How to Cure an Externality

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How to Cure an Externality

• Economics of Public Policy
• PADM 625
• Ben Muse

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Optimal amount of negative externalities is not
necessarily zero
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Externalities

• Are byproducts of productive activities
• To eliminate the externality youd have to give
  up the productive activity
• What you want to do is find a balance

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Balance marginal benefits and costs

• Consider steps taken to mitigate a pollution
  externality
• Reducing the amount of the externality will have
  costs
• installation of and operation of new capital
  equipment
• reduction in potentially valuable activity

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Balance marginal benefits and costs

• Reduction in the level of a negative externality
  will generate marginal benefits
• As weve discussed before in this class
• The optimal level of the activity (abatement)
  must balance benefits and costs

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Balance marginal benefits and costs
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What should we do about externalities?
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What is our goal?

• To move toward an optimal level of externalities.
• Not necessarily to eliminate them.
• We would like to do so at the lowest cost
  possible as well.

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The key -

• There are a variety of ways that we can structure
  situations so that
• parties producing negative externalities
• face the costs of their actions

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What to do about externalities

• Nothing
• Define property rights better
• Command and control
• Emission fees
• Transferable quotas

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Do nothing?

• Coase theorem
• If transactions costs are zero, parties to an
  externality will reach the optimal outcome.
• The intuition is simple - externalities create
  opportunities for gains from trade (or merger).

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The problem with this is

• The transactions costs of dealing with many
  pollution problems are high
• In the electricity example
• there are a lot of people on one side of the
  agreement who have to coordinate and negotiate
• This may preclude agreement

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Still

• Administrative costs of action
• may be high relative to
• potential benefits
• If government action is more costly than the lost
  efficiency
• may still be better to do nothing

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Also, note inframarginal externalities

• The size of the external benefit or harm doesnt
  depend on small changes in the quantity of the
  good around the market equilibrium quantity.

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Following slide

• Positive externality
• Person gets an education
• The first few years have broad benefits for the
  rest of society
• The later years dont produce the same positive
  externalities

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An inframarginal externality
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Private solutions to negative externalities
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Unitize

• Private merger
• Condominium associations
• definition of jurisdictions

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The key -

• By bringing all parties into the same decision
  making organization
• the costs are internalized

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John Wesley Powell and externalities

• Important scientific figure in second half of
  19th Century U.S.
• Made a number of arguments about political
  arrangements that depended on a consideration of
  water externalities in the American west
• Organize Montana counties on basis of watersheds

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John Wesley Powell and externalities

• Organize Montana counties on basis of watersheds
• So that farming communities in lower lands
• could control development in uplands that might
  have impacts (negative externalities - maybe
  through erosion) on the lower lands

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Assign property rights

• To each party and let them negotiate
• If the property rights are clear and the costs of
  negotiating are small the parties should reach an
  agreement that maximizes their joint benefits
• but plenty of room for debate over dividing the
  benefits

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Interstate compacts

• Provide a constitutional mechanism for this
• States upstream and downstream on the same river
• could negotiate a common approach to pollution
  and flood control by forming an interstate compact

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Interstate compacts

• Is there scope for states or provinces to reach
  agreements with each other
• to deal with joint pollution problems?
• The Coase theorem suggests there are
• Constitutional provisions that might help this
  work?

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Legal system (torts)

• Suppose we let people sue a large polluter for
  its smoke discharges
• This can force the polluter to bear the costs of
  its action
• and lead it to pursue an optimal level of that
  action
• Speeding tickets are another example

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Some problems

• Public good (free rider) problems
• Problems with imperfect information
• Transactions costs
• Uncertainty about litigation outcomes and
  differential access to court systems

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Public solutions to negative externalities
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Impose standards

• Impose firm standards on activity
• No firm may emit more than 500 metric tons/year
• No noise above xdecibels
• limit of one fish per trip for recreational
  anglers
• zoning

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Command and control

• Tell the firm what to do and how to do it
• Specify appropriate technologies that must be in
  use under different conditions
• a problem - one size fits all

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Pros/cons of standards, command and control

• In one sense, easy to impose
• However, one size fits all
• impose same burdens on firms that can clean up
  cheaply and firms that face high costs
• Ultimately can be more costly than other
  alternatives

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Pros/cons of standards, command and control

• Firms may have different marginal cost curves for
  reducing pollution
• Ideally wed like to allocate pollution reduction
  responsibilities among firms to equalize marginal
  costs of further reduction

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Pros/cons of standards, command and control

• But standards/command and control, dont pay
  attention to this
• High cost cleaner-uppers will probably clean up
  more than they should
• low-cost clean up less

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Pros/cons of standards, command and control

• Otherwise we could reduce pollution at less cost
• by making low cost cleaner-uppers clean up more
• and reducing the burden on high-cost
  cleaner-uppers

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Taxes and subsidies

• Impose a tax on the activity
• For example, if you are dealing with a firm
  emitting air pollution impose a tax on each
  metric ton of emissions
• This increases the firms opportunity costs of
  emissions to reflect the marginal cost of the
  externality

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Taxes and subsidies

• Conversely, we could subsidize the abatement of
  the externality -
• if pollution we could subsidize pollution
  abatement (instead of taxing pollution)

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Taxes and transferable quotas can bring about
emission reductions at lower cost.
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Taxes

• Remember that the problem is that firms dont
  face the full cost of their actions
• The electricity plants pay for most inputs, but
  they dont pay for the service the environment
  provides for pollution disposal

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The idea of a pollution tax

• Is to charge firms a price that reflects the
  costs
• that their pollution imposes

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Firms would

• Respond to that price and each would choose its
  optimal level of electricity production and
  pollution
• given that price

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Fees are relatively rare

• Most fee systems of which I am aware exist
  primarily to raise revenues for pollution control
  efforts
• They arent calibrated to reflect the external
  costs of pollution

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Which brings us to transferable pollution rights.
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The basic idea

• The appropriate level of pollution is determined
  administratively
• The rights to pollute are divided up among the
  different sources
• If the total emissions level is 100,000 metric
  tons (reduced from 150,000)
• Each firm will be allocated a share of that

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Allocation can be done in different ways

• Equal division of the available rights
• Allocation in proportion to historical emissions
  activity
• Auction of the rights to the highest bidder (rare
  if it occurs at all)

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Transferable rights

• Once allocated
• Firms are free to buy and sell them
• A firm that could clean up its act fairly cheaply
• Will have an incentive to do so and reduce its
  requirements for emission credits or quotas

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Then...

• It can sell its surplus quotas to
• a firm that can only reduce emissions at high cost

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Look how everyone benefits...

• Total pollution is reduced to the level
  determined by the total quotas
• The high cost firms dont have to reduce as much
  since they can buy credits
• Their purchases of credits subsidize the
  reduction efforts of low cost firms

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Transferable licenses or quotas

• Note similarity to procedures used in Alaskas
  halibut and sablefish IFQ programs

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Sources

• Nicholaou, K.C. And Christopher N.C. Boddy.
  Behind Enemy Lines. Scientific American. May,
  2001.
• Stegner, Wallace. Beyond the Hundreth Meridian.
  John Wesley Powell and the Second Opening of the
  West. 1953.
• Friedman, David. Laws Order. What Economics
  Has to Do with Law and Why it Matters. Princeton
  University Press. 2000.

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Sources

• Stiglitz, Chapter 9, Externalities and the
  Environment.