1

Chapter 3

Externalities and Public Policy

2

Externalities Externalities are costs or benefits of

market transactions not reflected in prices. Negative externalities are costs to third

parties. Positive externalities are benefits to third

parties .

3

Externalities and Efficiency

The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. These occur when market transactions for a good produce negative externalities.

4

Social Costs

MSC = MPC + MEC

5

Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency

MPC + MEC = MSC

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Tons of Paper Per Year (Millions)

D = MSB

S = MPC

5

100 A

105

4.5

B10

110G

6

Implications of Figure 3.1 Market equilibrium occurs

where

MPC = MSB Efficiency Requires that

MSC = MPC + MEC = MSB

7

Positive externalities The marginal external benefit is

the dollar value of the benefit to third parties from an additional unit of production or consumption of a good. These occur when the market for a good creates positive externalities.

8

Social Benefit

MSB = MPB + MEB

9

Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency

MPB + MEB = MSBH10

V30

12

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Inoculations Per Year (Millions)

0

S = MSC

MPB

U25

10

Z45

10

Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output

S = MSC

S' = MSC'

MPBi

A 25

10

B

12

MPBi + MEB = MSB

16

C 20

20 Pri

ce

, B

en

efi

t, a

nd

Co

st

(Do

llars

)

Inoculations per Year (Millions)

0

F 30

11

Internalization of Externalities An externality can be

internalized under policies that force market participants to account for the costs of benefits of their actions.

12

Corrective Taxes to Negative Externalities

Setting a tax equal to the MEC will internalize a negative externality.

13

Figure 3.4 A Corrective TaxP

rice

, B

enef

it,

and

Co

st (

Do

llar

s)

Tons of Paper Per Year (Millions)

D = MSB

S = MPC

S’ = MPC + T = MSC

T100

5

A

110Net Gains in Well-Being

G

105

95

4.5

Tax Revenue = TotalExternal Costs

B

14

Results of a Corrective Tax Price rises. The tax revenue is sufficient

to pay costs to third parties. Socially optimal levels of

production are achieved.

15

Using a Corrective Tax The greenhouse effect and a “Carbon

Tax” The greenhouse effect is caused by

burning carbon-based fuels. A carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels.

It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.

16

Theory of the Second Best When one condition for an

optimum is violated, then maintaining the others will not guarantee a second-best solution.

17

A Polluting Monopolist Chapter 2 showed that monopoly

creates a loss to society. This chapter shows that a negative externality causes a loss as well.

The losses do not necessarily add to one another. In fact, they can cancel each other out.

18

Figure 3.5 A Second Best Efficient Solution

MR

Pri

ce

Output per Year 0

MPC + MEC = MSC

D = MSB

MPC

M

M

Q

P A

C

Q*

B

F

19

Corrective Subsidies Setting a subsidy equal to

MEB will internalize a positive externality.

20

Subsidy Payments

Figure 3.6 A Corrective Subsidy

0

Pric

e, B

en

efit

, an

d C

ost

(D

olla

rs)

Inoculations per Year (Millions)

Y 10 X

D' = MPBi + $20 = MSB

D = MPBi

S = MSC

25

10

U

30

12

V R

45 Z

21

Property Rights and Internalization of Externalities Externalities arise because some resource

users’ property rights are not considered in the marketplace by buyers or sellers of products.

Governments can give businesses the right to emit wastes in the air and water or it can give individuals the right to clean air and water.

22

Coase's Theorem By establishing rights to use

resources, government can internalize externalities when transactions or bargaining costs are zero.

23

The Significance of Coase’s Theorem The efficient mix of output will result simply as a

consequence of the establishment of exchangeable property rights.

It makes no difference which party is assigned the right to use a resource.

If the transactions costs of exchanging the rights are zero, the efficient mix of outputs among competing uses of the resource will emerge.

24

Figure 3.7 Coase’s Theorem

PW

PB

B A

Pri

ce o

f B

eef

(Do

llar

s)

Pri

ce

of

Wh

eat

(D

olla

rs)

Wheat Output per Year Beef Output per Year

MCW

MPCB

QW1 QB1

MCW*

MPCB + MEC = MSC

QW* QB*

25

Limitations of Coase’s Theorem Transactions costs are not

zero in many situations. However you allocate the

property rights, the distribution of income is affected.

26

Applying Coase's Theorem The Clean Air Act of 1990 allows for the sale

of the "right to pollute." Firms face a tradeoff when they pollute. If they pollute, they forgo the right to sell their emission permits to others.

In markets for electricity, Clean Air Act has motivated firms to shift to natural gas and away from coal as a means of producing electricity.

27

Figure 3.8 Pollution Rights and Emissions

S = Supply of Pollution Rights

D = MSB of Emitting Wastes

100,000Pri

ce

an

d M

arg

ina

l So

cia

l Be

ne

fit

Tons of Annual Emissions and Number of Pollution Rights

0

$20

75,000

28

Figure 3.9 The Efficient Amount of Pollution Abatement

MSB

MSC

E

A*

Ma

rgin

al S

oc

ial C

os

t a

nd

Be

ne

fit

Percent Reduction in Waste Emitted per Year 0 100

29

Recycling Recycling may be a less efficient and more

polluting use of labor, land and capital than simple land fill disposal because: Collecting waste for recycling costs three

times as much as collecting it for disposal. Rural land is inexpensive. Recycling paper creates more water pollution

and does not “save” trees; it simply reduces the number that are planted.

30

Regulatory Solutions Instead of using market

forces to force firms to internalize externalities, we can use emission standards and apply these to all market players.

31

Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of

Emissions

MSB

MSB QRB

QRA

A

B

G

H

QR

MEC = MSC

MEC = MSC

10

10

C

F

QA*

QB* 0

Firm A

Co

st a

nd

Ben

efit

(D

oll

ars)

Firm B

QB1

QA1

Tons of Emissions per Year

32

Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions

MEC = MSC

QRD

QRC

MEC = MSC 20

X

QC*

T

QD*

Firm C

Tons of Emissions per Year

Firm D

Co

st a

nd

Ben

efit

(D

oll

ars)

MSB

MSB

S

Y

Z

R

QRQR

33

Markets for Pollution Rights The Clean Air Act of 1990 allowed firms the

right to trade Sulfur Dioxide emissions allowances.

The market for the allowances began in 1991. Firms must have the allowances to emit Sulfur

Dioxide. Firms increasing production can buy permits or

use pollution controls to keep their total emissions constant.

Firms that reduce their emissions can sell their allowances to others.

34

Sulfur Dioxide Emission Prices

35

Global Externalities CFC’s Deforestation Global Warming

36

Costs and Benefits to the EPA The EPA estimates that annual compliance costs

could be in the range of $225 billion per year. The EPA estimated in 1990 that the benefits of

the Clean Air Act were nearly 50 times the costs. Ninety percent of the benefits are estimated to

come from laws pertaining to power plants and factories.