Download Chapter10 Externalities

Chapter10 Externalities
Outline of Topics
T1 Externalities and Market Inefficiency
T2 Private Solutions to Externalities
T3 Public Policies toward Externalities
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• Markets do many things well, but they do not do everything
well. Governments can sometimes improve market
outcomes.
• An externality arises when a person engages in an activity
that influences the well-being of a bystander and yet neither
pays nor receives any compensation for that effect.
– Negative Externalities: if the impact on the bystander is
adverse
– Positive Externalities: if the impact on the bystander is
beneficial
T1 Externalities and Market inefficiency
• Consider the market for aluminum.
• See Figure 10-1 on page 207, a case without externalities.
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• Now let’s suppose that aluminum factories emit pollution:
for each unit of aluminum produced, a certain amount of
smoke enters the atmosphere. It is a negative externalities
because this smoke creates a health risk for those who
breathe the air.
• Because of this externality, the cost to society of producing
aluminum is larger than the cost to the aluminum producers.
• Consider what a benevolent social planner would do in this
case.
– The planner wants to maximize the total surplus derived
from the market: the value to consumers of aluminum
minus the cost of producing aluminum
– The planner would choose the level of aluminum
production at which the demand curve crosses the socialcost curve.
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– See Figure 10-2 on page 208.
– Note that the equilibrium quantity of aluminum, Qmarket is
larger than the socially optimal quantity, Qoptimum.
– The reason for this inefficiency is that the market
equilibrium reflects only the private costs of production.
– So, reducing aluminum production and consumption
below the market equilibrium level raises total economic
well-being.
• Using the concept of deadweight loss to measure the value
of this increase in economic well-being
– Deadweight loss: the fall in total surplus that results
from a market distortion, such as a negative externality
– See Figure10-3 & Table 10-1 on page 210
– At market Equilibrium, (Pmarket, Qmarket)
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• CS: A+B+C+D
• The cost to society of producing the aluminum:
F+G+B+C+ H
• So, PS: E+F+G-(F+G+B+C+ H)  E-(B+C+ H)
• (In the presence of an externality, we use the social
cost rather than using the private cost to sellers of
producing aluminum to measure the producer
surplus.)
• So, total surplus, TS = CS+PS =
A+B+C+D+ E-(B+C+ H)
=A+D+E-H
– At socially optimum (Poptimum, Qoptimum)
• CS:D
• PS:A+E
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• TS= D+A+E
• Deadweight Loss in Economic Welfare due to the negative
externality
– Triangle H is the deadweight loss to society, or reduction
in total surplus, caused by the externality associated with
producing aluminum.
• Another way of understanding the nature of the market
failure arising from an externality and determining the
deadweight loss triangle si to consider the difference
between the social cost curve and the demand curve for
aluminum at the equilibrium level of production, Qmarket.
– At Qmarket, the social cost curve lies above the demand
curve. TS would therefore be higher if this last unit of
aluminum was not produced at all.
– The loss of TS of producing Qmarket rather than Qoptimum
is equal to the area of the triangle formed by the social
cost Curve and the demand curve between Qoptimum and
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Qmarket.
• How might a social planner achieve the socially optimal
level of aluminum production and eliminate the deadweight
loss associated with the externality? Taxes
• The tax would shift the supply curve for aluminum up by
the size of the tax. If the tax accurately reflects the social
cost of pollution, the new supply curve coincide with the
social-cost curve.
• Such a tax is said to internalize the externality because it
gives buyers and sellers in the market the incentive to take
account of the external effects of their actions.
• Taxes that internalize negative externalities are called
Pigovian taxes.
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• Positive Externalities in Production
• Consider the market for robots. See Figure 10-4 on page
213.
• Robots are at the frontier of a rapidly changing technology.
Whenever a firm builds a robot, there is some chance that it
will discover a new and better design. This new design will
benefit not only this firm but also the society as a whole
because the design will enter society’s pool of technological
knowledge. This type of positive externality is called a
technology spillover.
• In the presence of a positive externality to production, the
social cost of producing robots is less than the private cost.
The optimal quantity of robots, Qoptimum is therefore larger
than the equilibrium quantity, Qmarket- which generates a
deadweight loss.
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• Externalities in Consumption
• The consumption of alcohol, for instance, yields negative
externalities if consumers are more likely to drive under its
influence and risk the lives of others.
• The consumption of education yields positive externalities
because a more educated population leads to better
government, which benefits everyone.
• See Figure 10-5 on page 215
• General lessons:
– Negative externalities in production or consumption lead
markets to produce a larger quantity than is socially
desirable.
– Positive externalities in production or consumption lead
markets to produce a smaller quantity than is socially
desirable.
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– To remedy the problem, the government can internalize
the externality by taxing goods that have negative
externalities and subsidizing goods that have positive
externalities.
T2 Private Solutions to Externalities
• Although externalities tend to cause markets to be
inefficient, government action is not always need to solve
the problem. In some circumstance, people can develop
private solutions. For examples, sometimes, the problem of
externalities is solved with moral codes, social sanctions
and a contract.
• The Coase Theorem
– According to Coase theorem, if private parties can
bargain without cost over the allocation of resources,
then the private market will always solve the problem of
externalities and allocate resources efficiently.
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• See Dick and Jane’s case on page 216 & 217.
• To sum up: The Coase theorem says that private economic
actors can solve the problem of externalities among
themselves. Whatever the initial distribution of rights, the
interested parties can always reach a bargain in which
everyone is better off and the outcome is efficient.
• The Coase theorem applies only when the interested parties
have no trouble reaching and enforcing an agreement.
• In the real world, however, bargaining does not always
work, even when a mutually beneficial agreement is
possible.
• Sometimes the interested parties fail to solve an externality
problem because of transaction costs, the costs that parties
incur in the process of agreeing to and following through
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through on a bargain.
T3 Public Policies toward Externalities
• When an externality causes a market to reach an inefficient
allocation of resources, the government can respond in one
of two ways.
– Command-and-control policies regulate behaviour
directly
– Market-based policies provide incentives so that private
decision makers will choose to solve the problem on their
own.
• Example: Suppose that two factories- a paper mill and a
steel mill-are each dumping 500 tonnes of glop into a river
each year.
– Regulation: Environment Canada could tell each factory
to reduce its pollution to 300 tonnes of glop per year
– Pigovian Tax: Environment Canada could levy a tax on
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each factory of $50,000 for each tonne of glop it emits.
• Most economists would prefer the tax. The reason why
economists would prefer the tax is that it reduces pollution
more efficiently. The regulation requires each factory to
reduce pollution by the same amount, but an equal reduction
is not necessarily the least expensive way to clean up the
water.
• In essence, the Pigovian tax places a price on the right to
pollute. Just as markets allocate goods to those buyers who
value them most highly, a Pigovian tax allocates pollution to
those factories that face the highest cost of reducing it..
• Pigovian taxes correct incentives for the presence of
externalities and thereby move the allocation of resources
closer to the social optimum. Thus,while Pigovian taxes
raise revenue for the government, they enhance economic
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efficiency.
• Tradable Pollution Permits
• Consider our previous example of the paper mill and the
steel mill. Suppose Environment Canada adopts the
regulation and requires each factory to reduce it pollution to
300 tonnes of glop per year. Assume that the steel mill
wants to increase its emission of glop by 100 tonnes. The
paper mill has agreed to reduce its emission by the same
amount if the steel mill pays it $5 million.
• Should Environment Canada allow the two factories to
make this deal? From the standpoint of economic
efficiency, allowing the deal is good policy.
• The deal must make the owners of the two factories
better off because they are voluntarily agreeing on it.
• Moreover, the deal does not have any external effects
because the total amount of pollution remains the
same.
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• The same logic applies to any voluntary transfer of the
right to pollute from one firm to another.
• One advantage of allowing a market for pollution permits
is that the initial allocation of pollution permits among
firms does not matter from the standpoint of economic
efficiency.
– Those firms that can reduce pollution most easily
would be willing to sell whatever permits they get, and
those firms that can reduce pollution only at high cost
would be willing to buy whatever permits they need.
– As long as there is a free market for the pollution
rights, the final allocation will be efficient whatever the
initial allocation.
• Although reducing pollution using pollution permits may
seem quite different from using Pigovian taxes, in fact the
two policies have much in common.
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• In both cases, firms pay for their pollution.
– With Pigovian taxes: polluting firm must pay a tax to the
government.
– With Pollution Permits: polluting firms must pay to buy
the permit.
– Both Pigovian taxes and pollution permit internalize the
externality of pollution by making it costly for firms to
pollute.
• See Figure 10-6 on page 222.
• In panel (a), the supply curve for pollution rights is perfectly
elastic (because firms can pollute as much as they want by
paying the tax), and the position of the demand curve
determines the quantity of pollution.
• In panel (b), Environment Canada sets a quantity of
pollution by issuing pollution permits. The supply curve for
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pollution right is perfectly inelastic ( because the
Quantity of pollution is fixed by the number of permits)
and the position of the demand curve determines the
price of pollution.
• Hence, for any given demand curve for pollution,
Environment Canada can achieve any point on the demand
curve either by setting a price with a Pigovian tax or by
setting a quantity with pollution permits.
• However, in some cases, selling pollution permits may be
better than levying a Pigovian tax because the government
does not know the demand curve for pollution.
• Many environmentalists object to the use of pollution
permits and other market-based solutions to pollutions on
the grounds that it is simply not right to allow someone to
pollute for a fee. Economists have little sympathy with this
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type of argument because people face tradeoff.