Externality - 国際公共政策専攻naito/teaching_web/public... · Introduction Consider global...

Externality y

Introduction (1)Introduction (1)

In the previous slide, we learned the first welfare theorem. Now let’s review the graph again. Let’s consider the market of the laptop computer

Demand side is the same as in the previous lecture.

In the market economy, the equilibrium is determined as follow:determined as follow:

Introduction (2)Introduction (2)

For the supply side, assume that to produce 1 computer, it costs $200. To produce the

$second computer, it costs $300. To produce 3rd computer, it costs $400. To produce 4th

$computer, it costs $500.

PricePrice

600500500400300

1 2 3 4demand for compuer

Demand and supply of computer

600 Dd d600

500

Ddemand curve

4400

33003300

200Supply curve

Introduction (3)Introduction (3)

Note that demand curve is the society’s willingness to pay for the computer.

The marginal cost curve is also the society’s marginal cost of producing the laptop g gcomputer.

Thus, we can think that the demand curveThus, we can think that the demand curve also represent the social marginal benefit of consuming the laptop computer. We denoteconsuming the laptop computer. We denote as SMB(Social marginal benefit)

Introduction (4)Introduction (4)

We can also think that the supply curve’s is the society’s cost of producing additional computer. Thus, we denote as SMC. (social marginal cost)

To maximize the social surplus, it should be SMB=SMC.SMB SMC.

Introduction (5)Introduction (5)

On the other hand, in the market economy, Each consumer maximizes the utilty subject y j

to price and income. Thus, the private marginal benefit ofThus, the private marginal benefit of

consuming laptop computer is equal to the price of computer.price of computer.

The firm maximizes its profit. Thus the price of laptop computer is equal to Thus, the price of laptop computer is equal to

the PMC of the laptop computer.

Social marginal benefit is equal to social

Introduction (6)Introduction (6)

This implies PMB=PMC On the other hand, in the absence of

externality, PMB=SMB. PMC=SMC.externality, PMB SMB. PMC SMC. Thus, SMB=SMC. This is the condition of social surplus This is the condition of social surplus

maximization.

ExternailityExternaility

Externalities can be negative or positive: Acid rain, global warming, pollution, or a

neighbor’s loud music are all negative externalities.

Research and development or asking good questions in class are positive externalities.

IntroductionIntroduction

Consider global warming, a negative externality. Many scientists believe this warming trend is caused by human activity, namely the use of fossil fuels.

These fuels, such as coal, oil, natural gas, and ggasoline produce carbon dioxide that in turn traps heat from the sun in the earth’s atmosphere.

Figure 1Figure 1 shows the trend in warming over the last century.y

Figure 1This table shows the global

temperature during the 20th century.

Global Average Temperature Over Time

58.5

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erat

ure

There has been a distinct trend upward in temperature

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57.5

rage

tem

pe upward in temperature

56.5

57

Glo

bal a

ver

56

0 0 0 0 0 0 0 0 0 0 0 0 0

G

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Year

IntroductionIntroduction

Al h h hi i d h i ff Although this warming trend has negative effects overall on society, the distributional consequences vary.vary. In much of the United States, warmer temperatures

will improve agricultural output and quality of life. In Bangladesh, which is near sea-level, much of the

country will be flooded by rising sea levels. If ’ d i h h ld b t If you’re wondering why you should care about

Bangladesh, then you have identified the market failure that arises from externalities.

From your private perspective, you shouldn’t!

EXTERNALITY THEORYEXTERNALITY THEORY

Externalities can either be negative or positive, and they can also arise on the supply side (production externalities) or the demand side (consumption externalities)demand side (consumption externalities).

A negative production externality is when a firm’s production reduces the well-being of others who are notproduction reduces the well being of others who are not compensated by the firm.

A negative consumption externality is when an g p yindividual’s consumption reduces the well-being of others who are not compensated by the individual.

The basic concepts in positive externalities mirror those in negative externalities.

Economics of Negative Production Externalities

To understand the case of negative production externalities, consider the following example: A profit-maximizing steel firm, as a by-product of its

production, dumps sludge into a river. The fishermen downstream are harmed by this

activity, as the fish die and their profits fall. This is a negative production externalities because:

Fishermen downstream are adversely affected.w v y And they are not compensated for this harm.

Production ExternalityProduction Externality

For the firm, the private cost is the resource needed to produce the steel.

The private marginal cost shows the additional resourced needed for the firm to increase the production of steel additionally.

Production ExternalityProduction Externality

For consumers, the marginal private benefit is the willingness to pay for the additionally produced steel. It is natural that the willingness to pay for additionalIt is natural that the willingness to pay for additional steel is decreasing as the amount of steel become larger. g

Note that since the consumption of steel does not generate consumption externality, the willingness to pay is also equal to the marginal social benefit. It only increase the social surplus by the amount of

illi twillingness to pay.

Price S=PMCof steel

S=PMC

p1

D = PMB =D PMB SMB

0 QSTEEL

Market equilibrium in the steel marketMarket equilibrium in the steel market

Production externalityProduction externality

In the above graph, the demand curve show the private marginal benefit since it is willingness to pay. Because there is no consumption externality it is theBecause there is no consumption externality, it is the marginal social benefit.

However the marginal cost DOES NOT show the However, the marginal cost DOES NOT show the marginal social cost. There is negative damage arising from the production of steel.

Let’s assume that the marginal damage is constant. It implies that to increase one unit of production of steel, it causes a constant damage to the society

Price S=PMCSMC = PMC + MD

of steelS=PMCMD

This triangle DWLp2

g

p1

MD

D = PMB =D PMB SMB

0 Q2 Q1 QSTEEL

Economics of Negative Production Externalities

In the market mechanism, the production of steel is determined by the supply and demand. Demand curve is the willingness to pay curve and it shows the marginal private and social benefit. Supply curve is the marginal cost curve. Consumer’s optimal behavior implies that price=PMB.

Producer’s optimal behavior implies that price=PMC

This yields a quantity of steel Q1 at a price of P1.

Economics of Negative Production Externalities The steel firm’s emits pollution causing

damage to the fishery. This is represented by the marginal damage curve. Ideally, the fishery prefers the situation there is no damage.

This would yield zero steel production, which is obviously not in the steel firm’s best interests.

Economics of Negative Production Externalities

The social marginal cost accounts for both the direct costs to the steel firm and the indirect harm to the fishery:

SMC=PMC+MD We find the socially optimal quantity of steel Q2 at a

price of P2, by solving:p 2, y g SMC=SMB.

Economics of Negative Production Externalities

The socially optimal quantity entails less production of steel. By doing so, the steel firm would be worse off but the fishery would be better off. Graphically, this triangle in between the PMB and

PMC curves from Q2 to Q1. The damage to the fishery is reduced as well.g y

Graphically, this is the area under the MD curve from Q2 to Q1.Q2 Q1

Price S=PMCSMC = PMC + MD

of steelS=PMCMD

p2

TThis p1

MD

triangle is DWL

D = PMB =D PMB SMB

0 Q2 Q1 QSTEEL

Economics of Negative Production Externalities

The deadweight loss from the original production level Q1 is graphically illustrated as the triangle in between the SMC and SMB curves from Q2 to Q1.

Note that the SMB equals the PMB curve in this qcase.

The Externality of SUVsThe Externality of SUVsThe Externality of SUVsThe Externality of SUVs

Consider a real-life example: the use of sport utility vehicles (SUVs). They create three sorts of externalities: Environmental externalities: They consume a lot of

gasoline and create more pollution. Wear and tear on roads: SUV drivers do not bear the

costs that result from their vehicles. Safety externalities: When SUVs are in accidents, the

other drivers are often more severely injured.

The Solution (Coase Theorem)The Solution (Coase Theorem)

The Coase Theorem: When there are well-defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level.

Thus, the role of government intervention may be very limited—that of simply enforcing property rights.

The Solution (Coase Theorem)The Solution (Coase Theorem)

Consider the Coase Theorem in the context of the negative production externality example from before.

Give the fishermen property rights over the amount of steel production.p

Price S = PMCSMC = PMC + MD

of steelS = PMCMD

p2

p1

MD

D = PMBD PMBSMB

QSTEEL0 Q2 Q11 2

The Solution (Coase theorem)The Solution (Coase theorem)

Through a process of bargaining, the steel firm will bribe the fishery to arrive at Q2, the socially optimal level.

After that point, the MD exceeds (PMB -(PMC), so the steel firm cannot come up with a large enough bribe to expand production further.

The Solution (Coase Theorem)The Solution (Coase Theorem)

Another implication of the Coase Theorem is that the efficient solution does not depend on which party is assigned the property rights, as long as someone is assigned them.

The direction in which the bribes go does depend on the assignment, however.

Now, let’s give the property rights to the steel firm over the amount of steel production.firm over the amount of steel production.

Figure 6 illustrates this scenario.

Price S = PMCSMC = PMC + MD

of steelS = PMCMD

p2

p1

MD

D=PMB=SMBD PMB SMB

QSTEEL0 Q2 Q1

The Solution (Coase Theorem)The Solution (Coase Theorem)

The above graph shows that even though the bargaining process is somewhat different, the socially efficient quantity of Q2 is achieved.

Problems with Coasian SolutionsProblems with Coasian Solutions

There are several problems with the Coase Theorem, however. The assignment problem The holdout problemp The free rider problem Transaction costs and negotiating problems Transaction costs and negotiating problems

Problems with Coasian SolutionsProblems with Coasian Solutions

The “assignment problem” relates to two issues: It can be difficult to truly assign blame. It is hard to value the marginal damage in g g

reality.

Problems with Coasian SolutionsProblems with Coasian Solutions

The “holdout problem” arises when the property rights in question are held by more than one party. The shared property rights give each party power

over all others. This could lead to a breakdown in negotiations.

Problems with Coasian SolutionsProblems with Coasian Solutions

The “free rider” problem is that when an investment has a personal cost but a common benefit, individuals will underinvest.

Negotiation is costly and time consuming. g gEverybody has an incentive to free ride on the negotiation process.

Problems with Coasian SolutionsProblems with Coasian Solutions

Finally, it is hard to negotiate when there are large numbers of individuals on one or both sides.

Problems with Coasian SolutionsProblems with Coasian Solutions

In summary, the Coase Theorem is provocative, but perhaps not terribly relevant to many of the most pressing environmental problems.

PUBLIC-SECTOR REMEDIES FOR EXTERNALITIES

Coasian solutions are insufficient to deal with large scale externalities. Public policy makes use of three types of remedies to address negative externalities:

PUBLIC-SECTOR REMEDIES FOR EXTERNALITIES

Corrective taxation Subsidies Regulation

Corrective TaxationCorrective Taxation

The government can impose a “Pigouvian” tax on the steel firm, which lower its output and reduces deadweight loss.

If the per-unit tax equals the marginal gdamage at the socially optimal quantity, the firm will cut back to that point.

Corrective TaxationCorrective Taxation

The Pigouvian tax essentially shifts the private marginal cost.

The firm cuts back output, which is a good thing when there is a negative externality.g g y

Corrective TaxationCorrective Taxation

The steel firm’s privately optimal production solves: Price =PMC+tax Consumer’s behavior implies that Price =PMB Price =PMB If the tax=MD, then PMB=Price=PMC+tax=PMC+MD=SMC Since PMB=SMB, PMB=SMC

RegulationRegulation

Finally, the government can impose quantity regulation, rather than relying on the price mechanism.

RegulationRegulation

In an ideal world, Pigouvian taxation and quantity regulation give identical policy outcomes.

In practice, there are complications that may make taxes a more effective means of addressing gexternalities.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

The key goal is, for any reduction in pollution, to find the least-cost means of achieving that reduction.

One approach could simply be to reduce output. Another approach would be to adopt pollution-pp c w d b d p p

reduction technology.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

The models we have relied on so far have examined reductions in output. Thus, we will modify this.

Our basic model now examines pollution reduction, rather than say, steel production.p

PR Marginal costR Marginal cost of reducing pollution

MD = SMBSMB

*

D = PMB

F ll QR0 R* RFull

More pollutionP*PFull 0

More pollution

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

the private market outcome is zero pollution reduction, while the socially efficient level is higher.

Suppose that the government imposes a tax T for one unit of generating pollution. This implies that if g g p pthe firm reduces the pollution by one unit, the firm will decrease the tax by T dollar. In this case, MD amount is imposed for one unit of pollution. The firm will chose

PRPollution ReductionRPollution Reduction

marginal cost of pollution

reductioneduction

MD = SMBSMB

*

D = PMB

F ll QR0 R* RFull

More pollutionP*PFull 0

More pollution

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

Assume now there are two firms, with different technologies for reducing pollution.

The total cost of reduction in firm A is C_A(R_A) and C_B(R_B). ( ) ( )

Consider now the cost minimization problem given that society wan to reduce the totalgiven that society wan to reduce the total amount R.

The question is how to assignment the The question is how to assignment the reduction to firm A and firm B.

Different type of firms for reduction Then mathematical problem is to solve Mini C_A(R_A) + C_B(R_B) subject to _ ( _ ) _ ( _ ) j

R=R_A+R_B. First we can solve for R A:R A=R-R B. PlugFirst we can solve for R_A:R_A R R_B. Plug

this into the objective function. Then the problem becomes Then the problem becomes Mini C_A(R-R_B)+C_B(R_B) Since, there is one control variable we can

solve it.

By taking a derivative, we have -C_A’(R_A) + C_B’(R_B)=0_ ( _ ) _ ( _ ) Or MC_A(R_A)=MC_B(R_B). In other words for the efficient reduction of In other words, for the efficient reduction of

the pollution, the marginal cost should be equal for both firmsequal for both firms.

This implies that for deriving the social marginal cost or reducing R the marginalmarginal cost or reducing R, the marginal cost of firm A and firm B should be the same.

PR PMCR

S = PMCA + PMCB = SMC

PMCB PMCA

PMCBPMC

MD=SMBPMCA

Q0 R*R RR QR0 R*RA,RB

RARB

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIESAPPROACHES TO ADDRESSING EXTERNALITIES

The above graph shows that price regulation through taxes is more efficient than is quantity regulation.

A final option is quantity regulation with y gtradable permits. Idea is to: Issue permits that allow firms to pollutep p And allow firms to trade the permits

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

As in the previous figure, initially the permits might be assigned as quantity regulation was assigned. This means that initially RA = RB.

But now Firm B has an interest in buying some of y gFirm A’s permits, since reducing its emissions costs PMCB (>PMCA). Both sides could be made better B ( A)off by Firm A selling a permit to Firm B, and then Firm A simply reducing its pollution level.p y g p This trading process continue until PMCB=PMCA.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

Finally, the government may not always know with certainty how costly it is for a firm to reduce its pollution levels.

Next graph shows the case when the social marginal g p gbenefit is “locally flat.”

PR PMC2R

PMC1

PMC2

Social optimal level of reduction

DDWL by pollution tax

MD =

y p

DWL quantity reguation

MD = SMB

R F ll QR0 R1 RFull

More pollutionPFull 0

R3

Figure 12 Model with Uncertainty and Locally Flat Benefits

p

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

The next graph shows the case when the social marginal benefit is “locally steep.”

PR PMC2R

PMC1

PMC2

Socially optimal reduction

pollution taxDWL by quantity regulation

MD = SMB

R F ll QR0 R1 RFull

More pollutionPFull 0

R3

p

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSINGQUANTITY APPROACHES TO ADDRESSING

EXTERNALITIES

These figures show the implications for choice of quantity regulation versus corrective taxes.

When the marginal damage of the pollution is very flat or constant, the price regulation is better than p gquantity regulation

When the marginal damage of pollution become W g g pincreasingly high as the pollution level becomes higher, the quantity regulation is better. g , q y g

Quantity vs Price reguationQuantity vs. Price reguation

Thi h i i li i f CO2 This has an important implication for CO2 regulatoin for the green house effect.Si h h ff i d i d b h Since the greenhouse effect is determined by the stock of CO2, the marginal damage on temperature due to one unit increase of CO2 is almost flatdue to one unit increase of CO2 is almost flat

Thus, this is the case where price regulation is better. H i h K l i l i However, in the Kyoto protocol, quantity regulation

method is used. This is clearly adverse effect when there is uncertainty on the technology on reducingthere is uncertainty on the technology on reducing pollution

Recap of Externalities:Problems and Solutions

Externality theory Private-sector solutions Public-sector solutions Distinctions between price and quantity approaches Distinctions between price and quantity approaches

to addressing externalities