Chapter 5: Externalities Problems and Solutions Outline Externality theory Private solutions Public solutions Focus on prices or focus on quantities? A

Chapter 5: ExternalitiesProblems and Solutions

Outline Externality theory Private solutions Public solutions Focus on prices or focus on

quantities? A couple problems

Introduction Externalities arise whenever the actions

of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.

As we will see, this represents a market failure for which government action could be appropriate and improve welfare.

Externalities can be negative or positive: Acid rain, bad. Asking good questions in class,

good.

Introduction

Global warming is likely the result of a negative externality. Most scientists who study the issue believe this warming trend is caused by human activity, namely the use of fossil fuels.

These fuels, such as coal, oil, natural gas, and gasoline 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.

Figure 1

Global Average Temperature Over Time

56

56.5

57

57.5

58

58.5

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Year

Glo

bal

ave

rag

e te

mp

erat

ure

This table shows the global temperature during the 20th century.

There has been a distinct trend upward in temperature

Introduction Although this warming trend has negative

effects overall on society, the distributional consequences vary. In much of the United States, warmer temperatures

may 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 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! But

this is the essence of an externality – your actions have consequences for others that you do not consider.

EXTERNALITY 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).

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

A negative consumption externality is when an individual’s consumption reduces the well-being of others who are not compensated by the individual. Positive externalities are similar to negative externalities,

except the actions have beneficial effects for others.

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. And they are not compensated for this harm.

Figure 2Figure 2 illustrates each party’s incentives in this situation.

Price of steel

p1

p2

0 Q2 Q1

This framework does not capture the harm done to

the fishery, however.

The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q1.

QSTEEL

D = PMB = SMB

S=PMCSMC = PMC + MD

MD

Figure 2 Negative Production Externalities

The socially optimal level of production is at Q2, the

intersection of SMC and SMB.

The yellow triangle is the consumer and producer

surplus at Q1.The marginal damage

curve (MD) represents the fishery’s harm per unit.

The social marginal cost is the sum of PMC and MD, and represents the cost to society.

The red triangle is the deadweight loss from the private production level.

The steel firm overproduces from society’s viewpoint.

Negative Consumption Externalities

We now move on to negative consumption externalities. Consider the following example: A person at a restaurant smokes cigarettes. That smoking has a negative effect on your

enjoyment of the restaurant meal. In this case, the consumption of a good

reduces the well-being of someone else. Figure 3Figure 3 illustrates each party’s incentives in

the presence of a negative consumption externality.

QCIGARETTES

Price of cigarettes

0 Q2

D=PMB

Q1

p1

S=PMC=SMC

SMB=PMB-MD

MDp2

The yellow triangle is the surplus to the smokers (and producers) at Q1.

This framework does not capture the harm done to non-smokers, however.

The smoker sets PMB=PMC to find his

privately optimal quantity of cigarettes, Q1.The MD curve represents

the nonsmoker’s harm per pack of cigarettes.

The social marginal benefit is the difference between PMB

and MD.

The socially optimal level of smoking is at Q2, the

intersection of SMC and SMB.

The smoker consumes too many cigarettes from society’s

viewpoint.

The red triangle is the deadweight loss from the private production level.

Figure 3 Negative Consumption Externalities

Externalities Result in Underproduction or

Overproduction

The theory shows that when a negative externality is present, the private market will produce too much of the good, creating deadweight loss.

When a positive externality is present, the private market produces too little of the good, again creating deadweight loss.

Graphing Externalities Determine whether the externality is associated

with production (steel, donuts) or consumption (smoking, landscaping).

Is the externality positive (donuts, landscaping) or negative (steel, smoking). Negative production externality, SMC is above PMC Positive production externality, SMC is below PMC Negative consumption externality, SMB is below PMB Positive consumption externality, SMB is above PMB

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.

QSTEEL

Price of steel

0 Q2

D = PMB SMB

Q1

p1

S = PMCSMC = PMC + MD

MD

p2

But there is room to bargain. The steel firm gets a lot of surplus from the first unit.

1 2

This bargaining process will continue until the socially

efficient level.

There is still room to bargain. The steel firm gets a bit less surplus from the second unit.

Thus, it is possible for the steel firm to “bribe” the fishery in

order to produce the first unit.

The reason is because any steel production makes the

fishery worse off.

Thus, it is possible for the steel firm to “bribe” the fishery in

order to produce the next unit.

If the fishery had property rights, it would initially impose

zero steel production.

While the fishery suffers only a modest amount of damage.

While the fishery suffers the same damage as from the

first unit.

Figure 5

Negative Production Externalities and Bargaining: Giving the Fish People Property Rights

The gain to society is this area, the difference between (PMB -PMC)

and MD for the second unit.

The gain to society is this area, the difference between (PMB -PMC) and MD for the first unit.

Figure 6

Negative Production Externalities and Bargaining: Steel Producers Have Property Rights

QSTEEL

Price of steel

0 Q2

D=PMB=SMB

Q1

p1


MD

p2

The fishery gets a lot of surplus from cutting back

steel production by one unit.

This level of production maximizes the consumer and

producer surplus.

If the steel firm had property rights, it would initially choose

Q1.

While the steel firm suffers a larger loss in profits.

The gain to society is this area, the difference between MD and (PMB-

PMC) by cutting back 1 unit.While the steel firm suffers

only a modest loss in profits.

The gain to society is this area, the difference between MD and (PMB -

PMC) by cutting another unit.

This bargaining process will continue until the socially

efficient level.

Thus, it is possible for the fishery to “bribe” the steel firm

to cut back another unit.

Thus, it is possible for the fishery to “bribe” the steel firm

to cut back.

The fishery gets the same surplus as cutting back from

the first unit.

Problems with Coasian Solutions

There are several problems with the Coase Theorem, however. The assignment problem

Hard to assign blame, hard to value marginal damages The holdout problem

Each party has power, so it can be hard to negotiate settlements

The free rider problem If investment is costly, but benefits are common,

individuals will underinvest. Transaction costs and negotiating 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: Corrective taxation Subsidies Regulation

QSTEEL

Price of steel

0 Q2

D = PMB = SMB

Q1

p1

S=PMCSMC=PMC+MD

p2

The steel firm initially produces at Q1, the intersection of PMC

and PMB.Imposing a tax shifts the PMC

curve upward and reduces steel production.

S=PMC+tax

Imposing a tax equal to the MD shifts the PMC curve such that

it equals SMC.

The socially optimal level of production, Q2, then maximizes

profits.

Figure 7 Pigouvian Tax

Subsidies

The government can impose a “Pigouvian” subsidy on producers of positive externalities, which increases its output.

If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point.

Figure 8Figure 8 illustrates such a subsidy.

QDONUTS

Price of donuts

0 Q2

D = PMB = SMB

Q1

p1

S = PMC

SMC=PMC-EMB

p2

The donut shop initially chooses Q1, maximizing its

profits.

Providing a subsidy shifts the PMC curve downward.

The socially optimal level of donuts, Q2, is achieved by such

a subsidy.

Providing a subsidy equal to EMB shifts the PMC

curve downward to SMC.

Figure 8 Pigouvian Subsidy

Regulation

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

For example, return to the steel firm in Figure 9Figure 9.

QSTEEL

Price of steel

0 Q2

D = PMB = SMB

Q1

p1


p2

The firm has an incentive to produce Q1.

Yet the government could simply require it to produce no

more than Q2.

Figure 9 Quantity Regulation

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY 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-reduction technology.

Figure 10 Model of Pollution Reduction

On its own, the steel company would set QR=0 and QSteel=Q1.

QR

PR

0

MD = SMB

R*

S=PMC=SMC

D = PMB

S=PMC

While it faces increasing marginal costs from reducing

its pollution level.

While the benefit of pollution reduction is zero the firm, society benefits by MD.

The good that is being created is “pollution reduction.”

Since it pays for the pollution reduction, the SMC is the same

as PMC.

Pollution reduction has a price associated with it.

The steel firm’s private marginal benefit from pollution

reduction is zero.Such an action maximizes its profits.

The optimal level of pollution reduction is therefore R*.

RFull

At some level of pollution reduction, the firm has achieved

full pollution reduction.

More pollution

P*PFull 0

Thus, the x-axis also measures pollution levels as we move

toward the origin.



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

Assume firm “A” is more efficient than firm “B” at such reduction.

Figure 11Figure 11 illustrates the situation.

QR

PR

0

MD=SMB

R*

S = PMCA + PMCB = SMC

Firm B has relatively inefficient pollution

reduction technology.

PMCB PMCA

PMCB

PMCA

For any given output level, PMCB>PMCA.

While Firm A’s is more efficient.

The SMB curve is the same as before.

RA,RB

Quantity regulation in this way is clearly inefficient,

since Firm B is “worse” at reducing pollution.

If, instead, we got more reduction from Firm A, we could lower the total social

cost.

RARB

The efficient level of pollution reduction is the same as before.

To get the total marginal cost, we sum

horizontally.Efficient regulation is

where the marginal cost of pollution reduction for each firm equals SMB.

Quantity regulation could involve equal reductions in

pollution by both firms, such that R1 + R2 = R*.

Imposing a Pigouvian tax equal to MD induces these

levels of output.

Figure 11 Two Firms Emit Pollution



Figure 11Figure 11 shows that price regulation through taxes is more efficient than is quantity regulation.

A final option is quantity regulation with tradable permits. Idea is to: Issue permits that allow firms to pollute And allow firms to trade the permits



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 Firm A’s permits, since reducing its emissions costs PMCB (>PMCA). Both sides could be made better off by Firm A selling a permit to Firm B, and then Firm A simply reducing its pollution level. This trading process continue until PMCB=PMCA.



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

Figure 12Figure 12 shows the case when the social marginal benefit is “locally flat.”

Figure 12 Model with Uncertainty and Locally Flat Benefits

QR

PR

0

MD = SMB

R1

PMC1

First, assume the SMB is downward sloping, but fairly

flat.

RFull

More pollution

PFull 0

This could be the case for global warming, for

example.

In addition, imagine that the government’s best

guess of costs is PMC1.

But it is possible for the firm’s costs to be PMC2.

PMC2

Regulation mandates R1.

If, instead, the government levied a tax, it would equal

MD at QR = R1.

Suppose the true costs are PMC2.

Then there is large deadweight loss.

This results in a much smaller DWL,

and much less pollution reduction.

R3



Figure 13Figure 13 shows the case when the social marginal benefit is “locally steep.”

Figure 13Model with Uncertainty and Locally Steep Benefits

QR

PR

0

MD = SMB

R1

PMC1

RFull

More pollution

PFull 0

In addition, imagine that the government’s best

guess of costs is PMC1.

But it is possible for the firm’s costs to be PMC2.

PMC2

Regulation mandates R1.

If, instead, the government levied a tax, it would equal

MD at QR = R1.

This results in a larger DWL, and

much less pollution reduction.

R3

First, assume the SMB is downward sloping, and fairly

steep.

This could be the case for nuclear

leakage, for example.

Suppose the true costs are PMC2.

Then there is small deadweight loss.



These figures show the implications for choice of quantity regulation versus corrective taxes. The key issue is whether the government wants to

get the amount of pollution reduction correct, or to minimize firm costs.

Quantity regulation assures the desired level of pollution reduction. When it is important to get the right level (such as with nuclear leakage), this instrument works well.

However, corrective taxation protects firms against large cost overruns.

Documents

Chapter 5: Externalities Problems and Solutions Outline Externality theory Private solutions Public solutions Focus on prices or focus on quantities? A