organization where reduced GG was expensive >$40 they buy permits. The local information was used in the right way. There was an incentive to do the right thing not lie.

Pro’s and Con’s of Pigou vs Command Pros Cons Efficiency (static) across differentDifficult to get right polluters. Incentives to reduce pollutionMay not need uniform in the future (dynamic efficiency).treatment. Raises revenue and can eliminateIf already monopoly, other (worse) taxes.then pollution under provided

Coasian Decentralized Solution Idea allocate property rights and let the polluter and the polluted negotiate a solution. Bargaining between the polluter and the polluted Polluter Set of Feasible Agreements Polluted

Coasian Decentralized Solution If the polluter has the right not to be polluted, then if no bargain is reached the polluted can take the polluter to court and fine them for a violation Polluter Outcome imposed by law Polluted

Coasian Decentralized Solution Negotiated solution should be better than this for both parties. Polluter Negotiated Outcome Polluted

Coasian Decentralized Solution If the polluter has a right to pollute (eg be noisy) and then the law will impose a settlement that is good for the polluter. Polluter Legal Outcome Polluted

Coasian Decentralized Solution The negotiated outcome is now more favourable to the polluter. Negotiated Outcome Polluter Polluted

Coasian Decentralized Solution Summary: Coasian negotiation depends on who gets the rights but will be efficient under perfect information. Negotiated Outcomes Polluter Polluted

Problems of the Coasian Solution It requires: • Very clear property rights. • No costs of transactions. • Perfect information

Externalities and the Environment