Externalities and Public Policy

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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 .

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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.

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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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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.

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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 rises.
• The tax revenue is sufficient to pay costs to
  third parties.
• Socially optimal levels of production are
  achieved.

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A Polluting Monopolist

• Monopoly creates a loss to society.
• 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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Theory of the Second Best

• When two opposing factors contribute to
  efficiency losses, the can offset one anothers
  distortions.

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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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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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Figure 3.8 Pollution Rights and Emissions
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Figure 3.9 The Efficient Amount of Pollution
Abatement
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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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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.