Externalities and Public Policy

1
Chapter 3

• Externalities and Public Policy

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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 .

3
Externalities and Efficiency

• The marginal external cost (MEC) 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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Figure 3.1 Market Equilibrium, A Negative
Externality and Efficiency
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Implications of Figure 3.1

• Market equilibrium occurs where
• MPC MPB (which is equal to 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 benefits occur when the market for a
  good creates positive externalities.

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Social Benefit
MSB MPB MEB
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Figure 3.2 Market Equilibrium, A Positive
Externality and Efficiency
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Figure 3.3 A Positive Externality for Which MEB
Declines With Annual Output

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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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Figure 3.4 A Corrective Tax
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Results of a Corrective Tax

• Price of paper rises and quantity of demanded
  deceases.
• A consequent transfer of income away from paper
  producers and consumers in favor of individuals
  who use recreational services.
• Socially optimal levels of production are
  achieved.

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• The previous results lead to
• Paper producers, employees, and consumers will
  likely vote against the corrective tax.
• Recreational users and taxpayers (other than
  paper producers) will likely vote in favor of the
  corrective tax.
• So, the corrective tax creates some benefits to
  certain groups at the expense of other groups.
  This results in an income redistributive effect.

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• Note The tax does not eliminate negative
  externalities. It only reduces it. As long as
  there is production of paper, there is a negative
  externality. The policy generates a tradeoff
  between better environment quantity of paper
  produced.

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Using a Corrective Tax

• The greenhouse effect and a Carbon Tax
• 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
  second-best 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
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Corrective Subsidies

• Setting a subsidy equal to MEB will internalize a
  positive externality.

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Figure 3.6 A Corrective Subsidy
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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 Coases Theorem

• 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 Coases Theorem
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Limitations of Coases 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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• Pollution rights are transferable permits to emit
  a certain amount of particular wastes into the
  atmosphere or water per year.
• The advantage of permits over emissions charges
  or corrective taxes is that the regulatory
  authority could strictly control the amount of
  emissions by issuing a fixed number of permits.

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Figure 3.8 Pollution Rights and
Emissionscompetition for the 75000 pollution
rights results in a price of 20 per right
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Figure 3.9 The Efficient Amount of Pollution
Abatement is determined when MSC of additional
reduction in wastes emitted equals the MSB of
that reduction (A)
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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
• 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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Figure 3.10 Regulating Emissions Losses in
Efficiency From Differences in the Marginal
Social Benefit of Emissions
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Figure 3.11 Losses in Efficiency From Emissions
Standards When MEC Differs Among Regions
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Markets for Pollution Rights

• 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

• CFCs
• 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.