McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 5

ExternalitiesExternalities

5-2

Externalities

Externality – An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism

5-3

The Nature of Externalities

Externalities can be produced by consumers as well as firms

Externalities are reciprocal in nature Externalities can be positive Public goods can be viewed as a special kind

of externality

5-4

The Nature of Externalities-Graphical Analysis

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

Actual outputSocially efficient output

ab

c

d

f

e

g

h

5-5

What Pollutants Do Harm?

Empirical Evidence: What is the Effect of Pollution on Health?

What Activities Produce Pollutants? What is the Value of the Damage Done? Empirical Evidence: The Effect of Air

Pollution on Housing Values

5-6

The Coase Theorem

Coase Theorem – Provided that transaction casts are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights

Assumptions necessary for Coase Theorem to work The costs to the parties of bargaining are low The owners of resources can identify the source of

damages to their property and legally prevent damages

5-7

Other Private Solutions

Mergers Social conventions

5-8

Public Responses to Externalities - Taxes

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

Pigouviantax revenues

i

j

5-9

Public Responses to Externalities - Subsidies

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

(MPC + cd)

i

jgk

h

f

e

Pigouviansubsidy

5-10

Cap-and-Trade v Emissions Fee

0Pollution reduction

MSB

MC*

e*

f*

$

MC’

ef e’

Too much pollution reductionToo little pollution reduction

5-11

Cap-and-Trade v Emissions Fee

0Pollution reduction

MC*

e*

f*

$

MC’

ef e’

MSB

Too much pollution reductionToo little pollution reduction

5-12

Emissions Fee v Cap-and-Trade

Responsiveness to Inflation Responsiveness to Cost Changes Responsiveness to Uncertainty

5-13

Command-and-Control Regulation

Incentive-based regulations Command-and-control regulations

technology standard performance standard

Is command-and-control ever better? hot spots

5-14

The U.S. Response

Clean Air Act Command-and-control in the 70s How well did it work?

5-15

Progress with Incentive-based Approaches

Policy Perspective: Cap-and-Trade for Sulfur Dioxide

Policy Perspective: Cap-and-Trade to Protect Fisheries and Wildlife individual transferable quotas

5-16

Implications for Income Distribution

Who Benefits? Who Bears the Cost?

5-17

Positive Externalities

Researchper year

$

MPB

MC

MEB

MSB = MPB + MEB

R*R1