Environmental policy

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Environmental policy

• Topic 12

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Overview

• Externalities
• Positive and negative
• Optimal production and externalities
• Taxes and subsidies for externalities
• The Coase theorem.

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For Thursday and Friday

• We will review the material from the entire
  course (or at least the bits you want reviewed)
• Please send through an e-mail message with any
  particular question you want answered I will
  then print them out, order them and (hopefully)
  answer them in class.
• Only one question per e-mail (but feel free to
  send multiple e-mails).

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Externalities

• Up until now we have considered three groups
  affected by a market transactions
• Buyers, sellers, government
• Now we consider when a market transaction affects
  people who do not participate in the transaction
• May be via air pollution, noise pollution, or
  some other cost or benefit
• These external effects of market transactions
  are called externalities.

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Definition of an externality

• An externality is the impact of one persons
  actions on the well being of a bystander where
  there is no related payment between the person
  and the bystander.
• If the action creates a benefit for the
  bystander, then it is a positive externality
• If the action creates a harm to the bystander
  then it is a negative externality

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Negative externalities and the effect on optimal
production

• Remember that the supply curve just represents
  the private marginal cost of producing a product.
• If there is a negative externality then the
  social marginal cost exceeds the private marginal
  cost
• Social marginal cost private marginal cost
  external marginal cost.
• The demand curve represents social marginal value
  (or marginal willingness to pay).
• So socially optimal production occurs where the
  social marginal cost of an extra unit equals the
  social marginal value. Note with an externality
  this is not where demand intersects supply

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Negative externality and socially optimal
production
Notes With a negative externality, social
marginal cost exceeds private marginal cost by
the external marginal cost (e.g. the marginal
pollution cost). The competitive market over
produces the product. This is because market
participants do not have to bear the external
cost so they ignore it.
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Positive externalities

• Positive externalities mean that there is an
  additional value to the product that is not
  captured by the market place.
• The demand curve gives the private marginal
  benefit of the product, but the social marginal
  benefit is higher
• Social marginal benefit private marginal
  benefit external marginal benefit

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Positive externalities and optimal production
Notes The positive externality means that the
social marginal value is greater than the private
marginal value to an individual buyer. The
difference is the external marginal benefit. In a
competitive market there is too little production
of the product because the market participants do
not take account of the benefits that they create
for people outside the market
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Examples

• Negative externalities include air pollution,
  water pollution, noise pollution, bad smells, and
  even envy.
• Positive externalities include the spillover
  benefits of RD, the visual benefits of gardens,
  historic houses and urban landscape, and even the
  benefits from charity.
• Note according to economists there is a
  socially optimal amount of an externality (e.g. a
  socially optimal level of pollution)

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Solving externalities

• To solve an externality it needs to be
  internalised to the market.
• The market participants need to either bear the
  marginal cost they impose on others (for a
  negative externality) or receive the marginal
  benefits they create (for a positive
  externality).
• One way to do this is through taxes or
  subsidies

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Taxing a negative externality
Say the government imposes a tax exactly equal to
the external marginal cost on the good. Then this
will reduce output in the market back to the
socially optimal level. This tax T is called
the Pigouvian Tax.
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So.

• A standard response is to tax products with
  negative externalities and subsidize products
  with positive externalities.
• Note that an alternative approach for negative
  externalities is to simply limit the amount of
  production (e.g. by production licenses)
• Note that both Pigouvian taxes and production
  licenses suffer from problems how does the
  government know the correct level of the tax or
  the level of output.
• Production licenses have an extra problem how
  do we make sure that the most efficient firms get
  the licenses?
• One solution is tradeable pollution permits.

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The Coase theorem is government needed?

• Coase argued that the problem of externalities is
  a problem of property rights.
• If the relevant property rights are allocated
  then trade will eliminate the excessive
  production.
• What rights e.g. rights to noiseless air,
  rights to make noise, rights to emit pollution,
  rights to clean air, etc.

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An example of Coase.

• Verdi and Kiri are neighbors
• Verdi likes to play loud opera music. He gets 40
  benefit from his first hour of opera, 20 from
  the second, 10 from the third, 5 from the
  fourth and -1 from the fifth.
• Kiri hates loud opera music. The marginal cost to
  Kiri of listening to an hour of music is 7 per
  hour for each hour.
• Without compensation, Verdi will play four hours
  of music
• The socially optimal level of playing is three
  hours
• Total marginal social gain from first hour is 33
• Total marginal social gain from second hour is
  13
• Total marginal social gain from third hour is 3
• Total marginal social gain from fourth hour is -2

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• Suppose Kiri has the right to quiet air. Then
  Verdi has to buy the right to play opera off
  Kiri. Kiri will be happy to sell him up to three
  hours but no more.
• Verdi must now pay for playing opera so the
  external cost is internalised.
• Efficient trading will lead to the socially
  optimal level of production.
• Alternatively, suppose Verdi has the right to
  play opera. Then Kiri has to bribe Verdi not to
  play music. She will pay him up to 7 not to play
  in the fourth hour and Verdi will accept
  achieving the socially optimal outcome.
• Again the externality is internalised Verdi now
  faces the opportunity cost of playing opera
• The socially optimal outcome is achieved
  regardless of who starts with the property right.

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Lessons

• With externalities, competitive markets do not
  maximise social surplus
• Externalities can be fixed if they are
  internalised through taxes and subsidies.
• Output licenses can overcome negative
  externalities but tradeable permits are usually
  better.
• Sometimes market solutions (the Coase theorem)
  can be used to solve externalities with little
  government information required.