ECN101: Externalities

1
ECN101 Externalities

• Define
• Negative and Positive Externalities
• Production and Consumption Externalities
• Solutions
• Private
• Government Intervention

2
Market Efficiency - Market Failures

• Recall that invisible hand of the marketplace
  leads self-interested buyers and sellers in a
  market to maximize the total benefit that society
  can derive from a market.

But market failures can still happen.
3
Market Failures Externalities

• When a market outcome affects parties other than
  the buyers and sellers in the market,
  side-effects are created called externalities.
• Externalities cause markets to be inefficient,
  and thus fail to maximize total surplus.

4
An externality arises...

• . . . when a person engages in an activity that
  influences the well-being of a bystander and yet
  neither pays nor receives any compensation for
  that effect.

5
Market Failures Externalities

• When the impact on the bystander is adverse, the
  externality is called a negative externality.
• When the impact on the bystander is beneficial,
  the externality is called a positive externality.

6
Examples of Negative Externalities

• Automobile exhaust
• Cigarette smoking
• Barking dogs (loud pets)
• Loud stereos in an apartment building

7
Examples of Positive Externalities

• Restored historic buildings
• Research into new technologies

8
The Market for Aluminum...
Supply (private cost)
Demand (private value)
0
Quantity of Aluminum
9
The Market for Aluminum and Welfare Economics

• The quantity produced and consumed in the market
  equilibrium is efficient in the sense that it
  maximizes the sum of producer and consumer
  surplus.

10
The Market for Aluminum and Welfare Economics

• If the aluminum factories emit pollution (a
  negative externality), then the cost to society
  of producing aluminum is larger than the cost to
  aluminum producers.

11
The Market for Aluminum and Welfare Economics

• For each unit of aluminum produced, the social
  cost includes the private costs of the producers
  plus the cost to those bystanders adversely
  affected by the pollution.

12
Pollution and the Social Optimum...
Supply
(private cost)
Demand
(private value)
Quantity of
0
Aluminum
13
Negative Externalities in Production

• The intersection of the demand curve and the
  social-cost curve determines the optimal output
  level.
• The socially optimal output level is less than
  the market equilibrium quantity.

14
Achieving the Socially Optimal Output

• Internalizing an externality involves altering
  incentives so that people take into account the
  external effects of their actions.

15
Achieving the Socially Optimal Output

• The government can internalize an externality by
  imposing a tax on the producer to reduce the
  equilibrium quantity to the socially desirable
  quantity.

16
Positive Externalities in Production

• When an externality benefits the bystanders, a
  positive externality exists.
• The social costs of production are less than the
  private cost to producers and consumers.

17
Positive Externalities in Production

• A technology spillover is a type of positive
  externality that exists when a firms innovation
  or design not only benefits the firm, but enters
  societys pool of technological knowledge and
  benefits society as a whole.

18
Positive Externalities in Production...
Supply (private cost)
Demand
(private value)
Quantity
0
of Robots
19
Positive Externalities in Production

• The intersection of the demand curve and the
  social-cost curve determines the optimal output
  level.
• The optimal output level is more than the
  equilibrium quantity.
• The market produces a smaller quantity than is
  socially desirable.
• The social costs of production are less than the
  private cost to producers and consumers.

20
Internalizing Externalities Subsidies

• Government many times uses subsidies as the
  primary method for attempting to internalize
  positive externalities.

21
Internalizing Production Externalities

• Taxes are the primary tools used to internalize
  negative externalities.
• Subsidies are the primary tools used to
  internalize positive externalities.

22
Consumption Externalities...
(b) Positive Consumption Externality
(a) Negative Consumption Externality
Price
of Alcohol
Price of
Supply
Education
(private cost)
Supply
(private cost)
Social
Demand (private value)
value
Demand
(private value)
Social value
0
Q
Q
0
Q
Q
Quantity of
Quantity
MARKET
OPTIMUM
MARKET
OPTIMUM
Education
of Alcohol
23
Externalities and Market Inefficiency

• Negative externalities in production or
  consumption lead markets to produce a larger
  quantity than is socially desirable.
• Positive externalities in production or
  consumption lead markets to produce a larger
  quantity than is socially desirable.

24
Private Solutions to Externalities

• Government action is not always needed to solve
  the problem of externalities.

25
Types of Private Solutions to Externalities

• Moral codes and social sanctions
• Charitable organizations
• Integrating different types of businesses
• Contracting between parties

26
The Coase Theorem

• The Coase Theorem states that if private parties
  can bargain without cost over the allocation of
  resources, then the private market will always
  solve the problem of externalities on its own and
  allocate resources efficiently.

27
The Coase Theorem

• Ex Suppose Rachel and Joey are roommates and
  Rachel likes to listen to music. The following
  table shows the private marginal benefit (PMB)
  and the private marginal cost (PMC) to Rachel of
  listening to music. However, Joey is not a music
  fan. The table illustrates the marginal damage
  (MD) that each hour of music does to Joey

28
If Rachel makes a decision of how much music to
listen to on her own, what will she choose and
why?
29
If Rachel makes a decision of how much music to
listen to on her own, what will she choose and
why?
Rachels private choice PMBPMC
30
What is the socially optimal level of music? How
do you know?
31
What is the socially optimal level of music? How
do you know? Compare PMB to SMC
Socially optimal because PMBSMC
32
Why are they different?
Socially optimal because PMBSMC
Rachels private choice PMBPMC
33
Why are they different? No one owns the rights to
the noise level in the room, so Rachel doesnt
consider the costs to Joey.
Socially optimal because PMBSMC
Rachels private choice PMBPMC
34
Suppose their neighbor Monica has power to assign
property rights to the noise level in the
apartment.
Socially optimal because PMBSMC
Rachels private choice PMBPMC
35
What if she gives the rights to Joey? Joey owns
the right to music/noise in the apartment. If
Rachel wants music hours, she can buy it from
Joey.
How many hours of music will Joey choose
initially?
36
What if Joey has the rights ?
How many hours of music will Joey choose
initially? 0 Can Rachel pay him to listen to
more hours?
37
What was Rachels net benefit of the 1st
hour?What was the cost to Joey of the 1st
hour?Can they agree to a deal?
38
What was Rachels net benefit of the 1st hour?
10What was the cost to Joey of the 1st hour?
4Can they agree to a deal? YES, Rachel can pay
Joey enough to get him to listen to the 1st hour
of music
39
What was Rachels net benefit of the 2nd
hour?What was the cost to Joey of the 2nd
hour?Can they agree to a deal?
40
What was Rachels net benefit of the 2nd hour?
6What was the cost to Joey of the 2nd hour?
4Can they agree to a deal? YES
41
What was Rachels net benefit of the 3rd
hour?What was the cost to Joey of the 3rd
hour?Can they agree to a deal?
42
What was Rachels net benefit of the 3rd hour?
4What was the cost to Joey of the 3rd hour?
4Can they agree to a deal? YES
43
What was Rachels net benefit of the 4th
hour?What was the cost to Joey of the 4th
hour?Can they agree to a deal?
44
What was Rachels net benefit of the 4th hour?
2What was the cost to Joey of the 4th hour?
4Can they agree to a deal? NO-Rachel cannot
pay enough
Hours of music if Joey has the property rights
45
What if she gives the rights to Rachel? Now,
Rachel owns the right to music/noise in the
apartment. If Joey wants quiet, he can buy it
from Rachel.
How many hours of music will Rachel choose
initially?
46
What if Rachel has the rights?
How many hours of music will Rachel choose
initially? 5 Can Joey pay her to listen to fewer
hours?
47
What was Rachels net benefit of the 5th
hour?What was the cost to Joey of the 5th
hour?Can they agree to a deal?
48
What was Rachels net benefit of the 5th hour?
0What was the cost to Joey of the 5th hour?
4Can they agree to a deal? YES, Joey can pay
Rachel enough to get her not to listen to the 5th
hour of music
49
What was Rachels net benefit of the 4th
hour?What was the cost to Joey of the 4th
hour?Can they agree to a deal?
50
What was Rachels net benefit of the 4th hour?
2What was the cost to Joey of the 4th hour?
4Can they agree to a deal? YES
51
What was Rachels net benefit of the 3rd
hour?What was the cost to Joey of the 3rd
hour?Can they agree to a deal?
52
What was Rachels net benefit of the 4th hour?
4What was the cost to Joey of the 4th hour?
4Can they agree to a deal? YES
53
What was Rachels net benefit of the 2nd
hour?What was the cost to Joey of the 2nd
hour?Can they agree to a deal?
54
What was Rachels net benefit of the 2nd hour?
6What was the cost to Joey of the 2nd hour?
4Can they agree to a deal? NO - Joey cannot
pay enough
Hours of music if Rachel has the property rights
55
Coase Theorem

• Socially efficient number of hours?
• 3
• How many hours of music if Joey has the property
  rights?
• 3
• How many hours of music if Rachel has the
  property rights?
• 3

56
Coase Theorem

• With low bargaining costs, the private market
  will reach the efficient outcome on their own.
  The efficient solution arises no matter who gets
  the property rights.

57
Coase Theorem Problems

• Need few transaction costs - small number of
  people
• Need to be able to identify the source of the
  externality

58
Why Private Solutions Do Not Always Work

• Sometimes the private solution approach fails
  because transaction costs can be so high that
  private agreement is not possible.

59
Public Policy Toward externalities

• When externalities are significant and private
  solutions are not found, government may attempt
  to solve the problem

60
Public Policy Toward Externalities

• Command-and-Control Policies
• Market-Based Policies
• Pigouvian Tax
• Tradeable rights

61
Command-and-Control Policies

• Usually take the form of regulations
• Forbid certain behaviors.
• Require certain behaviors.
• Examples
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by
  the Environmental Protection Agency (EPA).

62
Market-Based Policies

• Government uses taxes and subsidies to align
  private incentives with social efficiency.
• Pigovian taxes are taxes enacted to correct the
  effects of a negative externality.

63
Examples of Regulation versus Pigovian tax

• If the EPA decides it wants to reduce the amount
  of pollution coming from a specific plant. The
  EPA could
• tell the firm to reduce its pollution by a
  specific amount (i.e. regulation).
• levy a tax of a given amount for each unit of
  pollution the firm emits (i.e. Pigovian tax).

64
Pigovian Tax
Supply
(private cost)
Demand
(private value)
Quantity of
0
Aluminum
65
Pigouvian Tax Problems

• Need to know who is creating the externality
• Need to know the value of the cost -- MD

66
Pigouvian Tax Distributional Effects

• The consumers and producers in the market that
  creates the externality pay the tax and are worse
  off.

67
Pigovian Subsidy
Supply (private cost)
Demand
(private value)
Quantity
0
of Robots
68
Market-Based Policies

• Tradable pollution permits allow the voluntary
  transfer of the right to pollute from one firm to
  another.
• A market for these permits will eventually
  develop.
• A firm that can reduce pollution at a low cost
  may prefer to sell its permit to a firm that can
  reduce pollution only at a high cost.

69
Regulation and Tradable Pollution rights

• Example We want to limit the output of sulfur
  dioxide (SO2), which causes acid rain. Suppose
  Wisconsin Power and Light (WPL) currently emits
  13 units of sulfur dioxide and Tennessee Valley
  Authority (TVA) currently emits 15 units of
  sulfur dioxide for at total of 28 units. Suppose
  the government wants to decrease the total units
  of sulfur dioxide to 22.

70
Marginal Cost of Eliminating Sulfur Dioxide (S02)
What is marginal cost (MC)? Cost of reducing
pollution by one more unit!
71
Suppose the government regulates that both must
reduce pollution to 11 units. Cost of regulation?
72
Recall WPL currently emits 13 units and TVA
currently emits 15
How many units does WPL have to eliminate to
get down to the govt regulated level of 11?
2. How much will that cost? How many units does
TVA have to eliminate? 4. How much will that
cost?
73
WPL currently emits 13 units and TVA currently
emits 15
How many units does WPL have to eliminate to
get down to the govt regulated level of 11?
2. How much will that cost? 100200 300 How
many units does TVA have to eliminate? 4. How
much will that cost? 4005007009002500 Total
cost of regulation 30025002800
74
Now suppose each company is given 11 rights to
pollute and they are tradable (i.e., one company
can buy them from the other)

• Who is going to buy permits?
• Who is going to sell?

75
A firm that can reduce pollution at a low cost
may prefer to sell its permit to a firm that can
reduce pollution only at a high cost.
76
Now suppose each company is given 11 rights to
pollute and they are tradable (i.e., one company
can buy them from the other)

• Who is going to buy permits? TVA
• Who is going to sell? WPL

77
Now suppose each company is given 11 rights to
pollute and they are tradable (i.e., one company
can buy them from the other)
78
Start with 11 permits each, how many units of
pollution have they eliminated?
79
Recall, there are only 22 permits in the economy.
If TVA wants to pollute more than 11, how can
they? Buy a permit from WPL!
80
How much is TVA willing to pay, not to have to
reduce the last unit of pollution (from 12 to
11)?How much is WPL willing to accept to
eliminate one more unit of pollution (from 11 to
10)?
81
How much is TVA willing to pay, not to have to
reduce the last unit of pollution (from 12 to
11)?How much is WPL willing to accept to
eliminate one more unit of pollution (from 11 to
10)?
82
Will a deal take place? YES! - Note still only 22
permits in the economy.
83
Recall, there are only 22 permits in the economy.
If TVA wants to pollute more than 12, how can
they? Buy a permit from WPL!
84
How much is TVA willing to pay, not to have to
reduce the last unit of pollution (from 13 to
12)?How much is WPL willing to accept to
eliminate one more unit of pollution (from 10 to
9)?
85
Will a deal take place? YES Note still only 22
permits in the economy.
86
Recall, there are only 22 permits in the economy.
If TVA wants to pollute more than 13, how can
they? Buy a permit from WPL!
87
How much is TVA willing to pay, not to have to
reduce the last unit of pollution (from 14 to
13)?How much is WPL willing to accept to
eliminate one more unit of pollution (from 9 to
8)?
88
Will a deal take place? NO stop at line 3!
89
From their initial polluting levelsHow many did
WPL eliminate? 13-9 4 At what cost? How many
did TVA eliminate? 15-13 2 At what cost?
90
WPL eliminated 4 At what cost?
1002003004501050 TVA eliminated 2 At what
cost? 400500900Total Cost 1050900 1950
91
Which is the lower cost way of eliminating
pollution, regulation or tradable pollution
rights?

• Total cost of regulation
• 2800
• How?
• WPL reduced by 2, TVA reduced by 4

• Total cost of tradable pollution rights
• 1950
• How?
• WPL reduced by 4, TVA reduced by 2

92
Which is more efficient, regulation or tradable
pollution rights? Tradable pollution rights!

• Total cost of regulation
• 2800
• How?
• WPL reduced by 2, TVA reduced by 4

• Total cost of tradable pollution rights
• 1950
• How?
• WPL reduced by 4, TVA reduced by 2

93
Which is more efficient, regulation or tradable
pollution rights? Tradable pollution rights!

• Regulations
• WPL reduced by 2, TVA reduced by 4

• Tradable rights
• WPL reduced by 4, TVA reduced by 2

WHY? With tradable pollution rights, the company
that can reduce pollution in the least costly
way does!
94
Government Intervention - Establish Property
Rights

• Externalities lead to inefficiencies because
  property rights (who owns the good) arent clear
• Example Rachel and Joey

95
Coase Theorem

• With low bargaining costs, establishing property
  rights is sufficient to lead to an efficient
  solution. The efficient solution arises no
  matter who gets the property rights.

96
Coase Theorem Benefits

• Minimum government intervention just assign
  property rights
• Ex Government doesnt need to know the value of
  the damage being done.

97
Coase Theorem Distributional Effects

• Person who gets the property rights is better
  off, person who does not, is worse off.

98
Summary

• When a transaction between a buyer and a seller
  directly affects a third party, the effect is
  called an externality.
• Negative externalities cause the socially optimal
  quantity in a market to be less than the
  equilibrium quantity.
• Positive externalities cause the socially optimal
  quantity in a market to be greater than the
  equilibrium quantity.

99
Summary

• Those affected by externalities can sometimes
  solve the problem privately.
• The Coase theorem states that if people can
  bargain without a cost, then they can always
  reach an agreement in which resources are
  allocated efficiently.

100
Summary

• When private parties cannot adequately deal with
  externalities, then the government steps in.
• The government can either regulate behavior or
  internalize the externality by using Pigovian
  taxes or assign pollution/property rights.