Further Topics

Chapter 7

Scope of Issues

 How does the distribution of property rights affect the working of the economy?

 What happens if some consumers get excluded from enjoying a particular public good?

 The distribution of incomes across consumers and over time

Eliminating Production Externalities

 The basic problem with externalities is the lack of markets for the associated goods or bads (e.g. clean air or pollution amounts)  The absence of markets for goods or bads involved into the production of externalities results in the inefficient (in the Pareto sense) allocation of resources

Million $

Costs of Reducing Emission by Two Firms

Million $ FIRM 1 Marginal Costs of Reducing Emission FIRM 2 10 8 6 10 16 16 Quantity of Emissions Reduced

Emission Standards

 The control authority wants to halve total emission level from the current 32 tons down to 16 tons. For example, emission limits of 8 tons may be imposed on each firm.

 This approach is the easiest one in the absence of perfect information on the firms ’ marginal costs  For the interval of emission levels below 10 tons first firm ’ s marginal costs are lower than the second firm ’ s marginal costs of reducing emission  This solution is not cost-effective: one can reduce social costs of reducing emission (i.e. the sum of the total costs for each firm of reducing its level of emission) by decreasing the limit of emission to 6 tons for the first firm (and increasing the limit for the second firm to 10 tons)

Uniform Emission Charge

 A uniform charge is the price a firm has to pay for each ton of emission it produces  Firms reduce their emission levels depending on the uniform charge and their marginal costs of reducing emissions    For a uniform charge of $10 million the first firm will choose to reduce 10 tons of emission (verify using graph) For a uniform charge exceeding $10 million the first firm will choose to reduce all its emission The second firm will be indifferent between all possible levels of reduction if the uniform charge is exactly $10 million  In order to solve the problem by imposing uniform charges on emission levels, the authority must possess perfect knowledge about the firms ’ production costs  Since perfect information is a utopia, the authority has to take a blind guess or engage in grid search, both options being too expensive

Transferable Emission Permit System

 Each firm is required to have a certain amount of permits to emit  For example, a firm possessing five permits is allowed to produce five tons of emission  Permits are freely transferable meaning the market for emission permits exists  Suppose the authority gives eight permits to emit to each firm. That opens the possibility for trade  In this way, by establishing the clear-cut property rights the authority achieves efficient level of emission reduction costs without the perfect knowledge of these costs, relying solely on the market

Markets May Still Fail

 What if firms cannot afford to invest in emission reducing equipment or to pay for the permits?

 What if a resource is a common property and access to it is free?    Remember the Tragedy of the Commons Ozone layer, fisheries The inefficiency results from the absence of a mechanism to restrict use

The Coase Theorem: An Example Dick owns a dog named Spot. Negative externality: Spot’s barking disturbs Jane, Dick’s neighbor. The socially efficient outcome maximizes Dick’s + Jane’s well-being.  If Dick values having Spot more than Jane values peace & quiet, the dog should stay. Coase theorem: The private market will reach the efficient outcome on its own…

The Coase Theorem: An Example  CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500 Cost to Jane of Spot’s barking = $800  Socially efficient outcome: Spot goes bye-bye.

 Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off.  Private outcome = efficient outcome.

The Coase Theorem: An Example  CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000 Cost to Jane of Spot’s barking = $800  Socially efficient outcome: See Spot stay.

 Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays.  Private outcome = efficient outcome.

The Coase Theorem: An Example  CASE 3: Jane has the legal right to peace & quie t. Benefit to Dick of having Spot = $800  Spot.

 Private outcome: Dick pays Jane $600 to put up with Spot’s barking.

 Private outcome = efficient outcome.

Coase

’

s Theorem

 If property rights are well-defined, trade between agents results in a cost efficient allocation of an externality  Coase ’ s Theorem  Under certain circumstances the efficient outcome is independent of the assignment of property rights

Willingness to Pay and Costs of Reducing Pollution Levels

 When the air is dirty, consumers’ WTP for a reduction of even one ton is very high  WTP decreases as air gets cleaner  When the air is dirty, reduction of emissions by one ton is cheap  Higher air quality costs more to achieve

Coase’s Theorem

In the absence of transactions costs the level of production of goods or services in an industry in which there are externalities is independent of whether or not the party who perpetrates negative externalities is legally liable for the costs of the externalities on other parties.

$ P*

Coase

’

s Theorem: an Illustration

5. For any Q

Initial Property Rights Allocation

1.

2.

3.

Firms have the right to pollute without limit: consumers bribe the firms, moving to Q* Consumers have the right to 100% clean air: firms will bribe consumers to move to Q* Irrespectively of the property rights allocation, bribery will result in a socially efficient outcome

Coase Theorem: a Corollary

 In case Coase is right, do we need the government?

 Government’s key role is to enforce property rights  According to Coase, property rights don’t matter from the point of view of Pareto efficiency  Do we need the government to deal with (negative) externalities?

Caveats of Coase

’

s Theorem

 Redistributing property rights may affect prices in other markets  Not all people may be indifferent to which party must compensate and which party is being compensated  The theorem works under the assumption of perfect and costless information (remember the prisoner ’ s dilemma case)

Internalizing the Externality by Merging

 When one or several economic agents start behaving in a way that results in an efficient outcome, economists say they internalize the externality  Suppose one firm the other firm) ’ s production adversely affects the other firm ’ s production (i.e. the first firm produces a negative externality on  If the two firms merge, it is in their interest to remove the sources of the first firm ’ s negative externality so as to maximize joint profits  In this way, mergers between firms are another market solution to the problem of internalizing the externalities

Local Public Goods

 A local public good is the one whose consumption is limited to a particular geographical area  Examples  Traffic lights  Parks  Tiebout (1956): local governments face competition because households can move communities (voting with one’s feet)

Tiebout Hypothesis

 In order to attract residents, a local community government must produce high quality local public goods in the cheapest way possible  Tiebout hypothesis: competition between state and many local governments results in efficient provision of public good

Local Public Goods

 Local public goods are only available to households living in the same geographical area (traffic lights, parks)  Charles Tiebout hypothesis: to a different community Local governments face competition with the other governments since households that are unhappy with the provision of local public goods may move  In other words, competition with the other communities forces local governments to provide public goods efficiently  Caveats   Relocation costs may be substantial Legal restrictions on relocation  Job market situation

Lump-Sum Taxation and Pareto Efficiency  Re-cap: unit or ad-valorem taxes decrease social welfare (the sum of consumer and producer surplus) by inflicting a deadweight loss on the society  Lump sum taxes (i.e. taxes independent of the amount of goods purchased or sold) are not supposed to shift neither the demand nor the supply curves  However, depending on the redistribution policies by the government, shifts in supply or demand are possible  If the government redistributes tax earnings to the poor, the aggregate demand curve may shift to the right  In general, lump sum taxation leaves the society on its utility possibilities frontier

Tax Rates and Revenue

•

A tax rate is the amount of tax people are required to pay per unit of whatever is being taxed.

•

In general, doubling the excise tax rate on a good or service won’t double the amount of revenue collected because the tax increase will reduce the quantity of the good or service transacted.

•

In some cases, raising the tax rate may actually reduce the amount of revenue the government collects.

Price of h otel room $140 120

Tax Rates and Revenue

(a)

An excise tax of $20

(b)

An excise tax of $60

Price of h otel room $140 120 110 S S Excise tax = $ 20 per room 90 80 70 Area = tax r evenue E 40 20 D Excise tax = $ 60 per room 80 50 40 20 E D 0 6 ,000 7,500 10,000 15,000 Quantity of hotel rooms 0 2,500 5,000 10,000 15,000 Quantity of hotel rooms

A Tax Reduces Consumer and Producer Surplus • • • • A fall in the price of a good generates a gain in consumer surplus.

Similarly, a price increase causes a loss to consumers. So it’s not surprising that in the case of an excise tax, the rise in the price paid by consumers causes a loss.

Meanwhile, the fall in the price received by producers leads to a fall in producer surplus.

 A tax reduces both, the CS and the PS.

A Tax Reduces Consumer and Producer Surplus P r i c e Fall in consumer surplus d ue to tax S P C Excise tax = T P E P P A C B F E Fall in producer surplus du e to tax D Q T Q E Quantity

•

The Deadweight Loss of a Tax

• Although consumers and producers are hurt by the tax, the government gains revenue. The revenue the government collects is equal to the tax per unit sold, T, multiplied by the quantity sold, Q

T .

But a portion of the loss to producers and consumers from the tax is not offset by a gain to the government. • The deadweight loss caused by the tax represents the total surplus lost to society because of the tax— that is, the amount of surplus that would have been generated by transactions that now do not take place because of the tax.

The Deadweight Loss of a Tax

Price Deadweight loss P C Excise tax = T P E P P E S D Q T Q E Quantity

Are There Pareto Efficient Tax Structures?

 Lump sum taxes do not depend on the consumed quantities so they are not considered distortionary  Effects of lump sum taxes  Initially D and S do not move  Depending how the government uses tax proceeds, demand can move anywhere (e.g. transfers to poor family shift demand rightwards)

Lump Sum Taxes

 Lump sum taxes are a convenient means of income redistribution if information on preferences is perfect  Able individuals will prefer not to disclose information on their ability to avoid higher taxation

Inelastic Supply of Factors

 Taxing inelastic supply results in zero DWL (verify)

 

Distortionary Taxation and Pareto Efficiency

Equilibrium without taxation or lump sum taxation: point A High income utility Utility Possibilities Frontier P Utilitarian equilibrium:  Point B under lump sum or no taxation (utility possibilities frontier PP) and redistribution by the government  Point C under distortionary taxation (utility possibilities frontier RR) and redistribution by the government R A C D B  Rawlsian equilibrium: point D   Why is the distortionary taxation utility possibilities frontier backward bending?

Points C and D correspond to higher social welfare compared to A R Tax-distorted Utility Possibilities Frontier Low P income utility

Progressive Taxes: Case of Sweden

   Dramatic increase in progressivity of income taxes in 1970s Disposable incomes leveled out between high- and low-income earners But: interest payments tax deductible  More incentives for the rich to take out loans  Wealth distributed back to the rich in value of owner-occupied housing

Progressive Taxation and Welfare Maximization

 In Sweden, income taxes became very progressive in 1970s  The idea was to redistribute tax proceeds from high income households to the poor households  However, it is not clear whether poor households gained from this policy  Interest payments in Sweden are tax deductible  As a consequence, the opportunity cost of not applying for a mortgage loan to buy a house are high  Wealthy people increase their demand for the housing driving up real estate prices   Since the wealth got redistributed back to the rich households, it is not clear whether the sharpening of progressive taxation worked or not Englund and Persson (1982): not clear who the winners and losers are

Can Taxation be Pareto Optimal?

 In general, the government can redistribute income from high-income groups to low-income groups by raising (distortionary) tax revenue  In some cases (see previous slide) distortionary taxation combined with redistribution of tax proceeds may be a Pareto improvement compared to no taxation (compare points C and D with A)  However, lump sum redistributions if such are possible would yield even higher welfare levels

Intergenerational Equity

Utility of current generations  It is also possible to draw a utility possibilities frontier between generations of individuals (see the graph)  What is a fair intergenerational distribution?

  Current generations may use too much scarce non-renewable resources (crude oil for example), but how can we determine each generation ’ s fair share of oil?

A diversification approach suggests producing at the utility possibilities frontier giving the largest potential for intergenerational transfers  The problem of discount rates   How can we value consumption of future generations in terms of today ’ s prices?

Utilitarian approach: zero discount rate   The problem of excess demand for consumption today (no incentives to save for the future) Zero discount rate is not possible because we do not know how many generations there will exist (in that case we must use a non zero positive discount rate) Utilitarian Rawlsian Utility of future generations

Paretians and Libertarians

 Pareto principle claims that if everyone prefers state A to state B the whole society prefers state A to state B  Liberalism says that, irrespectively of the social welfare function, certain choices should be left to individuals themselves (sleeping on the back or on the belly for example)  Even if Pareto improvement is possible by making the individuals choose actions that maximize the social welfare function, libertarians would deny such an improvement  Is it possible to be both a Paretian and a libertarian?