Chapter 17 Externalities

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1 Goldwasser AP Microeconomics BEFORE YOU READ THE CHAPTER Chapter 17 Externalities Summary This chapter describes positive, negative, and network externalities and the effects of these externalities in the marketplace. The chapter explores the economic inefficiency that arises when externalities are not accounted for, and it presents several alternative methods for correcting externalities. The chapter makes the case for government intervention in the form of emissions taxes, tradable permits, or Pigouvian subsidies as an efficient means of correcting externalities. The chapter also discusses environmental standards as an inefficient government policy. Finally, the chapter looks at industrial policy and how network externalities are an important feature of high-tech industries. Chapter Objectives Objective #1. A principal source of market failure occurs when the market fails to take into account side effects or externalities of consumption or production decisions. A negative externality is a side effect that imposes costs on others, and a positive externality is a side effect that provides benefits to others. When externalities are present, the market fails to produce the optimal amount of the good: in the case of a negative externality, the market produces too much of the good if it does not take into account the externality; in the case of a positive externality, the market produces too little of the good if it does not take into account the externality. When the externality can be directly observed, then it can be regulated through direct controls, taxation, or subsidization. When the externality cannot be directly observed, then the government must implement policies that aim at generating the right amount of the activity that produces the externality. This chapter discusses these two approaches-targeting the side effect versus targeting the original activity-as it reviews different policies available to the government to correct the problem presented by externalities. Objective #2. Many activities produce pollution as a side effect of these activities. One of the problems with pollution is that it inflicts a cost on the entire society, and this cost is typically not borne by the companies or individuals who generate the pollution. The chapter explores how to determine the optimal amount of pollution by developing the concepts of the marginal social cost of pollution and the marginal social benefit of pollution. Pollution generates costs as well as benefits to society. The marginal social cost of pollution is the additional cost imposed on society of an additional unit of pollution. The marginal social cost of pollution is an upward-sloping line, since each additional unit of pollution represents a greater cost to society as the environment deteriorates.

2 The marginal social benefit of pollution is the additional benefit to society from an additional unit of pollution. Cleaning up pollution requires the use of scarce resources that would otherwise be used to produce goods and services. From a producer's perspective, the benefit from emitting one more unit of pollution is measured by the costs the producer saves from not having to buy and install expensive pollution-control equipment. One can measure the marginal social benefit of an additional unit of pollution by finding out what is the highest willingness to pay for the right to emit this unit of pollution among all the polluters in the society. Polluters know that to avoid polluting requires using scarce resources and therefore reduction of pollution carries a cost. The marginal social benefit of pollution is a downward-sloping line: when pollution is negligible, then an additional unit of pollution has a high benefit to society; when there is a lot of pollution, then an additional unit of pollution brings little benefit to society. The optimal amount of pollution for a society is the level of pollution at which the marginal social cost of pollution is equal to the marginal social benefit of pollution. Figure 17.1 illustrates these concepts. It is unlikely that the market will generate the optimal amount of pollution, because those who produce the pollution do not have to compensate those who bear the costs of the pollution. The polluting producer can pass along the pollution costs to all members of society, and thus the market, left to its own devices, will result in too much pollution. In the absence of government intervention, polluters will pollute up to the point where the marginal social benefit of pollution is equal to zero. The market outcome is represented in Figure 17.2: note that the market level of pollution is greater than the optimal level of pollution, and that the market level of pollution is inefficient since, at this level of pollution, the marginal social cost of pollution is greater than the marginal social benefit of pollution.

3 Objective #3. According to the Coase theorem, the private sector can correct externalities and produce the efficient level of the good, provided that transaction costs are sufficiently low. The Coase theorem states that externalities need not lead to inefficiencies since people have an incentive to make mutually beneficial transactions, which leads individuals to take externalities into account when making decisions, provided that the transaction costs are not too great. When individuals take into account externalities when making decisions, this is referred to as internalizing the externality. Internalization of the externality does not occur if the cost of communication between the affected parties is too high, if the cost of making a legally binding agreement is too great, or if there are costly delays in the bargaining. When transaction costs prevent people from internalizing the externality, then the government must intervene to correct the market and its failure to internalize the externality. Objective #4. The government can reduce the amount of pollution by enforcing environmental standards, which are rules that protect the environment by specifying what actions need to be taken by producers and consumers. Although effective, these standards are not efficient since they do not incorporate the costs of reducing pollution. Economists believe that pollution can be reduced at lower cost through the use of taxes and tradable permits. Emissions taxes are taxes that depend on the amount of pollution a firm produces. An emissions tax is more efficient than an environmental standard, since the emissions tax ensures that the marginal benefit of pollution is equal for all sources of pollution while the environmental standard does not consider the marginal benefit of pollution when it is enforced. Figure 17.3 illustrates the differences between these two approaches using two different firms, firm A and firm B, that both produce pollution but have different marginal social benefit of pollution curves. The graph on the left illustrates the environmental standard approach: pollution for all firms in the society must, by law, be reduced to 450 units for each firm. With this standard, however, notice that the marginal social benefit of reducing pollution is different for the two firms: for firm A the marginal social benefit is $225 for the last unit of pollution emissions, while for firm B the marginal social benefit is $450 for the last unit of pollution emissions.

4 The graph on the right illustrates the emissions tax approach using an emissions tax of $300 per unit of pollution: each unit of pollution emitted is taxed, and polluters reduce their pollution by considering the tax versus the benefit of the pollution. Both firm A and firm B select the level of pollution emissions where the emissions tax is equal to their marginal social benefit from pollution: for firm A this corresponds to a reduction in pollution emissions of 600 units, while for firm B this corresponds to a reduction in pollution emissions of 300 units. The total amount of pollution reduction is the same in both programs (900 units), but the emissions tax is efficient since all producers reduce pollution to the point where the marginal social benefit of pollution is exactly equal to the tax. Taxes can be used to reduce any kind of activity that generates a negative externality. This use of taxes to address the problem of negative externality is referred to as a Pigouvian tax. Although effective as a policy, Pigouvian taxes are difficult to implement since government officials do not always know with certainty what level of tax is the efficient level of tax. Tradable emissions permits are licenses granted by the government that give the holder of the license permission to emit limited quantities of the pollutant. These tradable emissions permits can be bought and sold by the polluters. In essence, the government determines the legal amount of pollution and then sells permits equal to this amount of pollution. Producers who pollute must own permits granting them the right to generate their level of pollution. Producers

5 can either purchase the right to pollute or they can clean up their production and eliminate the polluting activity. Firms that find the cost of reducing pollution greater than the cost of buying the permits will buy the permits. Firms that find the cost of reducing pollution less than the cost of buying the permits will eliminate their pollution. Since the level of pollution is limited by the amount of permits in the market, this results in producers basing their decision about whether or not to pollute on the costs of reducing their pollution. In effect, the government creates a market in the right to pollute by using tradable emissions permits. The greatest challenge for government when implementing a tradable emissions permit program is determining the optimal number of permits for the economy: issue too many permits, and pollution is not reduced enough; issue too few permits, and pollution is reduced too much. Both emissions taxes and tradable emissions permits create an incentive for producers to create and use less-polluting technology. Cap-and-trade systems are another name for tradable emissions permits. In this case, the government issues a cap, or a total amount of pollutant that can be emitted, then the government issues tradable emissions permits and enforces a rule that polluters must hold a number of permits equal to the amount of the pollutant they emit. This policy is effective with pollution that is dispersed, but it is less effective with pollution that is geographically localized. As with any policy, policymakers also face political pressure to set the level of the cap at either too high or too Iowa level. Finally, these measures to reduce pollution require a high degree of monitoring and compliance if the policy is to be effective. Objective #5. When an activity generates an external cost, or a cost incurred by someone other than the people directly involved in the transaction, the market produces too much of the good. This situation of an external cost is an example of a negative externality. Figure 17.4 illustrates a negative externality. From the producers' perspective, the market supply curve represents the private costs they incur when they produce the good. However, when this good is produced there are also social costs that the producers do not include in their costs of production. The result is a difference between the market supply curve and the true marginal social costs of production. The market, when it fails to correct for the externality, produces Q market which is more than Q optimal. Notice that at Q market the marginal social benefit of consuming the last unit of the good produced (as measured by the demand curve) is less than the marginal social cost of producing this last unit. Too much of this good is being produced by the market, and therefore too many resources are being devoted to its production. This negative externality can be remedied by applying the appropriate Pigouvian tax, equal to the externality per unit of the good produced, on producers so that Q optimal is produced by the market. The application of this tax on the market causes the market to internalize the negative externality.

6 Objective #6. When an activity generates an external benefit, or a benefit received by someone other than the people directly involved in the transaction, the market does not produce enough of this good. This situation of an external benefit is an example of a positive externality. In the case of a positive externality, the government must target the original activity rather than the external benefit because the external benefit can be difficult, or impossible, to measure. For example, the external benefit from people getting vaccinated is a reduction in the spread of disease among the whole population, but it is impossible to measure how many people benefit from an individual getting vaccinated. When individuals consider getting vaccinated, they consider only the benefits they directly receive and do not include the external benefits the vaccination provides to other people. This implies that people will consume less than the ideal level of vaccinations because they do not include the external benefits. This scenario can be illustrated by thinking about the demand curve that represents the private benefits that individuals receive from the vaccination and the demand curve that includes the private benefits as well as the external benefits. Figure 17.5 illustrates the case of a positive externality: in the graph the quantity produced by the market is Q market and the optimal quantity, where the marginal cost of producing the last unit is equal to the marginal social benefit from consuming the last unit, is given by Q optimal. This situation of a positive externality can be corrected by application of the optimal Pigouvian subsidy, a subsidy equal to the positive externality cost per unit of the good. The application of this subsidy in this market causes the market to internalize the externality.

7 Objective #7. The creation of knowledge poses the greatest single source of external benefits in the modern economy. Technology spillover is a term that describes the spread of knowledge among individuals and firms: technology spillover measures the external benefit that occurs when new knowledge is discovered in one application and then this knowledge is used in other applications. Some people advocate for an industrial policy that would support specific industries due to the existence of these technology spillover effects. This industrial policy would amount to subsidization or reductions in competition from foreign producers through the imposition of trade restrictions for specific industries deemed to generate these technology spillovers. Economists are not strong advocates of industrial policy because it is hard to identify with certainty positive externalities, and because these policies may result in the promotion of industries with political power rather than industries that create technology spillovers. Objective #8. A final type of externality is that of network externalities. A network externality occurs when the value of a good to a consumer increases as more people own or use the good. These types of externalities frequently occur in technology-driven sectors of the economy. With a network externality, the marginal benefit to the individual is dependent on the number of other individuals who use the good. A good with a network externality also exhibits positive feedback: as more people use the good, even more people are inclined to use the good, and if fewer people use the good, then even fewer people are inclined to use the good. The good's ultimate success or failure is self-reinforcing: a well-accepted good becomes ever more accepted, while a poorly received good is quickly abandoned because of this positive feedback effect. Companies recognize the importance of network externalities and the positive feedback effect, and they sometimes offer a new product at a very low price in hopes of generating a strong network effect. Key Terms Notes marginal social cost of pollution the additional cost imposed on society as a whole by an additional unit of pollution. marginal social benefit of pollution the additional gain to society as a whole from an additional unit of pollution. socially optimal quantity of pollution the quantity of pollution that society would choose if all the costs and benefits of pollution were fully accounted for. external cost an uncompensated cost that an individual or firm imposes on others; also known as negative externalities. external benefit an uncompensated benefit that an individual or firm confers on others; also known as positive externalities. externalities external benefits and external costs. negative externalities external costs.

8 positive externalities external benefits. Coase theorem the proposition that even in the presence of externalities an economy can always reach an efficient solution as long as transaction costs are sufficiently low. transaction costs the costs to individuals of making a deal. internalize the externality when individuals take into account external costs and external benefits. environmental standards rules established by a government to protect the environment by specifying actions by producers and consumers. emissions tax a tax that depends on the amount of pollution a firm produces. Pigouvian taxes taxes designed to reduce external costs. tradable emissions permits licenses to emit limited quantities of pollutants that can be bought and sold by polluters. marginal social cost of a good or activity the marginal cost of production plus the marginal external cost. Pigouvian subsidy a payment designed to encourage activities that yield external benefits. technology spillover an external benefit that results when knowledge spreads among individuals and firms. industrial policy a policy that supports industries believed to yield positive externalities. marginal social benefit of a good or activity the marginal benefit that accrues to consumers plus the marginal external benefit. network externality the increase in the value of a good to an individual is greater when a large number of others own or use the same good. positive feedback put simply, success breeds success, failure breeds failure; the effect is seen with goods that are subject to network externalities. AFTER YOU READ THE CHAPTER Tips Tip #1. The key concept in this chapter is the idea that markets fail to produce the optimal amount of the good whenever there is a cost or a benefit that the market fails to include in its reckoning when deciding what the optimal quantity of the good will be in the market. A negative externality occurs when there is some kind of cost that is not internalized in the market, and a positive externality occurs when there is some kind of benefit that is not internalized in the market. When there is an externality in the market that is not internalized, the market does not produce the efficient level of output because it is not producing the level of output where the marginal social cost of production is equal to the marginal social benefit of consumption.

9 Tip #2. Negative externalities can occur on the production or the consumption side of the model of supply and demand. For example, when a producer produces a good whose production generates substantial pollution and the producer does not take into account the cost of this pollution, then there is a negative externality on the production or cost side of the market. This implies that the producer's supply curve does not represent the true societal costs of producing the good. Alternatively, a consumer can engage in behaviors that inflict a negative benefit on others: for instance, the decision to drink alcoholic beverages and then operate a car has potential negative consequences for others in the community. In this case, the demand curve for the individual does not take into account the negative externality imposed by the individual's consumption decision. In either case (the negative externality on the production side of the model or the negative externality on the consumption side of the model), the market produces too much of the good when the externality is not accounted for in the market. Figure 17.6 illustrates these two examples. Imposition of the appropriate Pigouvian tax will correct the market outcome and result in the market producing the optimal amount of the good where the marginal social benefit from consuming the last unit of the good is equal to the marginal social cost of producing the last unit of the good.

10 Tip #3. Positive externalities can occur on the production or the consumption side of the model of supply and demand. For example, when a producer produces a good whose production generates technology spillovers and the producer does not take into account the benefit of this technology spillover on the rest of the economy, then there is a positive externality on the production or cost side of the market. This implies that the producer's supply curve does not represent the true societal costs of producing the good. Alternatively, a consumer can engage in behaviors that inflict a positive benefit on others: for instance, the decision to maintain the exterior of one's house results in positive externalities with regard to the property values for neighboring properties. In this case, the demand curve for the individual does not take into account the positive externality created by the individual's consumption decision. In either case (the positive externality on the production side of the model or the positive externality on the consumption side of the model), the market produces too little of the good when the externality is not accounted for in the market. Figure 17.7 illustrates these two examples. Imposition of the appropriate Pigouvian subsidy will correct the market outcome and result in the market producing the optimal amount of the good where the marginal social benefit from consuming the last unit of the good is equal to the marginal social cost of producing the last unit of the good.

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