Public Economics

Chikako YamauchiAssistant Professor, GRIPS

Lecture 5

ExternalitiesRosen, Ch. 5 (Externalities)

Outline

1. The Nature of Externalities2. Graphical Analysis3. Private Responses to Externalities4. Public Responses to Externalities5. Implications for Income Distribution

Introduction

Paper mills produce the chemical dioxin as a by-product, which ends up in human fat tissue and in the milk of nursing mothers. Some scientists say that dioxin is responsible for birth defects and cancer, etc.

The output choice of paper mills directly affects the utility of the neighboring people

This negative effect does not go through price changes. Different from the situation where an increase in the price of

paper leads to a decrease in the level of utility among paper consumers

Externality Defined An externality is present when the

activity of one entity (person or firm) directly affects the welfare of anotherentity in a way that is not reflected in the market price Negative externality: These activities

impose damages on others. Positive externality: These activities

create benefits for others.

1 The Nature of Externalities

Bart dumps industrial waste into a river no one owns Lisa fishes from the river, and is worse off from Barts

dumping without any reflection in prices Does Bart produce and contaminate water too much

or inefficiently? Why?

Inefficient choice and ownership

Barts production inputs

-Land

-Labor

-Capital

-Materials

-Water

Lisas production inputs

-Fishing rod & line

-Bait

-Fishing basket

-Clean water

Efficiency requires that Bart pays a price that reflects the waters value as a scarce resource that can be used for other activities (such as fishing)

BUT no one owns the river No market for clean water; anyone can use it for free

Externality is a consequence of the failure or inability to establish property rights 1st welfare theorem assumes a market exists for all

goods. This is because price carries information on how valuable the good is to society

Bart uses his other inputs efficiently because he must pay their owners prices that reflect their value in alternative uses

Inefficient choice and ownership

Inefficient choice and ownership

If someone owns a resource, its price reflects the value for alternative uses, and the resource is used efficiently If Lisa owned the river

she could charge Bart a fee for polluting that reflected the damage to her catch

Bart would take the charges into account, and would no longer use the water inefficiently

If Bart owned the river he could make money by charging Lisa for fishing in it Lisas willingness to pay for fishing in Barts river would depend on

the amount of pollution. Hence, Bart would have an incentive not to pollute excessively

If resources are owned in common, they tend to be over-used

Examples of Externalities

Negative Externalities Pollution Noise Littering Car exhaust Smoking

Positive Externalities Research &

development Vaccinations A neighbors nice

landscape Students asking good

questions in class

Nature of Externalities

Arise because there is no market price attached to the good

Can be produced by people or firms Can be positive or negative Public goods are special case

An externality can be a public good if it is positive and felt by everyone

E.g. a device for electrocuting mosquitoes in my garden

If it kills all the mosquitoes in the community, public good If it kills mosquitoes in a few neighbors, positive externality

2 Graphical Analysis

Figure 5.1: An externality problemAssumptions

Marginal private cost to Bart has a fixed component, and increases as Q increases

Marginal damage to Lisa increases as Q increases

Marginal benefit to Bart decreases as Q increases [MB is a horizontal line if he is a price taker]

Figure 5.1: An externality problemEquilibrium

Bart maximizes profits at MB=MPC. This quantity is denoted as Q1 in the figure.

However, marginal social cost is MPC+MD.

Social welfare is maximized at MB=MSC, which is denoted as Q* in the figure.

Implications

Q1[output level with negative externality] > Q*[socially efficient output level] Bart privately produces too much, because he does

not account for the damages to Lisa When externalities exist, private markets do not

produce the socially efficient output level What if Q=0? [Lisas damages are minimized]

But Bart cannot produce anything! Q* is not the preferred quantity for either party, but is

the best compromise In general, socially efficient allocation entails some

pollution

Figure 5.2: Gains and losses from moving to Q*

The area between the MB and MPC curve going from Q1 to Q* is the loss to Bart

the area under the MD curve going from Q1 to Q* is the gain to Lisa [cdhg is the same as abfd]

The net gain to society from producing at Q* instead of Q1 is the triangle dgh

Reality is more complicated

Implementing the framework of Fig. 5.2 requires identifying real MD and MB curves

How large is the amount of pollution associated with each Q? Which discharge creates harmful pollution?

How should the damage from the pollution be priced? There may be many fishermen Each fisherman may be affected differently

3 Private Responses to Externalities

Potential Solutions for Externalities

Private Responses1. Assign Property Rights / Coase Theorem2. Mergers3. Social conventions

Public Responses1. Taxes2. Subsidies3. Incentive-based regulation

1. Emissions fees2. Cap-and-trade programs

4. Command-and-control regulation

Private Response #1: Property Rights Suppose property rights to the river are

assigned to Bart, and it is costless for Bart and Lisa to bargain with each other regarding Q

Bart will decrease Q if he is paid more than (MB MPC)

Lisa will pay for decreased Q if payment < MD

if MD > payment >MB MPC, there is room for a bargain

At efficient level, MD= MB MPC

How the net gain dhg is divided depends on relative bargaining power

Coase Theorem The Coase Theorem states that once property

rights are established and transaction costs are small, then one of the parties will pay the other to attain the socially efficient quantity.

The socially efficient quantity is attained regardlessof to whom the property rights were initially assigned.

Once property rights are established, government intervention is not required to deal with externalities

Insight: root of the inefficiencies from externalities is the absence of property rights.

When Is the Coase Theorem Relevant?

Low transaction costs Few parties involved

Source of externality well defined

Example: Several polluting firms

Not relevant with high transaction costs or ill-defined externality

Example: Air pollution

Private Response #2: Mergers Mergers between firms internalize the

externality. A firm that consisted of both Barts firm and

Lisas fishery would only care about maximizing the joint profits of the two firms, not eithers profits individually.

Thus, it would take into account the effects of increased production on the fishery.

Private Response #3: Social Conventions

Certain social conventions can be viewed as attempts to force people to account for the externalities they generate.

Examples include conventions about not littering, not talking in a movie theater, etc.

4 Public Responses to Externalities

Potential Solutions for Externalities

Private Responses1. Assign Property Rights / Coase Theorem2. Mergers3. Social conventions

Public Responses1. Taxes2. Subsidies3. Incentive-based regulation

1.Emissions fees2.Cap-and-trade programs

4. Command-and-control regulation

Public Response #1: Taxes

Return to the Bart/Lisa example. Bart produces inefficiently because the price of

water incorrectly signals social costs. Natural solution is to levy a tax on a polluter.

A Pigouvian tax is a tax levied on each unit of a polluters output in an amount just equal to the marginal damage it inflicts at the efficient level of output.

How can we levy tax on Bart, so that he automatically chooses to produce Q*?

Public Response #1: Taxes

Figure 5.4: Analysis of a Pigouvian taxthe marginal damage Bart inflicts at the efficient level of output, Q*, = dc

With new marginal cost = MPC + cd, Bart chooses to produce less, at Q*

Pigouvian tax = dc

Pigouvian tax revenue=dc*Q*

Public Response #1: Taxes

Note: Compensating the victim isnt necessary and may cause more problems More people will join the activity receiving

compensation.

Practical problems in implementing a Pigouvian tax system How to find the correct tax rate or taxable goods? Sensible compromises

Suppose we want to reduce emissions from automobiles Instead of taxing on the number of miles driven at certain

locations [polluted areas] and time [congested time], a gasoline tax could be levied

Public Response #1: Taxes

Public Response #2: Subsidies Another solution is paying the polluter to not pollute. Government announces that it will pay Bart a

subsidy equal to the marginal damage at Q*, for each unit of output below Q1 he does not produce.

Now if Bart does not reduce Q, he will forgo the subsidy he could have obtained

i.e., perceived marginal cost is MPC + subsidy

Q per year

$

MB

0

MD

MPC

MSC = MPC + MD

Q1Q*

c

d

Barts perceived cost (MPC + cd)

i

jg

k

h

f

e

Pigouviansubsidy

Public Response #2: SubsidiesWith Pigouvian subsidy introduced at Q1, Barts perceived cost (MPC + cd) exceeds MB, so he has incentive to cut back his production level

This incentive continues till he reaches Q*

For Q

Public Response #2: Subsidies

The solution assumes that Q1 is known firms might game the system by undertaking inefficient actions that increase Q1

The subsidy leads to a socially efficient Q, but different distributional consequences: now the polluter receives a payment rather than paying

Subsidy could induce new firms to enter the market, which might increase overall pollution.

Also, it may be ethically undesirable to pay polluters.

Public Response #3: Incentive-based regulation [emissions fee]

Taxes on each unit of output might not give Bart the incentives to search for ways to reduce pollution other than reducing output

How about levying a tax on each unit of emissions?

Emissions fee Government levies an emissions fee, f*, for each unit of

pollution emitted f* is the marginal social benefit of pollution reduction at

the efficient level

Emissions Feee < e*: Barts cost of

reducing pollution, MC, is smaller than emission fee, f*, so Bart has incentive to reduce pollution

Pollution reduction

$

MSB

0

MC

e*

f*

e > e*: Barts cost of reducing pollution, MC, is larger than emission fee, f*, so Bart has incentive to increase pollution

MC: Marginal cost of reducing a unit of emission

MSB: Marginal Social Benefit of each unit of pollution Bart reduces

Efficient level of emission reduction, e*, arises when MSB = MC

Without fee, e=0 (no reduction). With fee f*, Bart reduces emission by e* units

Emissions Fee to Multiple Firms

Homers pollution reduction

$

50 90 Barts pollution reduction

How can the government allocate the burden of emission reduction? Is the equal allocation (50 to Bart and 50 to Homer) efficient?

$

50 90

MCH

MCB

Suppose Bart and Homer produce 90 units of emission, and Homer incurs higher cost than Bart in reducing a unit of emission

Suppose that government wants to reduce emission by 100 units

Emissions Fee to Multiple Firms

Homers pollution reduction

$

50 90 Barts pollution reduction

If government tells each firm to cut emission by 50, MC for Bart is lower than MC for Homer

If Bart reduces more and Homer reduces less, it would achieve the same reduction at a lower (aggregate) cost

The total cost of emissions reduction is minimized only when the marginal costs are equal across all polluters: cost effective outcome

$

50 90

MCH

MCB

Suppose Bart and Homer produce 90 units of emission, and Homer incurs higher cost than Bart in reducing a unit of emission

Suppose that government wants to reduce emission by 100 units

Emissions Fee to Multiple Firms

Homers pollution reduction

$

50 75 90 Barts pollution reduction

If emissions fee, f, is applied to both firms, each firm reduces emission up to the point where MC=f

Thus emissions fee achieves cost effective outcome: MCB=MCH It also rewards firms with better technology (which can reduce

emissions more) by charging less tax

$

25 50 90

f

MCH

MCB

Suppose Bart and Homer produce 90 units of emission, and Homer incurs higher cost than Bart in reducing a unit of emission

Suppose that government wants to reduce emission by 100 units

Hs taxBs tax

Bs reduction Hs reduction

Public Response #3: Incentive-based regulation [cap-and-trade scheme]

Alternative to Emissions fee Cap-and-trade scheme

Government sets the desired pollution level, or the number of permits which allow polluters to emit pollution

Provide those permits to polluters Let polluters trade the permits

Even if firms incur differing costs to reduce emission, the cap-and-trade scheme also leads to cost-effective outcome

Cap-and-trade Scheme

Homers pollution reduction

$

10 90 Barts pollution reduction

Without trading of permits, Homers marginal cost is far higher than Barts marginal cost

As long as MCH > price of permit > MCB, there is a scope for trade Trade settles when MCH =MCB , which is cost effective

$

90

MCH

MCB

Suppose government decided to reduce emission by 100, or allow total pollution to be 80 units

Government gives Bart 80 permits to emit

As Bart was emitting 90, with 80 permits, he has to reduce emission by 10

As Homer was emitting 90, with no permit, he has to reduce emission by 90

Emissions Fee v.s. Cap-and-trade Inflation lowers the real emissions fee and leads

to less pollution reduction Legislative adjustment is needed the cap-and-trade scheme leads to the same amount of

pollution reduction

When marginal cost of reducing emission increases, With the emissions fee, pollution reduction decreases With the cap-and-trade scheme, the price of permits

increases, but pollution reduction is constant

Neither system automatically leads to an efficient outcome when the costs of pollution reductions change

Emissions Fee v.s. Cap-and-trade Safety valve price

Combine the cap-and-trade system with the emissions fee system

Government sells as many additional permits as is demanded at a pre-established (HIGH) price (Safety valve price)

Likely to be used only when the cost of pollution reduction is much higher than expected

Responsiveness to Uncertainty

When the costs of reducing pollution is uncertain, emission fees and cap-and-trade system could lead to different outcomes

Implications differ depending on the elasticity of marginal social benefit curve

Inelastic MSB The reduction of the first unit is highly valued, but the

value for the additional units tapers off quickly

Elastic MSB The value of reduction remains relatively constant

Inelastic MSB Schedule

Pollution reduction

$MSB

0 ef e e*

f*

Emission fee, f*, is determined by MSB = MC. Since it is based on underestimated cost, f* is too low and ef too little compared to the efficient allocation, e

Under cap-and-trade scheme, government produces enough permits to reduce up to e*, which is too much.

e* is closer to e

MC*: governments guess on MC

MC: true MC

Elastic MSB Schedule

Pollution reduction

$

MSB

0 ef e e*

f*

It remains the case that ef is too little and e* is too muchcompared to the efficient allocation, e

But ef is now closer to e*

MC*: governments guess on MC

MC: true MC

Implications

When costs are uncertain and MSB is inelastic, a cap-and-trade system is preferable to an emissions fee

When costs are uncertain and MSB is elastic, an emissions fee is preferable to a cap-and-trade system

How to find out the shape of MSB? Information from various fields is required

Distributional effects Cap-and-trade system can produce no revenue to

government if permits are given to polluters for free

Public Response #4: Command-and-control regulation

Incentive-based regulations (emissions fees, cap-and-trade system) Allow polluters great flexibility in how to reduce their emissions

Command-and-control regulations Require a given amount of pollution reduction with limited or no

flexibility with respect to how it may be achieved Performance standard: firms must meet certain amounts of

pollution reduction Technology standard: firms must use certain technology

E.g., U.S. Corporate average fuel economy standards All new passenger cars must attain 27.5 miles per gallon Manufacturers cannot shift the burden among each other to lower

overall cost It is estimated that, if alternatively gasoline consumption is taxed,

the same reduction in gasoline consumption can be achieved with $700 million less per year

Limitation of incentive-based regulations

Incentive-based regulations may not work well if Pollution reductions cannot be monitored well There is a possibility of creating hot spots, or

localized concentrations of emissions

Command-and-control regulations may be the second-best, feasible solutions

5 Implications for Income Distribution

Who Benefits? In reality, individuals in different areas suffer

differently from various externalities Poor neighborhoods tend to have more exposure to air

pollution [Gayer, 2000] Removing air pollution would benefit low-income families more Cleaning recreational parks would benefit high-income families

Larger damage may not lead to higher willingness to pay A cleanup program may reduce the physical amount of

pollution faced by low-income families But high-income families might show higher willingness

to pay for the program

Who Bears the Cost? Implications of emissions reduction

Less inputs bought by polluters -> the owners of these inputs are worse off

Possible layoffs at polluters factories -> fired workers are worse off

If these people are low-income earners, income inequality is worsened

Polluters may also increase the price of their products Consumers of polluters products are worse off If these people are low-income earners, income

inequality is worsened