The economics of externalities

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The economics of externalities

• Today Graphical analysis
  Private responses
  Public responses

2
Today

• More on the externality problem
• Marginal damage will not be constant
• Private responses
• The Coase Theorem
• Mergers
• Social conventions

• Public responses
• Taxes
• Subsidies
• Command-and-control
• Cap-and-trade programs

3
The externality problem

• With externalities, quantity produced is
  typically not optimal
• Finding optimal quantity when marginal damage is
  not constant
• Deadweight loss of inefficient production

4
Graphical analysis of externalities
MSC MPC MD

MPC
h
d
g
c
MD
f
b
MB
a
e
0
Q1
Q
Q per year
Socially efficient output
Actual output
5
Graphical analysis of externalities
Producer surplus lost going from Q1 to Q
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Graphical analysis of externalities
Consumer surplus gained going from Q1 to Q
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Graphical analysis of externalities
Net social gain going from Q1 to Q
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Pollution

• Pollution is one of the biggest negative
  externalities around
• Multiple steps needed to try to find optimal
  amount of pollution
• Which pollutants actually do damage?
• Are there pollutants that indirectly cause
  damage?
• Example CFCs on the ozone layer
• How do we value the damage done?
• Very difficult to do, due to lack of markets

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Pollution and empirical studies

• Empirical studies have been done to try to
  determine the damages caused by pollution
• Remember from Chapter 2 that we need to use
  events that prevent bias

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Pollution and empirical studies

• Chay and Greenstone (2003, 2005)
• Pollution on health
• 1 percent reduction in total suspended
  particulates resulted in a 0.35 percent reduction
  in infant mortality rate
• Pollution on housing prices
• Improved air quality between 1970 and 1980 in
  pollution-regulated cities led to property value
  increases of 45 billion

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Costly negotiation

• Negotiation is typically costly
• Remember, time is worth something
• Even if a resource is owned by someone, costly
  negotiation can prevent better outcomes from
  occurring

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Coase theorem

• The Coase theorem tells us the conditions needed
  to guarantee that efficient outcomes can occur
• People can negotiate costlessly
• The right can be purchased and sold
• Property rights
• Given the above conditions, efficient solutions
  can be negotiated

Ronald Coase
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Coase theorem

• Notice that the Coase theorem addresses
  efficiency
• To get to efficiency, the quantity of most goods
  and services produced is still positive
• Example It is not efficient to get rid of all
  pollution
• If all pollution was gone, we could not live
  (since we exhale CO2)

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Bargaining and the Coase Theorem
MB exceeds MPC in this range ? Production will be
Q1 without negotiation
MSC MPC MD

MPC
h
d
g
c
MD
MB
0
Q1
Q
Q per year
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Bargaining and the Coase Theorem
MSC exceeds MB here ? With costless bargaining,
consumers will pay to reduce production from Q1
to Q
MSC MPC MD

MPC
h
d
g
c
MD
MB
0
Q1
Q
Q per year
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Other private responses to externalities

• Mergers
• When negative externalities only affect other
  firms, two firms can merge to internalize the
  externalities
• Social convention
• Social pressure to be nice can lower the amount
  of certain negative externalities

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Public responses to externalities

• Four public responses
• Taxes
• Also known as emissions fee in markets with
  pollution
• Subsidies
• Command-and-control
• Government dictates standards without regard to
  cost
• Cap-and-trade policies
• Also known as a permit system

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Taxes

• With no externalities, taxes on goods in complete
  and competitive markets lead to deadweight loss
• Quantity is below the optimal amount with taxes
• With negative externalities, taxes can improve
  efficiency
• The optimal tax is known as the Pigouvian tax
• Pigouvian tax equals marginal damage at the
  efficient output
• Increased Pigouvian taxes can also lead to lower
  income taxes without sacrificing overall tax
  revenue
• Double dividend hypothesis (More in Chapter 15)

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Pigouvian taxes in action
MSC MPC MD

(MPC cd)
Pigouviantax revenues
MPC
d
i
j
c
MD
MB
0
Q1
Q
Q per year
20
Emissions fee

• One way to implement Pigouvian taxes is to charge
  a tax on each unit of pollution, rather than on
  each unit of output
• This kind of tax is known as an emissions fee

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Emissions fee in action

MC of abatement
f
MSB of abatement
0
e
Abatement quantity
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Subsidies

• An alternative to taxes is providing a subsidy to
  each firm for every unit that it abates
• Problems with subsidies
• Efficient outcome only with a fixed number of
  firms
• Increased profits of firms in the industry will
  encourage new entrants into the industry
• Positive economic profits if new entry is not
  allowed
• Revenue is needed to provide subsidies
• Taxing income reduces inefficiencies
• Ethical issues Who has the right to pollute?

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Subsidies in action
MSC MPC MD

(MPC cd)
MPC
Pigouviansubsidy
d
k
i
f
g
j
h
c
MD
MB
e
0
Q1
Q
Q per year
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Command-and-control pollution reduction

• Two firms
• Each would pollute 90 units if there are no
  pollution controls
• Suppose each firm was forced to reduce pollution
  by 50 units
• Known as uniform pollution reduction
• Usually not efficient

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Uniform pollution reductions
MC is for abatement on these graphs
MCH
Total abatement costs are in red for each firm


MCB
25
Bartspollutionreduction
Homerspollutionreduction
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Inefficiencies of uniform reductions
Notice that MC of Homers last unit of abatement
is higher than Barts ? Doh


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Inefficiencies of uniform reductions
Overall abatement costs can be reduced if Homer
reduces abatement by 1 unit and Bart increases
abatement by 1 unit


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Command-and-control regulation

• Command-and-control regulations can take many
  forms
• Uniform reductions
• Percentage reductions
• Technology standards
• Each firm must use a certain type of technology
• This method may work best when emissions cannot
  be monitored easily
• Performance standards
• Government sets emissions goal for each polluter
• Firm can use any technology it wants
• Less expensive than technology standards

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Lowering abatement costs

• Going from command-and-control requirements to
  emissions fees can lower overall abatement costs
• Marginal cost of abatement of the last unit is
  equal for each firm with an emissions fee

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Emissions fees
MC is for abatement on these graphs
MCH
Barts TaxPayment
Homers TaxPayment
MCB
f 50
f 50
25
Bartspollutionreduction
Homerspollutionreduction
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Cap-and-trade policies

• Policy in which a permit is needed for each unit
  of pollution emitted
• Permits can be traded
• Policy is efficient if
• Bargaining costs are negligible
• Competitive permit markets exist
• Number of permits matches efficient pollution
  level
• Initial allocation of permits does not affect
  efficiency as long as the above criteria are met

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Cap-and-trade
Bart and Homer will negotiate until they agree on
a 50 price for permits
Suppose Bart starts with 80 permits and Homer
starts with none (see points a and b)
MCH
b
MCB
f 50
f 50
a
10
25
Bartspollutionreduction
Homerspollutionreduction
Bart sells 65 permits
Homer buys 65 permits
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Emissions fee versus cap-and-trade

• Given certain conditions, we notice that an
  emissions fee and cap-and-trade policies lead to
  the same result for efficiency
• 50 fee for each unit polluted (implicit fee
  under permits)
• Bart reduces pollution by 75 units
• Homer reduces pollution by 25 units

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The real world is more complicated

• We do not live in a world with perfect economic
  assumptions
• Complicating factors
• Inflation
• Cost changes
• Uncertainty
• Distributional effects

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Inflation

• If emissions fees do not represent real prices,
  the amount of pollution will change as real price
  changes
• Cap-and-trade policies do not need inflation
  factored in, since quantity limits are used

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Cost changes

• Suppose cost to abate decreases every year
• Optimal amount of abatement will increase each
  year
• If a new abatement technology is just being
  developed, future cost changes could be small or
  large
• Potential solution Impose a hybrid system
• Permit market
• Offer a high tax for pollution emitted without a
  permit

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Uncertainty

• Costs and benefits are typically not known with
  certainty
• With uncertainty, too much or too little
  pollution can be produced (relative to the
  efficient outcome)
• Two situations analyzed, with MC curve uncertain
• Inelastic MSB
• Elastic MSB

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Inelastic MSB curve
Marginal cost schedule could be as high as MC
MC

MC
Assume best guess of marginal cost schedule is MC
f
Permits are closer to efficient than fees in this
case
MSB
0
e
ef
e
Pollution reduction
Too little pollution reduction with fees
Too much pollution reduction with permits
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Elastic MSB curve
MC

MC
f
Fees are closer to efficient than permits in this
case
MSB
0
e
ef
e
Pollution reduction
Too little pollution reduction with fees
Too much pollution reduction with permits
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Distributional effects

• Firms
• Lose when they pay a tax
• Win when they are given permits
• Government can generate revenue
• If a tax is imposed
• If permits are sold
• Double dividend hypothesis supports taxes or
  selling permits
• Political pressure may encourage permit giveaways

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Distributional effects

• Since efficiency relates to willingness to pay,
  poor neighborhoods should have more pollution
  than rich neighborhoods
• Displacement concerns
• Job losses from environmental regulation Does
  this increase income inequity?
• Who bears the cost of pollution control?
• Depends on who uses the good that has the
  pollution control
• Example Cars that are 15 or more years old

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Externalities can be positive

• Remember that not all externalities are negative
• Some consumption leads to external benefits to
  others
• Recall some examples
• Planting flowers in your front lawn
• Scientific research
• Vaccination
• Prevents others from getting a disease from you

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Positive externalities and subsidies

• Subsidies can be used to increase efficiency in
  the presence of positive externalities
• Note that this money must be generated from
  somewhere, probably taxes
• Recall that tax money used for subsidies has its
  own deadweight loss
• Compare DWL with efficiency gains from the subsidy

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Positive externality example

MC
MSB MPB MEB
MPB
MEB
R
R1
Researchper year
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In what direction are we heading?

• Command-and-control policies often rely on states
  to enforce
• States do not always comply with these measures
• Fees and permits can often be controlled on the
  national level
• US policies have generally moved from
  command-and-control to taxes and permits
• Exceptions do still apply Emissions hot spots

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Summary

• Many methods are used to try to increase
  efficiency when externalities are present
• Negotiation
• Mergers between firms
• Social conventions
• Taxes, including emissions fees
• Subsidies
• Command-and-control policies
• Cap-and-trade programs using marketable permits

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Summary

• Distributional concerns are important for someone
  that thinks that social welfare is important
• Who benefits and loses from taxes versus permits?
• Firms?
• The government?
• Who benefits most when pollution is abated
• High-income more than low-income?