the price mechanism externalities & solutions open access common property (oacp) public goods median voter theorem

Transcription

1 theme 2: firms and market failure market failure notes the price mechanism externalities & solutions open access common property (oacp) public goods median voter theorem 2013 Tham Kah Loon Page 1 of 18

2 Cost of Abatement - suppose the firm emits pollutants that damage air quality - the firm can reduce its emissions, but only at a cost - EMC represents the marginal external cost of emissions - represents the increased harm associated with emissions - EMC slopes upwards because the marginal cost of the externality gets higher as the externality becomes more extensive - read the graph from right to left - MCA is the marginal cost of abating emissions - the additional cost to the firm of installing pollution-control equipment - downward sloping because the marginal cost of reducing emissions is low when the reduction has been slight and high when it has been substantial - hence, MCA increases as we seek to achieve greater and greater reductions in emissions - with no effort at abatement, the firm s profit-maximizing level of output is 26, where MCA = 0 - the efficient level of emissions is 12 units, where EMC is equal to MCA - e.g. if emissions are lower than E*, the marginal cost of abating emissions is greater than the marginal external cost of emissions - emissions will be too low relative to the social optimum Emissions Standard - a legal limit on how much pollutant a firm can emit - if the firm exceeds the limit, it can face monetary and even criminal penalties - ensures that the firm produces efficiently (in this case, 12 units of pollutants) - the firm meets the standard by installing pollution-abatement equipment - this expenditure will cause the firm s AC curve to rise (by the average cost of abatement) - firms will find it profitable to enter the industry only if the price of the product is greater than the average cost of production plus abatement - the efficient condition for the industry - limitations include imperfect information by the government and enforcement 2013 Tham Kah Loon Page 9 of 18

3 Emissions Fee - a charge levied on each unit of a firm s emissions (pollution tax) - as seen from the figure below, a $3 fee will generate efficient behavior - faced with this fee, the firm will minimize cost by reducing emissions from 26 to 12 units - this is because at levels above 12 units, the marginal cost of abatement is less than the emissions fee, so it pays for the firm to reduce emissions to 12 units - below 12 units, however, the marginal cost of abatement is greater than the fee, so firms will prefer to pay the fee rather than further reduce emissions - in the end, the firm will produce 12 units - the social optimum, and it will pay a total fee of the yellow rectangle and incur an abatement cost of the blue area Dollars per unit of emissions - can also be seen as a tax on output, by shifting the PMC up to cut PMB at the social optimum - if the government knows the EMC, it can set the output tax equal to the EMC at the social optimum, which causes the firm to internalize the externality: bear the cost of the harm that one inflicts on another EMC 2013 Tham Kah Loon Page 10 of 18

4 The Case for Fees over Standards - two firms have different abatement costs (Firm 2 has lower abatement costs than Firm 1) - both firms are producing at 14 units (28 units in total) - to achieve the social optimum of 14 units in total, the cheapest way is to have Firm 1 reduce emissions by 6 units and Firm 2 by 8 - then both firms will have MCA of $3 - this is achieved by a fee of $3 - if a standard is set and each firm has to cut down to 7 units each, Firm 1 s MCA increases from $3 to #3.75, while Firm 2 s MCA falls from $3 to $2.50, which is not cost-minimizing because the second firm can reduce emissions more cheaply - Firm 1 incurs additional abatement costs given by the green area but Firm 2 enjoys reduced abatement costs of the yellow area - since Firm 1 s increased costs are larger than Firm 2 s reduced costs, the standard achieves the same output as the fee but at a higher cost - in general, fees are preferable to standards because: - when standards must be applied equally to all firms, fees achieve the same emissions reduction at a lower cost - fees give a firm a strong incentive to install new equipment that would allow it to reduce emissions even further The Case for Standards over Fees - standards are preferable when the marginal external cost curve is very steep, which makes the welfare loss very large if a wrong fee is set - when the EMC is steep and MCA is relatively flat, the cost of not reducing emissions is high - standards will be preferable to fees because with incomplete information, standards offer more certainty about emissions levels but leave the costs of abatement uncertain - depends on the nature of uncertainty and the shapes of the cost curves 2013 Tham Kah Loon Page 11 of 18

5 Property Rights to Reduce Externalities (Coase Theorem) - government can assign a property right: an exclusive privilege to use an asset - according to Coase Theorem (Ronald Coase, 1960), the optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined - conditions: - well-established property rights - low transaction costs - externality must be well-defined - no strategic bargaining behavior - assume there is a factory, which dumps waste into a river, which will negatively affect fishermen as it reduces their catch (a negative externality) - without property rights, the factory will produce where PMB cuts PMC, which is not socially optimal (overproduction) - if the government grants the fishermen the property rights to the river, the fishermen can prevent the factory from dumping at all - rather than shutting down, the factory will offer to pay the fishermen for the right to dump - with low transaction costs, eventually an efficient outcome will be reached - does not matter who gets the property rights - will not affect efficiency but the distribution will affect equity - assuming the factory gets the property rights to the river, PMB will be the marginal revenue to the factory from each unit of output, PMC will be the cost of producing an additional unit, EMC will be the marginal damage done to the fishermen - the factory will produce at QSE, where PMC cuts PMB - at Q1, the fishermen will be willing to compensate the factory X amount, which is more than Y, the loss to the factory from not producing - the fishermen will be willing to compensate the factory up to QSE, where X = Y, and joint profits are maximized - social optimum 2013 Tham Kah Loon Page 13 of 18

6 Limitations of Coase Theorem - bargaining can be time-consuming and costly, especially when property rights are not clearly specified (e.g. how to assign rights to the air?) - externalities are often wide-ranging and overlap - bargaining can break down if both parties believe they can obtain larger gains - when many parties are involved, the costs of bargaining make it very difficult for the parties to reach a settlement (e.g. road congestion - many parties) - if either side lacks information about the costs or benefits of reducing pollution, a non-efficient outcome may occur - whoever gets the property rights will receive payment from the other party - issues of equity will result; usually goes to user with the highest utility for that resource - issues of bounded rationality and bounded self-interest Positive Externality: Subsidize/Direct Provision - government can subsidize to lower PMC to cut PMB at QSE - evaluate using inframarginal diagram: beyond a certain point, subsidies will only be increasing private benefit, not EMB - waste of resources leads to inefficiency 2013 Tham Kah Loon Page 14 of 18