Unit 9: Utility, Externalities, and Factor Markets Lesson 4: Externalities

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1 Unit 9: Utility, Externalities, and Factor Markets Lesson 4: Externalities Objectives: - Define externality - Draw negative and positive externality graphs. - Explain the remedies for positive and negative externalities. - Define the Coase Theorem, and explain its limitations. Externality: - Cost or benefit accruing to a third party that is external to the market not the buyer or seller. o Negative externality: buyer and seller do not bear the full cost of the product Example: pollution o Positive externality: buyer and seller do not reap the entire benefit of the product Example: vaccination - Externalities cause the market to produce the wrong amount of the product (i.e. allocative inefficiency); thus, it is a case of market failure Supply and Demand: - Supply curve shows what it costs the seller to make a certain quantity of output o Supply curve = marginal cost (MC) - Demand curve shows the value/utility the buyer gets from consuming a certain quantity of a product o Demand curve = marginal benefit (MB) - Price adjusts to balance supply and demand for a product so that marginal cost (MC) = marginal benefit (MB) Negative Externality: - Because the buyers and sellers do not bear the entire cost of the product, the marginal private cost (MPC) < marginal social cost (MSC) o Marginal private cost = cost of those participating in the market o Marginal social cost = cost to everyone - Distance between the MPC curve and the MSC curve equals the cost of the negative externality (i.e. cost that is not borne by the market participants) - Note: demand = marginal benefit because there is no spillover benefit to those who do not participate in the market

2 - Allocative efficiency: o Market output (Q MKT ) is where the marginal private cost (MPC) intersects marginal benefit (MB) o Allocatively efficient output (Q SO ) is where the marginal social cost (MSC) intersects the marginal benefit (MB) Note: efficient level of output takes into consideration ALL costs and benefits to society o Q MKT > Q SO Note: Because buyers and sellers do not bear the full costs of the product, too much of the product is produced Because there are more transactions than should occur, a negative externality results in deadweight loss. o P MKT < P SO Reflecting that the real cost of the product (P SO ) is more than the cost that buyers pay (P MKT ) Positive Externality: - Because the buyers and sellers do not reap all the benefits of the product, the marginal private benefit (MPB) < marginal social benefit (MSB) o Marginal private benefit = benefit of those participating in the market o Marginal social benefit = benefit to everyone - Distance between the MPB curve and the MSB curve equals the positive externality (i.e. benefit that is not reaped by the market participants) - Note: supply = marginal cost because there is no spillover cost to those who do not participate in the market - Allocative efficiency: o Market output (Q MKT ) is where the marginal private benefit (MPB) intersects marginal cost (MC) o Allocatively efficient output (Q SO ) is where the marginal social benefit (MSB) intersects the marginal cost (MC) Note: efficient level of output takes into consideration ALL costs and benefits to society o Q MKT < Q SO Note: Because buyers and sellers do not reap the full benefits of the product, too little of the product is produced Because there are less transactions than should occur, a positive externality results in a deadweight loss o P MKT < P SO Reflecting that the real benefit of the product (P SO ) is more than the benefit that buyers receive (P MKT )

3 Internalizing the Externality: - In cases of market failure, the government can sometimes offer a remedy - To fix an externality, buyers and sellers need to take account of the external effects of their actions. They need to internalize the externality. - Internalizing Negative Externalities: o With a negative externality, the goal is to get producers to take the cost of the externality into account so that less will be produced. o 3 remedies in order from least to most preferable: #1: Regulation: requiring or forbidding behavior Implementing the regulation increases the cost to the company o When costs increase, producers supply less because they are making less profit. o As a result, the supply=marginal private cost curve shifts to the left until it equals the marginal social cost curve. #2: Per-unit tax (a.k.a. excise tax or Pigovian tax) equal to the amount of the negative externality Per-unit vs. lump-sum tax: o Lump-sum tax is a fixed amount regardless of the quantity bought or sold o Per-unit tax is a tax on each unit bought or sold Thus, if quantity, the tax and vice versa Note: corrective per-unit tax does NOT create deadweight loss o Deadweight loss is created when the market is inefficient o Per-unit tax to fix a negative externality makes the market efficient

4 Economists prefer per-unit taxes to regulation because taxes reduce negative externalities at a lower cost to society o Some firms must pay substantially higher costs to reduce a negative externality than others. o Regulation would require all firms to reduce the negative externality regardless of the costs the firm must pay to do so. o Taxes allow firms who have higher costs of fixing the externality to continue to produce the negative externality and pay the tax instead. o This results in a lower overall cost to society because reducing a negative externality uses up scarce resources! Taxes may be able to achieve better results o Under regulations, companies have no reason to reduce a negative externality further than the required amount. o Taxes give companies an incentive (i.e. less taxes) to reduce the negative externality as far as they possibly can #3: Tradable Permits (a.k.a. cap and trade ) How it works: o Government sets a limit on a certain type of negative externality (i.e. pollution) then issues permits to companies that allow them to pollute a certain amount. o Companies can then trade the permits Creates a new scarce resource (i.e. permits) governed by the forces of supply and demand o Companies that can reduce pollution at a lower cost will do so and sell their permits to companies that face higher costs to reduce pollution. Economics prefer tradable permits to per-unit taxes because it is difficult to levy the right amount of per-unit taxes to reduce pollution by a certain amount; it is much easier to just set the amount of pollution the government wants, issue permits, and let the invisible hand of the market go to work. - Internalizing Positive Externalities: o With a positive externality, the goal is to get consumers or producers to reap the entire benefit of the externality so that more of the product will be bought. o 3 remedies: Subsidize buyers with a per-unit subsidy equal to the positive externality Example: give each family a coupon reducing the price of the vaccinations o Result: increase in demand increasing output to the efficient level

5 Subsidize sellers with a per-unit subsidy equal to the positive externality Example: pay a company for each vaccination it produces o Result: increase in supply and output to the efficient level Economists prefer to subsidize sellers rather than buyers o Because there are fewer sellers they are easier to identify than buyers. o Because identification uses up scarce resources, taking the easier route is more efficient Government provision of the product at the efficient quantity o Examples: Free vaccinations for polio Defense Coase Theorem: - Some externalities can be resolved through the private negotiations of the affected parties (i.e. without government intervention) o Example: owner of forest land plans to clear-cut thousands of acres of trees surrounding a lake. Also on the lake is a popular resort whose main attraction is the unspoiled natural beauty. Resort owner enjoys a positive externality (i.e. benefit that he is not paying for): natural beauty of the trees he doesn t own Owner of the resort has an incentive to negotiate with the forest owner Offer him money to not cut down the trees Buy the land Owner of the forest land has an economic incentive to negotiate with the resort owner Opportunity cost of cutting the trees is the foregone payment to not cut the trees from the resort owner - Private negotiations can resolve externalities only when: o Private property is involved (i.e. not public property like the air) o Transaction costs are small Transaction costs: costs of making and enforcing an agreement Greater the number of people affected by an externality, the greater the transaction costs - Note: private agreements to remedy externalities are contracts o Contracts are legally enforceable documents. o Thus, the government is still involved!

Chapter 17. The Economics of Pollution Control

Chapter 17. The Economics of Pollution Control Chapter 17 The Economics of Pollution Control Economic Rationale for Regulating Pollution Pollution as an Externality -pollution problems are classic cases of a negative externality -the MSC of production