Transcript Chapter 3 Externalities and Public Policy 1

Chapter 3
Externalities and Public Policy
1
Externalities

Externalities are costs or benefits of
market transactions not reflected in
prices.


Negative externalities are costs to third
parties.
Positive externalities are benefits to third
parties .
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Externalities and Efficiency

The marginal external cost is the
dollar value of the cost to third
parties from the production or
consumption of an additional unit
of a good. These occur when
market transactions for a good
produce negative externalities.
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Social Costs
MSC = MPC + MEC
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Price, Benefit, and Cost (Dollars)
Figure 3.1 Market Equilibrium, A Negative
Externality and Efficiency
MPC + MEC = MSC
110
105
100
G
B
S = MPC
10
A
D = MSB
4.5 5
Tons of Paper Per Year (Millions)
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Implications of Figure 3.1
Market equilibrium occurs
where
MPC = MSB
 Efficiency Requires that
MSC = MPC + MEC = MSB

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Positive externalities

The marginal external benefit is
the dollar value of the benefit to
third parties from an additional unit
of production or consumption of a
good. These occur when the
market for a good creates positive
externalities.
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Social Benefit
MSB = MPB + MEB
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Price, Benefit, and Cost (Dollars)
Figure 3.2 Market Equilibrium, A Positive
Externality and Efficiency
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Z
30
25
10
S = MSC
V
U
H
MPB + MEB = MSB
MPB
0
10 12
Inoculations Per
Year (Millions)
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Price, Benefit, and Cost (Dollars)
Figure 3.3 A Positive Externality for Which MEB
Declines With Annual Output
MPBi + MEB = MSB
30
25
F
A
B
S' = MSC'
C
20
0
S = MSC
MPBi
10 12
16
20
Inoculations per Year (Millions)
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Internalization of Externalities

An externality can be
internalized under policies
that force market
participants to account for
the costs of benefits of their
actions.
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Corrective Taxes to Negative
Externalities
 Setting a tax equal to the
MEC will internalize a
negative externality.
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Price, Benefit, and Cost (Dollars)
Figure 3.4 A Corrective Tax
S’ = MPC + T = MSC
S = MPC
G
110
105
100
95
B
Tax Revenue = Total
External Costs
T
A
Net Gains in
Well-Being
D = MSB
4.5 5
Tons of Paper Per Year (Millions)
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Results of a Corrective Tax
Price rises.
 The tax revenue is sufficient
to pay costs to third parties.
 Socially optimal levels of
production are achieved.

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Using a Corrective Tax

The greenhouse effect and a “Carbon
Tax”

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The greenhouse effect is caused by
burning carbon-based fuels. A carbon tax
can be imposed to limit greenhouse
gasses to their socially optimal levels.
It is called a carbon tax because the
amount of the tax would depend on the
amount of carbon in the fuel.
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Theory of the Second Best

When one condition for an
optimum is violated, then
maintaining the others will
not guarantee a secondbest solution.
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A Polluting Monopolist


Chapter 2 showed that monopoly
creates a loss to society. This
chapter shows that a negative
externality causes a loss as well.
The losses do not necessarily add
to one another. In fact, they can
cancel each other out.
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Figure 3.5 A Second Best Efficient Solution
MPC + MEC = MSC
F
MPC
A
Price
PM
B
C
D = MSB
MR
0
QM Q*
Output per Year
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Corrective Subsidies

Setting a subsidy equal to
MEB will internalize a
positive externality.
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Price, Benefit, and Cost (Dollars)
Figure 3.6 A Corrective Subsidy
Z
45
30
25
R
S = MSC
V
U
Subsidy Payments
10
Y
X
D' = MPBi +$20 = MSB
D = MPBi
0
10 12
Inoculations per Year (Millions)
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Property Rights and Internalization
of Externalities


Externalities arise because some resource
users’ property rights are not considered in
the marketplace by buyers or sellers of
products.
Governments can give businesses the right
to emit wastes in the air and water or it can
give individuals the right to clean air and
water.
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Coase's Theorem

By establishing rights to use
resources, government can
internalize externalities
when transactions or
bargaining costs are zero.
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The Significance of Coase’s
Theorem


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The efficient mix of output will result simply as a
consequence of the establishment of
exchangeable property rights.
It makes no difference which party is assigned the
right to use a resource.
If the transactions costs of exchanging the rights
are zero, the efficient mix of outputs among
competing uses of the resource will emerge.
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Figure 3.7 Coase’s Theorem
B
MPCB + MEC = MSC
MPCB
PB
QB* QB1
Beef Output per Year
Price of Wheat (Dollars)
Price of Beef (Dollars)
A
MCW
MCW*
PW
QW1QW*
Wheat Output per Year
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Limitations of Coase’s Theorem
 Transactions costs are not
zero in many situations.
 However you allocate the
property rights, the
distribution of income is
affected.
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Applying Coase's Theorem


The Clean Air Act of 1990 allows for the sale
of the "right to pollute." Firms face a tradeoff
when they pollute. If they pollute, they forgo
the right to sell their emission permits to
others.
In markets for electricity, Clean Air Act has
motivated firms to shift to natural gas and
away from coal as a means of producing
electricity.
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Price and Marginal Social Benefit
Figure 3.8 Pollution Rights and Emissions
S = Supply of Pollution Rights
$20
0
D = MSB of
Emitting Wastes
75,000 100,000
Tons of Annual Emissions
and Number of Pollution Rights
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Marginal Social Cost and Benefit
Figure 3.9 The Efficient Amount of Pollution
Abatement
MSC
E
MSB
A*
0
100
Percent Reduction in Waste Emitted per Year
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Recycling

Recycling may be a less efficient and more
polluting use of labor, land and capital than
simple land fill disposal because:


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Collecting waste for recycling costs three
times as much as collecting it for disposal.
Rural land is inexpensive.
Recycling paper creates more water pollution
and does not “save” trees; it simply reduces
the number that are planted.
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Regulatory Solutions

Instead of using market
forces to force firms to
internalize externalities, we
can use emission standards
and apply these to all
market players.
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Cost and Benefit (Dollars)
Figure 3.10 Regulating Emissions: Losses in Efficiency
From Differences in the Marginal Social Benefit of
Emissions
Firm A
B
MEC = MSC
C
10
A
DQRA
MSB
QA1
QA*
Firm B
10
Tons of Emissions per Year
F
MEC = MSC
G
H
DQRB
0
QB*
QR
MSB
QB1
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Cost and Benefit (Dollars)
Figure 3.11 Losses in Efficiency From Emissions
Standards When MEC Differs Among Regions
Firm C
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X
Y
MEC = MSC
Firm D
MSB
S
Z
DQRC
QC* QR
MSB
R
QR
T
MEC = MSC
QD* DQRD
Tons of Emissions per Year
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Markets for Pollution Rights

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The Clean Air Act of 1990 allowed firms the right
to trade Sulfur Dioxide emissions allowances.
The market for the allowances began in 1991.
Firms must have the allowances to emit Sulfur
Dioxide.
Firms increasing production can buy permits or
use pollution controls to keep their total
emissions constant.
Firms that reduce their emissions can sell their
allowances to others.
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Sulfur Dioxide Emission Prices
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Global Externalities
CFC’s
 Deforestation
 Global Warming

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Costs and Benefits to the EPA



The EPA estimates that annual compliance costs
could be in the range of $225 billion per year.
The EPA estimated in 1990 that the benefits of
the Clean Air Act were nearly 50 times the costs.
Ninety percent of the benefits are estimated to
come from laws pertaining to power plants and
factories.
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