Transcript Chapter 10

Externalities
Chapter 10
Ratna K. Shrestha
Introduction/Background
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Lets assume that your cigarette smoking in the
classroom benefits you by $10 but harms the rest
of the 150 students by $300 ($2 harm per head).
In this case if there is no regulation, you will smoke
in the classroom which will cause $300 – $10 =
$290 harm to the class as a whole (total harm net
of your benefits).
Then the question is how can the government
prevent this $290 harm from occurring?
An externality arises...
. . . when a person engages in an activity (production or
consumption) that influences the well-being of a
bystander and yet neither pays nor receives any
compensation for that effect.
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Externality can be Negative or Positive depending upon
whether the action of one party imposes a cost or benefit
on another party.
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Externality can also be production or consumption
depending on whether the externality is caused by
production or consumption activities.
Types of Externalities
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Negative Externalities: Examples
ä Steel plant dumping waste in a
river.
ä Noise in the neighborhood.
ä Vehicle exhaust causing harm to
the environment.
ä acid rain caused by coal burning
production releasing SO2.
ä global warming due to greenhouse
gases (carbon particles from fossil
fuel combustion, etc.).
ACID RAIN
Types of Externality
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Positive Externality: Examples
ä research and innovation.
ä neighbor’s nice backyard.
ä Immunization.
Examples of production externality:
ä A paper factory dumping its waste to the river.
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Example of consumption externality:
ä Cigarette smoking in the classroom, Drinking and
driving.
The Externality of SUVs
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Consider a real-life example: the use of sport utility
vehicles (SUVs). They create three sorts of
externalities:
ä Environmental externalities: They consume a lot
of gasoline and create more air pollution.
ä Wear and tear on roads: SUV drivers do not bear
the full costs of damage to the roads (other
vehicles also share the costs) that result from
their vehicles.
ä Safety externalities: When SUVs are in
accidents, the other drivers are often more
severely injured.
The Market for Aluminum...
Price of
Aluminum
Supply
(private MC)
Equilibrium
Demand
(private value)
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QMARKE
T
Quantity of AL
Market for Aluminum
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

In the absence of any externality, the quantity
produced and consumed in the market equilibrium is
efficient in the sense that in this case the sum of
producer and consumer surplus is maximized.
If the aluminum factory emits pollution (a negative
externality), then the cost to society of producing
aluminum is larger than the cost of production to
the factory.
MC to Society, MSC = MC of production of the
factory + MC of pollution to the environment.
The MC of pollution to the environment is called
marginal external cost (MEC).
Pollution and Dead Weight Loss
Price of
Aluminum
Social MC
=Private MC +MEC
Supply
Dead Weight Loss
(private MC)
Popt
.
PMarket
Market Equilibrium
Demand
(private value)
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QOptimumQMarket
Quantity of AL
Socially Optimal Output
The
government can internalize a negative
externality by imposing a Pigovian tax (t = MEC at
Qopt) on the producer.
This tax induces the producer to reduce the
equilibrium quantity to the socially desirable quantity,
and thus eliminate the Dead Weight Loss.
Pigouvian tax: as a solution to
negative externality
Price of
Aluminum
Market Eqlbm.
with tax
Supply after tax
(=Social MC)
MC+t
Supply
(private MC)
Ptax.
Pno tax
Market Equilibrium
without tax
t
Demand
(private value)
0
Qtax
Qno tax
Quantity of AL
Positive Externalities in
Production
When an externality benefits bystanders, a positive
externality exists.
A technology spillover is a type of positive
externality because a firm’s innovation or design not
only benefits the firm, but enters society’s pool of
technological knowledge and benefits society as a
whole.
Positive Externalities in
Production...
Price
of Robot
Marginal Value of Supply (private MC)
technology
spillover
Social MC
Market
Equilibrium
Deadweight
Loss
Optimum
Demand
(private value)
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QMARKET QOPTIMUM
Quantity
Of technology
Internalizing Externalities
1.
Subsidy: Government usually uses subsidies (s =
MEB at the optimum Q) as the primary method
for attempting to internalize positive
externalities.
2.
Technology Policy: Government intervention in
the economy that aims to promote technologyenhancing industries is called technology policy.
Technology policy is also one way to internalize
positive production externality
Technology Policy
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Patent laws are a form of technology policy that
give the individual (or firm) with patent
protection a property right over its invention.
The patent is then said to internalize the
externality, in that it provides more incentives to
invest in modern technology than that would
occur otherwise.
Externalities in Consumption
Externalities associated with consumption
activities.
Examples:
u Alcohol: If people drive under the influence of
alcohol, it imposes a negative externality.
u Education: a positive externality because more
education means a better society.
Consumption Externalities...
(b) Positive Consumption
Externality
(a) Negative Consumption
Externality
Price
of Alcohol
Supply
(private cost)
Price of
Education
DWL
Supply
(private cost)
DWL
Social
value
Demand
(private value)
Demand
Social value
0
Qo QM
Quantity
of Alcohol
(private value)
0
QM Qo
Quantity of
Education
Externalities and Market
Inefficiency
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u
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 smaller quantity than is
socially desirable.
Private Solutions to Externalities
Government action is not always needed to solve
the problem of externalities. Sometimes private
polluters themselves take care of it.
Examples:
1. Moral codes and social sanctions.
2. Charitable organizations.
3. Integrating different types of businesses.
4. Bargaining between parties
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 regardless
of who (i.e., polluter or victims) owns the property
rights.
Transaction costs are the costs that parties incur
in the process of agreeing to and following through
on a bargain.
Bargaining: An Example
Suppose Jim owns a dog from which he gets benefits = $ 500.
 The dog’s barking causes harm to Jerry = $ 800.
 Since benefit < harm, getting rid of dog is good for Jim and
Jerry combined (that is society as a whole).
 How can they come to a negotiated solution?

If
Jerry has the right to noise-free environment, then Jim
cannot offer any amount that is acceptable to Jerry. Jim cannot
keep the dog--the efficient solution.
 If Jim has the right, then Jerry can offer Jim $501 to $799 to
sell off the dog, which he will gladly accept—the efficient
solution.
Coase Theorem at Work
Garbage spilling in NY harbor caused damage to New
Jersey shore oftentimes littering its beaches.
New Jersey had right to clean beaches and could have sued
NY city.
 But by Sept of 1987, they came to a negotiated settlement.

Sometimes the private solution approach fails because
transaction costs can be so high that private agreement is not
possible.
Public Policy Toward Externalities
When externalities are significant and private solutions are
not found, government may attempt to solve the problem
through . . .
command-and-control policies.
market-based policies.
Command-and-Control Policies
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Usually take the form of regulations:
u Forbid certain behaviors.
u Require certain behaviors
u
Examples:
u Requirements that all students be immunized.
u Stipulations on pollution emission levels set by the
Environment Canada.
u Moratorium on cod fishing in the Atlantic Canada.
Command and Control: Examples
Smoking Ban
Emission Standard for Cars
Market-Based Policies
u
u
u
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.
Why gasoline is taxed so heavily?
 Causes many negative externalities: congestion,
accidents, pollution.
Examples of Regulation versus
Pigovian tax
If the Environment Canada (EC) decides to reduce
the amount of pollution coming from a specific plant,
it 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).
Market-Based Policies
u Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another.
u How does it work?
u The govt. creates the number of emission or
pollution permits equal to the desired level of
pollution and distribute them among the polluters.
u Polluters can pollute only if they possess emission
permits.
u Polluters are allowed to trade the permits among
themselves.
Market-Based Policies
u A market clearing price for the permits will evolve
in the market for pollution rights.
u A polluting firm that can reduce pollution at a lower
cost will find it beneficial to sell its permits (and
control pollution). On the other hand, a high cost
firm will find it beneficial to buy the permits and
emit pollution.
u The trade takes place until the MC of pollution
control are equal across all polluters with the
achievement of the desired level of pollution at the
minimum costs.
The Equivalence of Pigovian Taxes
and Pollution Permits...
(a) Pigovian Tax
Price of
Pollution
(b) Pollution Permits
Price of
Pollution
Pigovian
Tax
P
Supply of Permits
P
Demand
Demand
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Q
Quantity of 0
Pollution Permits
Q Quantity of
Permits