Chapter 18. Externalities. What will you learn in this chapter? What are externalities? How external costs and benefits affect tradeoffs.

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1 Chapter 8 Externalities What will you learn in this chapter? How external costs and benefits affect tradeoffs. What effects externalities have on market price, quantity, and surplus. What private solutions to externalities exist. How taxes, subsidies, quantity regulations, and tradable allowances can be used to counteract an externality. What are externalities? When individuals make calculated decisions, they weigh the costs and benefits of the action. Private benefit that accrues directly to the decision maker. Private cost that falls directly on an economic decision maker. Sometimes other people are affected by our decisions or have a stake in the outcomes. External cost describes a cost imposed without compensation on someone other than the person who caused it. External benefit describes a benefit that accrues without compensation to someone other than the person who caused it.

2 External costs and benefits The total cost of a decision, the social cost, includes both private costs and external costs. The total benefit of a decision, the social benefit, includes both private benefits and external benefits. External costs and external benefits are collectively referred to as externalities. Negative externality: external costs. Positive externality: external benefits. network externality is the effect that an additional user of a good or participant in an activity has on the value of that good or activity for others. Can be positive or negative. 4 Negative externality from the demand side How can drivers be forced to consider external costs, and thus operate on the social demand curve? The most straightforward option is to implement a gasoline tax. Market with private costs only Market with social costs. If drivers bear full social costs, the social demand Tax curve is below the private demand curve.. and the equilibrium is at a lower price and quantity. If drivers ignore the external cost of pollution, they only consider the private costs and benefits of driving. When drivers bear the full social cost, the externality is eliminated and they drive less. Negative externality from the demand side tax increases surplus when a negative externality is present in the market. Surplus under a negative externality External cost Surplus when a negative externality is internalized C. Under a negative externality, the surplus lost to those outside the market due to the external cost is subtracted from consumer and producer surplus, C. rea C is equal to $ = $. If the externality is internalized, demand shifts downward by the amount of the tax. CS and PS in the market are both lower. The external cost imposed on people is eliminated. 6

3 ctive Learning: Calculating the cost of negative externalities Suppose that a $ per unit tax can mitigate a negative externality. Using the following graphs: Calculate total surplus in the presence of a negative externality. Calculate total surplus when the negative externality is Surplus under a negative externality External cost Surplus when a negative externality is internalized C Negative externality from the demand side negative externality always reduces surplus unless it is Tax. Surplus gained by pollution sufferers. Surplus lost by consumers and producers. Gain in total surplus when externality is When the negative externality is internalized by imposing a tax, the demand curve shifts downward. Smaller quantity sold. CS and PS is lost from imposing a tax. Surplus is gained by others in society when they receive surplus from tax revenue. Surplus gain is yellow area. 8 Negative externality from the supply side How can drivers be forced to consider external costs, and thus operate on the social supply curve? The most straightforward option is to implement a gasoline tax. Market with private costs only Market with social costs. If gasoline retailers bear S social full social costs, the social supply curve is above the private supply curve. Tax. and the equilibrium is at a higher price and quantity. If drivers ignore the external cost of pollution, they only consider the private costs and benefits of driving. When drivers bear the full social cost, the externality is eliminated and they drive less. 9

4 Negative externality from the supply side tax increases surplus when a negative externality is present in the market. Surplus under a negative externality Surplus when a negative externality is internalized 4 C External cost. S social Under a negative externality, the surplus lost to those outside the market due to the external cost is subtracted from consumer and producer surplus, C. This area equals $ = $. If the externality is internalized, supply shifts upward by the amount of the tax. CS and PS in the market are both lower. The external cost imposed on people is eliminated. Negative externality from the supply side negative externality always reduces surplus unless it is Surplus gained by pollution Tax sufferers.. Surplus lost by consumers and producers. S social Gain in total surplus when externality is When the negative externality is internalized by imposing a tax, the supply curve shifts upward. Smaller quantity sold. CS and PS is lost from imposing a tax. Surplus is gained by others in society when they receive surplus from tax revenue. Surplus gain is yellow area. Positive externalities from the demand side positive externality also pushes quantity away from the efficient equilibrium level, reducing total surplus. Internalizing a positive externality, the market reaches an equilibrium with a higher quantity based on social costs and benefits.,,,7,. When homeowners capture external benefits, the social demand curve for house paintings is above the private demand curve, and 6. the equilibrium point moves to a higher price and quantity. Suppose a homeowner painting a house provides $ in external benefit to the neighborhood. If homeowners are able to capture the external benefits of painting a house, demand shifts upward. Larger quantity. 4

5 Positive externalities from the demand side The increase in total surplus can be calculated when a positive externality is present. Surplus under a positive externality Surplus when a positive externality is internalized,, External benefit,,,, C,7 rea C is the amount of surplus gained by those outside the market and is added to consumer and producer surplus. This surplus equals $ 8 = $K. 6 Internalizing the externality CS and PS increase; external benefits disappear TS = + = $4, ctive Learning: Calculating positive externalities Suppose a negative externality exists and a $ per unit subsidy resolves it. Calculate total surplus in the presence of a positive externality. Calculate total surplus when the positive externality is Surplus under a positive externality Surplus when a positive externality is internalized,, External benefit,, C 9 D private 6 4 Positive externality from the demand side positive externality always reduces surplus unless it is,,,, Gained when externality is Lost when externality is 6 Gained from extra trades. When the positive externality is internalized by imposing a subsidy, the demand curve shifts upward. Larger quantity sold. CS and PS is lost from internalizing externality. Surplus is gained by market participants receiving a subsidy from tax revenue. Surplus gain is green area.

6 Positive externality from the supply side positive externality also pushes quantity away from the efficient equilibrium level, reducing total surplus. subsidy corrects this market inefficiency, increasing surplus. Surplus under a positive externality $ External benefit Surplus under a positive externality $ $ $ $ C $ S social 6 Under a positive externality, the surplus by those outside the market is added to consumer and producer surplus, rea C. If the externality is internalized through a subsidy, the supply curve shifts downward. CS and PS in the market are both higher. The external benefit is now internalized to only market participants. 6 Positive externality from the supply side positive externality always reduces surplus unless it is Lost when externality is S social $ Gain in total surplus when externality is $ Gained when D $ externality is private 6 When the positive externality is internalized by imposing a subsidy, the supply curve shifts downward. Larger quantity sold. CS and PS is lost from internalizing externality. Surplus is gained by market participants receiving a subsidy from tax revenue. Surplus gain is green area. 7 External costs and benefits can be diffuse, complex, and hard to control. Solutions must ensure that individuals experience costs and benefits that are equal in value to the true social costs and benefits of their choices. This may require coordinating across millions of people. The Coase theorem states that if there are zero transaction costs to negotiate and agreements are enforceable, then an efficient equilibrium through private trades can be reached, even in the presence of an externality. Often, these two assumptions do not hold true. 8 6

7 ecause of the cost and difficulty of coordinating private solutions, people often turn to public policy for solutions to externalities. Pigovian tax counters the effects of a negative externality. There are two main problems with this solution: Setting the tax at the right level. No guarantee that the government can or will do anything to help people bearing the external cost. 9 s previously analyzed, a tax can move the market equilibrium to the social optimal equilibrium. () The effect of a negative externality () The effect of a Pigovian tax Price $/(gal.) 4 Under a negative externality, demand is above the optimal level. S 4 Pigovian tax can move the demand curve back to the optimal level. S.. Under a negative externality, the demand curve is above the optimal demand curve by the amount of the external cost. This causes quantity to be higher than the efficient level. Pigovian tax counteracts a negative externality. If the tax is set equal to the value of the external cost: The externality cost is canceled. Quantity goes to the efficient level.,,, s previously analyzed, a subsidy can move the market equilibrium to the socially optimal equilibrium.,7. $ subsidy creates a new demand curve, above the old one 6. if the subsidy exactly equals the positive externality, equilibrium occurs at the socially efficient outcome. Suppose government estimates that painting houses creates $ worth of external benefits for neighbors. If this subsidy exactly equals the external benefit of painting houses, equilibrium occurs at the socially efficient outcome. Increased efficiency does not imply increased fairness. Troublesome to quantify the externality. 7

8 One solution is to regulate quantity to be socially optimal. This does not make the market efficient if individuals make decisions based on net benefit (marginal benefit marginal cost = ). () Gasoline consumption under a quota Net benefit to driver () Gasoline consumption under a tax Net benefit to driver. Quantity is the same Quota...8 Range Prius Rover 6 Gallons of gasoline Under a quota, both drivers buy gallons regardless of the difference in their net marginal benefits.. but marginal benefit is different... and quantity varies accordingly.. Marginal benefit equals the tax level Prius Tax level Range Rover 6 Gallons of gasoline Under a $ tax, both drivers buy different amounts of gas. Neither is left wanting to buy more. Total gallons consumed remain 4. Marginal benefit to driver...8 Surplus under a quota Marginal benefit to driver Surplus under a tax Ranger Rover surplus Quota Prius surplus Tax revenue 4 + = = 6 Tax level Total surplus is higher under the tax than under the quota. The quota brings the two drivers to the same combined quantity of gas consumption as the tax does, but does it inefficiently (smaller total surplus). Range Prius Rover 6 Gallons of gasoline + = 4 Range Rover Prius 4 6 Gallons of gasoline t gallon quota, total surplus is $4. Under a $ tax, total surplus is $6. Using a quota to deal with externalities can be extended by permitting the buying and selling of quota allowances, a tradable allowance. Market quantity is socially optimal (efficient). Total surplus is maximized. Tradable allowance does not create any government revenue, because no taxes are imposed. 4 8

9 ecause of the difficulty of measuring externalities directly, many policies target individual goods and processes. The downside of targeting individual activities is that it risks misaligning the incentives that consumers and producers face with the goal of minimizing the externality. policy that directly taxes or subsidizes the externalities encourages the development of technology and processes. Consumers and producers have an incentive to find new ways of doing things that don t generate externalities. This allows them to avoid having to pay for a tax or the rights to an allowance, aligning their incentives with the end goal of the policy. Summary ny cost that is imposed without compensation on someone other than the person who caused it is an external cost. benefit that accrues without compensation to someone other than the person who caused it is called an external benefit. External costs and benefits are collectively referred to as externalities. The total cost of the decision, including any externalities, is referred to as the social cost. 6 Summary negative externality causes the individuals who bear only the private cost to demand or supply an inefficiently high quantity at any given price. positive externality causes individuals who enjoy only the private benefit to demand or supply an inefficiently low quantity at any given price. In the presence of externalities, markets fail to maximize total surplus. 7 9

10 Summary If agreements are enforceable and transaction costs are small, the Coase theorem states that individuals reach an efficient equilibrium through private trades. Pigovian tax counterbalances the effects of a negative externality. subsidy counterbalances the effect of a positive externality. 8 Summary Setting a quota to counteract inefficiently high consumption due to a negative externality can lower quantity to the socially optimal efficient level, but it does not maximize surplus. tradable allowance is a production or consumption quota that can be bought and sold. Efficient quantity. Total surplus is maximized. 9