Chapter 5: Externality policies

1
Chapter 5 Externality policies

• Consumption Externalities
• Regulating monopolies and middlemen
• Positive externalities
• Education and direct control
• Externalities from Cigarette Smoking
• The Economics of Illicit Drugs

2
Production ExternalitiesExample

• Inverse demand (D) Marginal Benefit (MB) a -
  bQ
• Marginal private cost (MPC)C?(Q) c dQ
• Marginal externality cost (MEC) e fQ
• Marginal social cost (MSC) MPC MEC c dQ
  e fQ c e (d f)Q

3
Outcomes alternative institutions
scenario quantity price tax
competitive (a-c)/(bd) a-b (a-c)/ (bd)
optimal (a-c-e) /(bdf) a-b (a-c-e) /(bdf)
monopoly (a-c)/(2bd) a-b (a-c)/ (2bd)
monopsony (a-c)/(b2d) a-b (a-c)/ (2bd)
Middle men (a-c)/2(bd) (a-c)/2(bd)

4
Monopoly is polluting excessively
High MSC
Low MSCsmall MEC High MSClarge MEC Unregulated
competitionQc MonopolyQm

A
MR
Low MSC
MPC
B
D
Qc
Q
Qm
Qlow
Q High
5
Regulating the monopoly- High MSC case
Move to Q where MBMSC Using a tax,subsidy or
standard The tax MR-MPC at Q
High MSC

A
MR
Low MSC
TAX
MPC
B
D
Qc
Q
Qm
Qlow
Q High
6
Regulating the monopoly- LOW MSC CASE
Move to Q where MBMSC Using upper bound on
price, or a standard The upper bound price is
P Minimum Quantity Qlow
High MSC

MR
Low MSC
P
MPC
B
D
Qc
Q
Qm
Qlow
Q High
7
Optimal policy monopoly

• If QltQm monopoly is over polluting
• RegulationTax, subsidy,standard
• The taxMR-MPC a-2bQ-(cdQ)
• (2bd)(a-c-e)
• MR minus MPC at Q (a-c)- ------------------
  (bdf)

MSC
D
MPC
TAX
MR
Qm
Q
8
Example-old numbers- Monopoly

• if a20,b2,c4,d2,e2 f.5
• Qm3.2ltQ4 under production
• intervention p12
• Price is reduced from 13.60 to 12
• If f3 Qm3.20 gt Q2.33
• Over production by monopoly
• A tax of 4.33 will lead the monopoly to reach
  optimal outcome (20-4-2.33(221)-4.330)

9
Intervention for middle men

• IF middle men produces less than optimal
• set upper bound on consumer price to be P
• If Middle men produces more than optimal output
• set a tax MR-MO at Q in case of example it is
  2.00.
• To check if that will lead to optimal Q with
  middle men
• MR will be 20-22Q-2
• MO will be 42Q
• Solution will be where 20-4-2-(42)Q14-6Q
• QQ2.33

10
Positive Externalities

• We now turn to positiveexternalities.
• Consumers benefit from conservation activities of
  producers-they generate environmental services

11
Positive externalities

• MPCMarginal privatel cost of production (0
  production externality)
• MPBconsMarginal Private Benefit Individual
  Demand
• MSBconsMarginal Social Benefit MPBcons
  MECbenefits
• Socially optimal outcome Q, P,
• Inefficient outcome under unregulated
  competitionQc,Pc

MPC
Psubsidy
Pc
MSB cons
P
MPB cons
Q
Q
Qc
12
Positive externality Case with a20,b2,c4,d1
,e-2 f-1

• Competition Pm9.33,Qm5.33
• CS28.44,PS14.22,ES24.89,SS67.56
• Optimal Q9 Sub11
• Consumer price P2.0 Producer price13
• CS9(20-2)/281
• PS9((112)-(413)/2)40.5
• ES9(211)/258.5
• Government expense91199
• Social welfare8199-9981

13
Positive vs negative externality

• Positive
• Basic principle- beneficiary pays -subsidy
• If government does not pay subsidy- private
  parties may

• Negative
• Basic principle-polluter pay-pollution tax
• Subsidy liked by industry
• Tradable permits leads to compromise

14
Policy tools

• Incentives ( taxes, subsidies)
• Cap and trade
• Direct controls
• Property rights
• Voluntary agreements
• Education

15
Voluntary agreement

• Government or NGO reach an agreement with a
  polluter to reduce pollution.
• It can be motivated by need to project a green
  image
• It may occur when government does not have
  sufficient power to control gains

16
Education communication

• Education can inform people of consequences of
  their activities. (e.g., farmers may modify waste
  management practices if they learn that these
  practices contaminate a lake they use).
• Education can modify preferences and lead to
  change in behavior. (e.g., people may learn to
  appreciate the environment, value the
  preservation of natural resources, and thus
  behave in a more environmentally friendly way).
• Education can inform the public of the firms that
  generate the most pollution. This may induce
  some of these firms to change their practices
  because this information may reduce the demand
  for their products.

17
Externalities from Smoking

• Health Costs Associated with Smoking
• ? Smokers' health costs shared by society.
• ? Cost of family support (in case of early
  death).
• ? Risk to nonsmokers (second-hand smoke).
• Estimated Death Toll (1989)
• Estimated Annual external costs of smoking
• 35 billion (medical cost)
• 20 billion (lost work)
• 5 billion (fires, smoke, odor damage)
• 60 billion (total cost)

Activity Annual deaths
Smoking 400,000
Drinking 150,000
Drugs 30,000
18
Policies to control cigarettes

• A cigarette tax or tobacco tax.
• A standard/quota to restrict quantities of
  cigarettes and tobacco.
• Approximately 30 billion packs of cigarettes are
  smoked annually.
• If marginal externality cost average
  externality cost, then the tax should be 2.00
  per pack (60 billion of externality cost / 30
  billion packs).

19
Policy consequences

• Producers Restriction on quantities may benefit
  producers or distributors if elasticity of demand
  is smaller than 1.
• Government Tax revenues can be used to
  compensate victims of smoking damages, or it can
  be used in lieu of other distortionary taxes
  (such as income taxes and sales taxes) to support
  government programs.
• Unintended Consequences May strengthen the case
  for the legalization of drugs.

20
The Economics of Illicit Drugs

• Should there be a drug legalization policy
  similar to the one for cigarettes?
• Proposals
• ? Legalize illicit drugs.
• ? Ban advertisement and sale to minors.
• ? Institute a tax on drugs.
• Benefits
• ? Increased government revenue.
• ? Reduced government costs (fewer prisoners and
  less drug enforcement).
• ? Reduced crime.
• Costs
• ? Increased addiction.
• ? Legalization may induce more to try.

21
Economic impacts of drug policy

• 1. Legalization of drugs would shift income from
  the illegal network of drug traffickers to
  government (taxes) and legal marketers
  (pharmacies).
• 2. Drug producers may be better off if drug
  cartels behave like the middlemen, since
  eliminating drug trafficker middlemen may result
  in increased quantity and higher producer prices.
  
• 3. Costs of crime enforcement may go down.
• 4. Consumer prices (inclusive of taxes) may go
  down and quantity may go up. There may be higher
  health costs associated with drug addiction.