externalities 15 chapter. objectives after studying this chapter, you will able to understand the...

EXTERNALITIES 15

CHAPTER

Objectives

After studying this chapter, you will able to Understand the nature and source of externalities in a

modern economy

Explain how property rights can sometimes be used to overcome externalities

Explain how emission charges, marketable permits, and taxes can be used to achieve efficiency in the face of external costs

Greener and Smarter

Environmental issues are at the same time everybody’s problem and nobody’s problem.

Human beings are learning more and more every day.

But are we learning more at a fast enough pace?

How can we ensure that we use resources efficiently in the face of externalities?

Externalities in Our Lives

An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer.

A negative externality imposes a cost and a positive externality creates a benefit.


So the four possible types of externality are:

Negative production externalities

•Examples: Smokestack emissions

Positive production externalities

•Examples: Worker training

Negative consumption externalities

•Example: Second hand smoke, tailpipe emissions

Positive consumption externalities

•Example: Immunization, education


Negative Production Externalities

Negative production externalities are common.

Some examples are noise from aircraft and trucks, polluted rivers and lakes, the destruction of animal habitat, air pollution in major cities from auto exhaust.


Positive Production Externalities

Positive production externalities are less common that negative externalities.

Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit production gets an external benefit from the bees, which pollinate the fruit orchards boost fruit output; and honey production gets an external benefit from the orchards.


Negative Consumption Externalities

Negative consumption externalities are a common part of everyday life.

Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.


Positive Consumption Externalities

Positive consumption externalities are also common.

When you get a flue vaccination, everyone you come into contact with benefits.

When the owner of an historic building restores it, everyone who sees the building gets pleasure.

Negative Externalities: Pollution

Pollution is an old problem and is faced by both rich industrial countries and poor developing countries.

It is an economic problem that is coped with by balancing benefits and costs.


The Demand for a Pollution-Free Environment

The demand for a pollution-free environment is expressed through the political process and this demand has increased for two reasons:

Higher incomes: A high-quality environment is a “normal good,” the demand for which increases with income.

Greater awareness: Greater knowledge about the causes of environmental problems raise understanding of environmental issues.


The Sources of Pollution

There are three sources of environmental pollution problems:

Air pollution

Water pollution

Land pollution


Figure 15.1 shows some 20-year trends in air pollution in the United States.


Private Costs and Social Costs

A private cost of production is a cost that is borne by the producer, and marginal private cost (MC) is the private cost of producing one more unit of a good or service.

An external cost of production is a cost that is not borne by the producer but is borne by others.

Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.


Marginal social cost is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost.

That is:

MSC = MC + Marginal external cost.

We express costs in dollars but must remember that the dollars represent the value of a forgone opportunity. Marginal private cost, marginal external cost, and marginal social cost increase with output.

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Figure 15.2 illustrates the MC curve,

the MSC curve,

and marginal external cost as the vertical distance between the MC and MSC curves.


Production and Pollution: How Much?

In an unregulated market with an externality, the pollution created depends on the market equilibrium quantity of the good produced.


Figure 15.3 shows the equilibrium in the presence of external costs.

The quantity produced is where marginal private cost equals marginal benefit.


MB is less than MSC in the market equilibrium, so the market equilibrium is inefficient.

The efficient quantity is where marginal social cost equals marginal benefit.

The competitive market overproduces and creates a deadweight loss.


Property Rights

Externalities arise because of the absence of property rights.

Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.


Figure 15.4 uses the example in Figure 15.3 to illustrate how the establishment of property rights achieves an efficient outcome.

The polluter bears all the costs and the market makes MSC = MC = MB.


The Coase Theorem

The Coase theorem is a proposition that if property rights exist, if only a small number of parties are involved, and if transactions costs (defined below) are low, then private transactions are efficient.

There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights.


Transactions costs are the cost of conducting a transaction.

An example is the transactions costs of buying a home include fees for a realtor, a mortgage loan advisor, and legal assistance.

When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality.


Government Actions in the Face of External Costs

There are three main methods that the government uses to cope with external costs:

Taxes

Emission charges

Marketable permits.


Taxes

The government can set a tax per unit of output equal to marginal external cost: Tax = MEC.

The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost:

MC + Tax = MSC = MC + MEC.

This tax is called Pigovian Tax, in honor of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.


Figure 15.5 shows how the efficient level of production can be generated with a pollution tax.


Emissions charges

The government sets a price per unit of pollution, so that the more a firm pollutes, the higher are its emissions charges.

For the emissions charge to induce the firm to generate the efficient level of pollution, the government would need a lot of information that is usually unavailable.


Marketable Permits

Each firm is assigned a permitted amount of pollution per period and firms trade permits.

The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome.

This method was used successfully to decrease lead pollution in the United States and is currently used to trade Sulfur Dioxide permits under the Clean Air Act.

Marketable Pollution Permits: The Basics

The market for pollution permits clears at $40 per permit, allowing 400 tons of SO2 to be discharged monthly into this air basin.

Marketable Pollution Permits: The Effect of More Firms

As new firms enter the air basin, they increase the demand for permits. This results in and increase in the price of permits to $60 per ton of SO2 allowed per month.

Marketable Pollution Permits: The Effect of Environmental Groups Buying Permits

Environmental groups may buy and retire permits. Here they purchase 200 permits per month. The supply curve shifts leftward by 200 permits resulting in a new equilibrium price of $60 per permit.

THE END