Transcript Slide 1

Intermediate Microeconomic Theory
Externalities
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Markets and Efficiency
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We have seen that markets can provide an
efficient mechanism for allocating scarce
resources.
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However, this result only holds when
markets are perfect.
(i) Tax revenue raised via lump-sum taxes,
(ii) Producers and consumers are price takers,
(iii) There are complete markets,
(iv) There is no asymmetric information.
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We discussed why allocations can fail to be
efficient if (i) and (ii) fail.
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What do we mean by (iii), and what if it
fails?
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Externalities
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What do we mean by an externality?
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What are some examples?
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Consumption Externalities?
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Production Externalities?
Why might externalities lead to
inefficiencies?
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Modeling an Externality
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Consider Giganto Corp.
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They produce ballbearings which sell for $37/Kg.
Their cost function: C(q) = q2/2 - 3q + 100
A byproduct of producing ballbearings is smoke: s = q/4 (cubic tons)
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Bill’s utility function: U = -10s2 + c and he has $1200
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How many lbs. of ballbearings will Giganto Corp. produce?
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What will be Giganto Corp’s profits?
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What will be Bill’s Utility?
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Modeling an Externality
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Is this efficient?
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What if we capped emissions at s = 3, but then imposed a $620 tax on
Bill and gave proceeds to Giganto Corp to help defray their costs?
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Externalities and Efficiency
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So in the presence of externalities, market
solution doesn’t lead to efficient outcomes.
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When making its production decision, Giganto
Corp weighs its own benefits against his own
costs, but does not take into account the total cost
to society.
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Externalities and Efficiency
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Clearly, such issues can arise in many other instances.
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When I consume an apple, it affects other people, by using up some
resources.
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However, I internalize these costs through having to forgo other consumption
due to the price I have to pay.
Under perfect markets, I pay the full societal cost of “producing” the apple
When I consume more driving, I again use resources which otherwise you
could have used (gas, my SUV)
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I internalize these costs through having to forgo other consumption by paying
the sticker prices for gas, car, etc..
However, I also use other resources in consuming driving, namely clean air. I
do not pay for these resources, so I overconsume relative to societal efficiency.
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Externalities and Efficiency
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So one way to increase efficiency might be
through direct regulation.
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What are difficulties with regulation?
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Externalities and Missing Markets
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What if a market was set-up for less pollution?
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Bill could pay $p for each cubic ton less smoke than
Giganto currently produces.
Giganto Corp. would be paid $p for each cubic ton less
smoke they produce.
How would this change things?
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Externalities and Missing Markets
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So an externality can in a way be thought
of as a missing market.
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If a market were developed, then the
“externality” doesn’t lead to inefficiency, as
entity originally producing externality
internalizes the true social cost.
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This brings us back to the world of the First
Welfare Theorem that competitive equilibria
are Pareto Efficient.
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Externalities, Missing Markets, and Distribution
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One issue that comes up with regulation is why
should we take money away from Bill to pay
Giganto Corp. to limit its emissions?
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Similarly, why should Giganto Corp. be given the
“property rights” to the air Bill breathes?
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Externalities and Missing Markets
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What if instead, Bill were given property rights to the air,
but could sell Giganto Corp permits to produce smoke.
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What would happen now?
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The Coase Theorem
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Coase Theorem – In the absence of
transactions cost, individuals should be able to
negotiate to an efficient allocation regardless of
how property rights are assigned.
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Essentially, given a market, the equilibrium
price will cause person imposing the externality
to internalize the social cost, once again
making the marginal benefit of last unit
consumed equal to the total cost of supplying
that unit to the market.
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So why do we even talk about externalities?
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Coase Theorem
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In the presence of externalities, how property rights are distributed
will affect distribution of wealth.
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Coase Theorem says nothing about what is a “just” distribution, it just
gets us to efficiency (like with any other perfect markets argument).
What else seems lacking in the “Coasian” picture of the world?
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Why the smoking ban in bars?
Why the regulation on car and factory emissions?
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Coase Theorem
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Coase Theorem – In the absence of transactions cost,
individuals should be able to negotiate to an efficient
allocation regardless of how property rights are
assigned.
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Should we expect transaction costs to always be low?
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Externalities and Transactions Costs
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Consider something like the environment (See NYT
article)
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A given polluter only affects each person a little bit.
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If all these people could get together, they could
certainly pay off polluter until we reach efficiency.
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Problem is how do all these people get organized? Who
will be in charge of organizing?
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In particular, the organizer must take on costs, but
only gets a little bit of the benefit from organizing.
This is a Public Goods problem.
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Externality Policy
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So what should be done about externalities?
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Taxation and Externalities
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What would be optimal tax to impose on Giganto Corp. for each
cubic ton of smoke it produces?
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Double Dividend of taxation of externalities.
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Production Externalities
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The same logic applies when only looking
at firms.
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Example:
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Firm 1 dumps its waste from producing its
own output into river upstream from Firm 2.
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Firm 2 uses river water for production and
Firm 1’s pollution raises Firm 2’s costs of
production.
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How does this relate to our discussion of
property rights?
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Production Externalities
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Consider two firms:
1.
Firm 1: C1(q1) = 0.5q12 + 2q1
2.
Firm 2: C2(q2) = q22 - q2 + 1 + 2q1
p1 = 10
p2 = 9
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How much will firms produce in the
absence of constraints?
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How do we know this won’t be efficient?
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Production Externalities
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Consider what production would be if one
firm ran both plants.
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Why will this lead to efficiency?
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Production Externalities
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What policies can we use in the face of
production externalities?
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Encourage mergers?
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Regulate pollution?
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Taxation?
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Re-allocate property rights and help set-up
missing markets/reduce transaction costs to
negotiation?
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Application: Emission Policy
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Why are economists so into tradable emissions permits?
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In a way, it is similar to rent control discussion from awhile back.
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Under rent control, how could we make everyone better off?
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Analogue is often true for pollution control.
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First, figure out how much total pollution should be allowed.
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Either directly sell permits to companies via an auction, or give each firm
a fixed amount of permits, then allow them to trade with each other.
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How is this better than just setting a pollution cap each firm must meet?
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What issue is still troublesome?
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