Chapter 3:Externalities and Government Policy

Transcription

1 Reading: page 98~130 (Public Finance in Canada, David N. Hyman 10th edition) :Externalities and Government Policy Objectives: Define an externality and understand how such externality can prevent efficiency Understand how corrective taxes or subsidies can be used to internalize externalities Coase theorem and its significance Why uniform emission standards lead to inefficiency 1. Externalities and Efficiency Externality exists when actions taken by firms or consumers impose costs or confer benefits on parties. Individual agents only care about costs and benefits. However, what matters for an efficient resource allocation is cost and benefits. When externalities are present, a market fails to achieve an efficient allocation of resources since the marginal costs (MPC) or marginal benefits (MPB) from the marginal social costs or benefits. Even if markets are perfectly competitive, externalities lead to inefficient allocation of resources. 1

2 Negative Externality Negative Externalities (External Costs) occur whenever actions taken by firms or consumers directly impose costs on others. The Marginal External Cost (MEC) is the cost to resulting from production of another unit of a good or service, not reflected by the market price. (Note: MEC is not necessarily constant over output.) MSC = MPC + MEC Price MPC MPB = MSB Qty 2

3 Summary When a negative externality exists, output is produced and sold in a competitive market relative to the efficient amount. The market price is than MSC at the market quantity. Market failure or an inefficient allocation of resources exists. Positive Externality 1. Positive Externalities (External Benefits) exist when one's consumption or production of a good provides to a third party who has not directly exchanged the good. The Marginal External Benefit (MEB) is the additional benefit to third parties resulting from consumption of another unit of a good or service, not reflected by the market price. (Note: MEB is not necessarily constant over output.) MSB = MPB + MEB 3

4 Price MSC = MPC MPB Qty Summary When a positive externality exists, output is produced and sold in a competitive market relative to the efficient amount. The market price is than MSB at the market quantity. Market failure or an inefficient allocation of resources exists. 2. A positive externality for which MEB declines with output In reality, the MEB may decline when output increase. In the example of inoculation, as more of the population is inoculated, there will be fewer people susceptible to the disease. At some point when enough people were inoculated, MEB will equal to. 4

5 If MEB declines with output, the implication of this type of externality for market failure is quite important. Let s assume a perfectly competitive market: P Inoculation per year The marginal social cost curve is S Market equilibrium price = Market equilibrium quantity = This market outcome is because. The marginal social cost curve is S Market equilibrium price = Market equilibrium quantity = 5

6 This market outcome is because. Summary For positive externalities such as this, whose marginal external benefit declines with output, competitive markets fail to perform efficiently only at levels of output. 2. Internalization of Externalities Internalization of an externality occurs when the MPB or MPC of a good or service is adjusted so that the economic agents consider the or of their decision for productive activities. Negative externality: Positive externality: Internalizing Negative Externality: Corrective Taxes A corrective tax is designed to adjust the of a good or service in such a way as to internalize the externality. Per unit tax = MEC Example: All paper production located near mountain streams and a corrective tax is imposed on production. (in a perfectly competitive market) 6

7 Price Tonnes of paper/yr Market price = Net price sellers receive = Market quantity = Total tax revenues = This market outcome is because Net gain in well-being allowed by per-unit tax = Note: the corrective tax does not reduce the pollutants in the streams to zero. It merely raises the of using the stream to reflect the marginal damage done to alternative users of the stream. 7

8 Q: Are there any winners or losers from the corrective tax? A: Internalizing Negative Externalities associated with Goods sold in Imperfectly Competitive Markets In this case, there are two distortions preventing the attainment of the efficient output: 1. The firm s monopolistic power results in than the efficient output. 2. The monopoly causes negative externalities, thus it produces than the efficient output. There are two ways to achieve the efficient outcome: 1. Break down the monopoly and impose the corrective tax 2. Since the monopoly is producing an output which is less than the efficient level of output, we can treat it as it were performing in a perfectly competitive market that subject to the corrective tax regulation which increases its MC. In effect, the monopolistic distortion can offset of the distortion resulting from the negative externality. 8

9 P Output per year a) Without the negative externality: MC = Monopolistic output = Monopolistic price = DWL = b) With the negative externality: MC = Efficient output = Efficient price = 9

10 In this case, the monopolistic output is the efficient output! In actuality, the efficient output can be greater or less than the monopolistic output. Summary A corrective tax on the monopolist s output must be than the corrective tax that would be necessary to achieve efficiency if the good were produced by a competitive industry. Internalizing Positive Externality: Corrective subsidies A corrective subsidy is a payment made by government to either buyers or sellers of a good so that the price paid by consumers is reduced. It is also used to adjust. Per unit subsidy = MEB Example: A corrective subsidy is given to the consumption of a preventive Inoculation. 10

11 Price Inoculations/yr Market price = Net price consumers pay = Market quantity = Total subsidy payments = This market outcome is because Net gain in well-being allowed by the per-unit subsidy = 11

12 3. Property Rights to Resource Use and Internalization of Externalities: The Coase Theorem The fundamental problem with externalities is a lack of assigned rights. The Coase Theorem states that if trade in an externality is possible and there are no transaction costs, negotiations will lead to an outcome regardless of the allocation of property rights. A transaction cost represents any bargaining costs, including the time, effort, and cash outlays involved in locating someone to trade with, negotiating terms of trade, drawing contracts and assuming risks associated with the contracts. Q: Between a buyer and seller, who would incur higher transaction costs? A: Exchange of Property Rights to Internalize a Negative Externality Example: Water pollution in a mountain stream A pulp mill may have the property right to pollute a river or, recreational users (swimmers or fishers) may have the property right to clean water. 12

13 There is no need for government intervention to correct externalities if the following conditions are met Property rights are and. All economic agents have information Transaction costs are or. The Coase Theorem Depends on Bribery: If recreational users (swimmers) have the right to clear water, the pulp mill may bribe them to be able to pollute the stream. If the pulp mill has the right to pollute the stream, then recreational users may bribe the pulp mill not to pollute. Pulp mill Swimmers $ $ MB MC A F B E C D 0% 50% 100% % of Pollution 13

14 Case 1: The pulp mill has the right to pollute Initial Outcome The level of pollution = Pulp mill's welfare = Swimmers' welfare = Social welfare = Outcome after negotiations: (A group of swimmers pays the pulp mill $S per unit pollution reduction.) The level of pollution = Pulp mill's welfare = Swimmers' welfare = Social welfare = Net gain in welfare = Q: Is the efficient level of pollution achieved after negotiations? A: Q: Who earns extra income through the negotiations? A: 14

15 Case 2: the swimmers have the Right to No Pollution Initial Outcome The level of pollution = Pulp mill's welfare = Swimmers' welfare = Social welfare = Outcome after negotiations: (the pulp mill pays the swimmers $P per unit pollution emitted) The level of pollution = Pulp mill's welfare = Swimmers' welfare = Social welfare = Net gain in welfare = Q: Is the efficient level of pollution achieved after negotiations? A: Q: Who earns extra income through the negotiations? A: 15

16 Summary Economic agents can to achieve an efficient allocation of resources, no matter which economic agent is given the property rights. Significance of The Coase Theorem The efficient mix of output will result simply as a consequence of the establishment of property rights. However, the property rights make a big difference to the parties involved in terms of their. The economic agent initially granted the right is, because they own a valuable property right that can either be used or exchanged. Therefore, the assignment of the property right by the government affects the of income between the two parties using the resource. Problems with Coase Theorem The Coase Theorem is difficult to implement in practice with transaction costs. Q: What factors would lead to higher transaction costs? A: number of players, Must be able to identify the source of damages, dealing with a good that property right cannot be easily 16

17 4. Emission Standards In practice, the primary method of treating the problem of pollution in Canada is government regulation. The typical method used to control the external costs of pollution is the establishment of standards that the amount of pollutants that can be emitted into the air or water. Emission Standards are requirements that set specific limits to the amount of pollutants that can be released into the environment. The regulatory authorities strictly control the amount of emission by issuing a number of. The MSC of pollution abatement is likely to as more pollution is abated. The MSB of pollution abatement is likely to as more pollution is abated. How does government determine the efficient level of pollution abatement? MSC & MSB % reduction in wastes emitted/yr 17

18 Q: What will be the level of pollution abatement if there is no regulation? Is the level efficient? A: Q: Should the government regulate 100% pollution abated? A: Q: Then, how does government determine the efficient level of pollution abatement? A: The emission standards are determined by a regulatory authority, based on the efficient amount of pollution abatement. Emission Standards and Efficiency In practice, standards are NOT viewed as a good policy due to the following reasons; Firms can pollute for up to the level of standard. No incentive to pollute below the standard and improve pollution reduction technology Uniform standards lead to if MECs or MEBs are varying. 18

19 Case I: Losses in efficiency from Uniform Emission Standards when MSB differs among firms. MSC & MSB Firm A Tonnes of Emissions/yr MSC & MSB Firm B Tonnes of Emissions/yr The DWL to Firm A with an uniform emission standard = The DWL to Firm B with an uniform emission standard = 19

20 Case II: Losses in efficiency from Uniform Emission Standards when MEC differs among Regions. MSC & MSB Urban areas Tonnes of Emissions/yr MSC & MSB Rural areas Tonnes of Emissions/yr The DWL to Rural areas with an uniform emission standard = The DWL to Urban areas with an uniform emission standard = 20

21 Summary The uniform standards for controlling emissions that result in negative externalities are likely to achieve. The total cost of a given level of pollution reduction is not minimized. Use of a standard approach to controlling negative externalities has to be to achieve an efficient amount of pollution. 21