Topic 4 ： Externalities

Definition of Externality• An externality is an economic cost or benefit t

hat is the by-product of economic activity but that is allacated outside of the market system.

• Resources are likely to be misallocated when there is an externality.

• There are two types of externalities: negative externality and positive externality.– Negative externalities occur when a cost is generat

ed by the producer of the externality, but because there is no market for the externality, the producer of the externality does not consider the costs that the externality imposed on others.

– Positive externalities occur when a benefit is generated by the producer of the externality, but because there is no market for the externality, the producer does not get compensated for the benefit to others and has no incertive to take it into account.

External Cost• Scenario [si’neəri:əʊ]

– Steel plant dumping waste in a river– The entire steel market effluent [‘eflu:ənt] can b

e reduced by lowering output (fixed proportions production function)

• Scenario– Marginal External Cost (MEC) is the cost imposed o

n fishermen downstream for each level of production.

– Marginal Social Cost (MSC) is MC plus MEC.

MC

S = MCI

D

P1

Aggregate social cost of

negativeexternality

P1

q1 Q1

MSC

MSCI

When there are negativeexternalities, the marginalsocial cost MSC is higher

than the marginal cost.

Firm output

Price

Industry output

Price

MEC

MECI

The differences isthe marginal external

cost MEC.

q*

P*

Q*

The industry competitiveoutput is Q1 while the efficient

level is Q*.

The profit maximizing firmproduces at q1 while the

efficient output level is q*.

• Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

• Positive Externalities and Inefficiency– Externalities can result in too little production, as c

an be shown in an example of home repair and landscaping.

MCP1

External Benefits

Repair Level

Value

D

Is research and development discouraged by positive

externalities?

q1

MSB

MEB

When there are positiveexternalities (the benefitsof repairs to neighbors),marginal social benefits

MSB are higher thanmarginal benefits D.

q*

P*

A self-interested home ownerinvests q1 in repairs. Theefficient level of repairs

q* is higher. The higher priceP1 discourages repair.

Public Policy toward Externalities• When large numbers and high transactions co

sts are invovled, government policy becomes important to internalize an externality.

• Internalizing an externality means changing the incentives of the parites involved so that they act as if there is a market for the external cost or benefit.

Negative Externalities in a Supply and Demand Framework• The concept of the negative externality can be

depicted graphically in a supply and demand framework as shown in figure 4.1.

• The externality generates additional opportunity costs that are not included in the supply curve. These costs can be depicted as amount E in the diagram.

• The curve S+E includes the entire opportunity cost of production, including the cost of the externality.

• Private actions to correct an externality– If only a few people are affected by the externality,

then private exchange might correct the problem.– The Coase Theorem states that in the absence of tr

ansactions costs, the allocation of resources will be independent of the assignment of property rights.

• Ronald Coase. The Problem of Social Cost. 1960

• Corrective taxation of an extenality– If the firms are charged a tax equal to the

external cost that they impose on others, then an economically efficient level of output will result.

– But there are problems in measuring the cost of the externality, so as to set the tax equal to the marginal cost of the externality.• The first problem is measuring the cost of the

externality.( One method might be to take a poll to see how much people would be willing to pay to reduce or eliminate the pollution.)

• The next problem is to decide who is responsible for the cost.

• What should be taxed?• The external cost is shown as a given amount

per unit of production. (figure 4.2, Panel A)• In this case, the only way to reduce the

externality is to reduce the amount of production.

• But the external cost could be reduced in other ways.

Placing a tax on each unit of output would not quite give firms the right incentives.

• In panel B, after the corrective tax is placed on the cost of the externality, firms can take action to reduce the amount of pollution they create per unit of production, to lower their tax.

• The external cost per unit of production then shifts down from E to E’.

Taxation v.s. Regulation• Because it is so difficult to apply a corrective t

ax on an externality in the real world, governments are more likely to use regulations requiring that certain steps be taken to reduce the externality.

• In the short term, a quota might work, but in the long run, the results from a quota and a corrective tax will differ.

• taxation versus regulation of an externality(figure 4.3)

• （ 1 ）平均总成本曲线开始时随产量增加而迅速下降，达到 M点时平均总成本最低（与边际成本曲线相交）。（ 2 ）平均可变成本曲线开始时随产量增加而逐步下降，达到 M’ 点时（与边际成本曲线相交）平均可变成本最低。（ 3 ）平均固定成本曲线随产量的增加而递减，逐渐向横轴接近。（ 4 ）边际成本曲线开始时随产量的增加而迅速下降，达到最低点后，便随产量的增加迅速上升，无论是上升还是下降，边际成本曲线的变动都快于平均变动成本曲线。

• The amount of the tax is shown by the entire shaded area, and, as a result, the firm is taking losses.

• If each firm is regulated by quotas Q*, they will make above-normal profits, represented by the heavily shaded area.

• In the long run, the regulation encourages entry, whereas the optimal tax encourages firms to leave the industry.

• the politics of quotas versus taxes– industry representatives will lobby for regulatory s

olutions– taxpayers can benefit from the tax– which one has more political influence?

• Incentive for pollution reduction with regulation versus taxation– incentives involved in regulating pollution are far in

ferior to those involved in corrective taxation.– however, it is often difficult to apply corrective taxa

tion, and there will be political pressures against it.– regulation may be the second-best solution.

Case Study:Standards and Fees

• Options for Reducing Emissions to E*– Emission Standard

• Set a legal limit on emissions at E* (12)• Enforced by monetary and criminal penalties• Increases the cost of production and the thresho

ld price to enter the industry

Level of Emissions

Dollarsper unit

of Emissions

MSC （ marginal social cost, 边际社会成本，是厂家不会主动考虑的）

MCA(marginal cost of abatement,边际减排成本，可视为边际排放收益）

3

12

E*

Standard

Fee

• Options for Reducing Emissions to E*– Emissions Fee

• Charge levied on each unit of emission

TotalAbatement Cost

Cost is less than thefee if emissions were

not reduced. So the firm would rather abate than

pay the fee.

Total Feeof Abatement

Level of Emissions

Dollarsper unit

of Emissions MSC

MCA

3

12E*

Fee

• Standards Versus Fees– Assumptions

• Policymakers have asymmetric [,æsi’metrik ，不对称 ]information

• Administrative costs require the same fee or standard for all firms

Firm 2’s ReducedAbatement

Costs

Firm 1’s IncreasedAbatement Costs

MCA1

MCA2

Level of Emissions

2

4

6

Fee perUnit of

Emissions

0 1 2 3 4 5 6 7 8 9 10 11 12 13

1

3

5

14

The cost minimizing solutionwould be an abatement of 6

for firm 1 and 8 for firm 2 andMCA1= MCA2 = $3.

3.75

2.50

The impact of a standard ofabatement of 7 for both firms

is illustrated.Not efficient because

MCA2 < MCA1.

If a fee of $3 was imposed,Firm 1 emissions would fall

by 6 . Firm 2 emissionswould fall by 8.

MCA1 = MCA2: efficient solution.

• Advantages of Fees– When equal standards must be used, fees achieve t

he same emission abatement at lower cost.– Fees create an incentive to install equipment that

would reduce emissions further.• Are fees always better than standards?

ABC is the increasein social cost less thedecrease in abatement

cost.

MarginalSocialCost

Marginal Costof Abatement

Level of Emissions

Fee perUnit of

Emissions

0 2 4 6 8 10 12 14 16

2

4

6

8

10

12

14

16

E

Based on incompleteinformation standard is 9

(12.5% decrease).ADE < ABC

DA

B

C Based on incompleteinformation fee is $7

(12.5% reduction).Emission increases to 11.

• Conclusions about Fees vs. Standards– Standards are preferred when MSC is steep and MC

A is flat.– Standards (incomplete information) yield more cer

tainty on emission levels and less certainty on the cost of abatement.

– Fees have certainty on cost and uncertainty on emissions.

– Preferred policy depends on the nature of uncertainty and the slopes of the cost curves.

Marketable Pollution Rights• A system of marketable pollution rights

– give all existing polluters the right to continue creating the amount of pollution that they currently creat.

– firms would not be allowed to increase their level of pollution without buying the right from someone else.

– if a firm could find a way to reduce its pollution, it could sell its right to pollute to others.

• Drawbacks of marketable pollution rights– must be possible to monitor the amount of pollutio

n created by various contributors– may creat new pollution– need muture markets

Case: Emissions Trading and Clean Air

• Bubbles– Firm can adjust pollution controls for individual so

urces of pollutants as long as a total pollutant limit is not exceeded.

• Offsets– New emissions must be offset by reducing existing

emissions • 2000 offsets since 1979

• Cost of achieving an 85% reduction in hydrocarbon( 烃 )emissions for DuPont– Three Options

• 85% reduction at each source plant (total cost = $105.7 million)

• 85% reduction at each plant with internal trading (total cost = $42.6 million)

• 85% reduction at all plants with internal and external trading (total cost = $14.6 million)

• 1990 Clean Air Act– Since 1990, the cost of the permits has fallen from a

n expected $300 to below $100.

• Causes of the drop in permit prices – More efficient abatement techniques– Price of low sulfur coal has fallen

The Optimal Amount of Pollution• Would it be optimal to eliminate all pollution?

– the costs of trying to reduce pollution might outweigh the negative effects of the pollution

– if pollution is reduced to the point where the marginal cost of doing so is just equal to the marginal benefit of the reduced pollution, some pollution will remain.

The Efficient Level of Emissions

Level of Emissions

2

4

6

Dollarsper unit

of Emissions

0 2 4 6 8 10 12 14 16 18 20 22 24 26

MSC

MCAE*

The efficient level ofemissions is 12 (E*) where

MCA = MSC.

Assume:1) Competitive market2) Output and emissions decisions are independent3) Profit maximizing output chosen

At Eo the marginalcost of abating emissions

is greater than themarginal social cost.

E0

At E1 the marginalsocial cost is greater

than the marginal benefit.

E1

Why is this more efficientthan zero emissions?

Positive Externalities• Positive externalities produce a benefit to others, but

this benefit is not allocated within the market(figure 4.4)

• Government subsidization– the government compensates the producer for the

value of the positive externality– the problem is how to calculate the optimal subsid

y, which should be equal to the external benefit