Consider the market for aluminum. The demand curve reflects the value of aluminum to consumers, measured by the prices they are willing to pay.

Transcription

1 Externalities and Market Inefficiency Consider the market for aluminum. The demand curve reflects the value of aluminum to consumers, measured by the prices they are willing to pay. At a given quantity, the height of the demand curve measures the willingness to pay of the marginal buyer the one who would leave the market if price was any higher. The supply curve reflects the cost of producing aluminum. At any given quantity the height of the supply curve is the cost of the marginal seller. When there is no externality from the production or consumption of aluminum, the buyers and sellers of aluminum are the only ones whose welfare is affected by the equilibrium price and quantity of aluminum. Thus total surplus equals consumer surplus plus producer surplus, and this measures the total benefit to society from the existence of an aluminum market. Now suppose aluminum factories emit a certain amount of smoke into the atmosphere for each unit of aluminum produced. This smoke worsens the health of those who breathe the air, so it is a negative externality. Because of the externality the cost to society of producing aluminum is higher than the cost to the firm of producing aluminum. We can draw the marginal cost to society curve above the marginal cost the the firm (supply) curve. If the cost to health due to the smoke is proportional to the amount of smoke in the atmosphere, the marginal social cost curve will be the marginal private (firm s) cost curve shifted vertically up. The marginal social cost at each quantity equals the marginal private cost to the firm plus the external cost to those who breathe the air. 1

2 P Marginal Social Cost Supply (Marginal Private cost) Private demand Q To see what quantity of aluminum should be produced, consider what the benevolent social planner would do. The planner wants to maximize total surplus from the market. In this case, to get total surplus, we must add to consumer surplus and producer surplus the surplus from those who are not in the market but who are affected by the externality. The planner chooses the level of aluminum Q at the intersection of the social cost curve and the (private) demand curve. This level of aluminum is optimal because: At any level of aluminum above Q, the marginal social cost of producing additional aluminum is higher than the marginal social benefit (measured by the demand curve) of producing additional aluminum. If the economy is at a point of aluminum production above Q, total surplus can be increased by decreasing aluminum production to the point where marginal social cost equals marginal social benefit, which is Q. If the economy is at a point of aluminum production below Q, total surplus can be increased by increasing aluminum production to the point where marginal social cost equals marginal social benefit, which is Q. 2

3 In particular, the equilibrium point Q e at the intersection between the private cost curve and the demand curve does not maximize total surplus. Note that equilibrium quantity of aluminum, Q e is larger than the socially optimal quantity Q. This is because the externality is negative, so the marginal social cost curve lies to the left of the marginal private cost curve. Therefore the intersection of the demand curve with the marginal social cost curve lies to the left of the intersection of the demand curve with the marginal private cost curve. How can the government achieve the social optimum level of aluminum production? There are several methods. One is to tax aluminum production by an amount per unit that equals the cost to people s health per unit of aluminum produced. That would shift the supply curve vertically up by the amount of the tax so that marginal the private cost curve with tax equals the marginal social cost curve. Then the equilibrium quantity would be the optimal quantity. Positive Externalities Example: Education. Much of the benefit due to education is private. The buyer of education becomes more productive as a worker as gets higher wages. But there are also positive externalities. More educated population may encourage development of technological advances leading to higher productivity and wages for all society. Consider the market for education. Assume that the true value to society of each unit of education is higher by the same amount at every quantity of education. Then the marginal benefit to society curve equals the private marginal benefit curve (demand) shifted up vertically by the marginal external benefit. The optimal quantity Q is at the intersection of the marginal social benefit curve with the marginal cost (supply) curve. This quantity is higher than the quantity Q e at the intersection of the private social benefit curve with the supply curve because the marginal social benefit curve lies to the right of the marginal private benefit curve. 3

4 P Supply Marginal Social benefit Demand (Private benefit) Q To move the market equilibrium closer to the socially optimal point of production, the government can subsidize education. A subsidy shifts the demand curve vertically up by the amount of the subsidy per unit. If the subsidy causes the demand curve to equal the marginal social benefit curve, then the socially optimal level of education is reached. Technology spillovers, industrial policy and patent protection One type of positive externality is called a technology spillover. This is the effect of one firm s research and production activities on other firms access to technological advance. Solutions to externalities Private (non-government) solutions In some cases of externalities the government need not intervene to reach an efficient outcome. People may develop solutions privately. 4

5 One example of a case of externality with private solution is littering. People are taught as children not to litter because if everyone did it, then places would look bad. Not littering because of this thought is an example of internalizing an externality taking into account effect of one s actions on everyone. Another example of private solutions to externalities is charities. Many charities are set up due to externalities. The Sierra Club, whose mission is to protect the environment from degradation, is funded with private donations. Also, colleges and universities receive gifts from alumni, foundations and corporations in part because of the positive externalities that education creates. Government encourages private solutions to externalities by giving income tax deductions to charitable donations. Sometimes the externality can be removed by integrating different businesses that affect each other. Consider an apple grower and a beekeeper located next to each other. The bees help the orchard produce apples by pollinating the apple trees. The trees help the bees get pollen to make honey. Thus, each business has a positive externality on the other. If the firms are separate, then the beekeeper and the apple grower will each neglect the externality when deciding how many bees to keep and how many trees to plant. Therefore they do not get the efficient outcome. If each produced more, the other could produce more as a result. If the firms were merged, the effect of the bees on the apple trees and the effect of the apple trees on the bees would be taken into account when making production decisions. The single firm would choose the optimal number of bees and of trees. Another way for an externality to be removed is for interested parties to negotiate over the externality. The only role that the government may have in this process is setting property rights over the externality. In the bees and trees example, the beekeeper and the apple grower could agree on a contract the would specify the number of trees grown and number of bees kept and if necessary, how much one would pay the other for the use it gets from the other s property. For this, it is necessary that property rights be decided on does the beekeeper or the apple grower own the pollen extracted by the bees from the trees or does the apple grower own it? The Coase theorem states that if bargaining is costless, then the parties affected by an externality will arrive at an efficient outcome on their own. The 5

6 rationale is that if there are mutual gains to be made, the affected people will exploit them. The Coase theorem also states that the efficient outcome reached does not depend on the initial distribution of property rights. This part holds only under special circumstances, though. An illustration of the Coase theorem. Dick and Jane are neighbors. Dick owns a dog named Spot who barks and disturbs Jane. Should Dick be forced to give away his dog, or should Jane be forced to suffer sleepless nights because of the barking? To find the socially efficient outcome, compare the benefit to Dick of having the dog with the cost to Jane of the barking. If the benefit exceeds the cost, it is efficient for Dick to keep Spot. If the cost exceeds the benefit, it is efficient for Dick to give Spot away to his uncle who lives in the country where the barking won t disturb anyone. According to the Coase theorem, Jane and Dick will arrive at the efficient outcome by themselves. If Dick has the right to own a barking dog, Jane can pay Dick to give Spot away. Dick will accept if the amount Jane offers is greater than the benefit to him of keeping the dog. Suppose that Dick has a $500 benefit from Spot and Jane bears an $800 cost from the barking. Then Jane can offer Dick, say, $600 to give Spot away. An efficient outcome is reached, as the dog is given away when the benefit to Dick from the dog is less than the cost to Jane of the barking. If Dick does not have the right to have a barking dog, there is no price he is willing to pay Jane to keep the dog, and Spot is given away as well. Now suppose Dick gets a $1000 benefit from the dog and Jane bears an $800 cost from the barking. Now there is no price Jane is willing to pay that Dick would be willing to accept to give away the dog. Then Dick keeps the dog. This outcome is efficient in this case. If Jane has the right to quiet (Dick has no right to have a barking dog), he will pay her, say, $900 to keep the dog, and again the efficient outcome will be reached. Who has the property rights determines who gets how much money. Each of them will be better off having the property rights than without them. However the distribution of property rights does not affect whether the dog is given away 6

7 or kept. In cases where bargaining or transaction costs exist, an efficient outcome may not be reached by private bargaining. Suppose Dick and Jane speak different languages and have to hire a translator. Assume Dick s benefit from the dog is $1000, Jane s cost from the barking is $800, and the cost of the translator is $400. Then there is no amount that Dick could pay Jane to keep the dog (if she has the right to quiet), because the cost of the bargaining would be more than the difference between their value and cost from the dog. So Dick is forced to give the dog away, even though his valuation of the dog is higher than Jane s cost from the dog, an inefficient outcome. More realistically, transactions costs would be the costs of lawyers needed to draft and enforce a contract. Another problem might be that they simply cannot reach an agreement. If Dick s benefit from the dog is $500, Dick might demand $750, and Jane might offer only $550. Then the bargaining would break down and the inefficient outcome would persist. When the number of interested parties is large reaching an agreement is especially difficult, because coordination is costly and difficult. Public solutions to externalities The government can respond with command-and-control policies or marketbased policies. Command and control policies regulate the level of the externality directly. For instance it can make it a crime to dump poisonous chemicals into the water supply. In most cases of pollution it is too costly to society to ban pollution completely. For instance most forms of transportation cause some pollution, but government cannot ban all transportation. Instead weights costs and benefits of transportation and the resulting pollution to decide how much pollution will be allowed. In US, EPA is the government agency that develops and enforces regulations for pollution. Sometimes EPA dictates a maximum level of pollution. Or it requires firms to adopt a technology to reduce emissions. Needs to know costs of specific industries and the costs and benefits of alternative technologies. Market-based policies 7

8 1. Corrective taxes and subsidies Government can tax activities that have a negative externality and subsidize activities that have a positive externality. Such taxes are called corrective taxes or Pigovian taxes. To get the socially efficient level of production, the tax per unit should equal the external cost per unit: The difference between the marginal social cost and the marginal private cost. Economists tend to prefer corrective taxes to regulations because they can deal with pollution at a lower cost to society. Consider an example. Two factories, a steel mill and a paper mill, are each dumping 500 tons of glop into a river each year. The EPA decides it wants to reduce the amount of pollution. Two possible solutions: Regulation: EPA tells each factory to reduce its pollution to 300 tons per year. Corrective tax: EPA could levy a tax on each factory of $50, 000 per ton of glop emitted. Most economists would prefer the tax. Any level of pollution can be achieved by setting the tax appropriately. The tax reduces pollution more efficiently. The regulation would require each firm to reduce pollution to the same amount. But it may cost more for one firm to reduce pollution than for the other. Then the most efficient way to reduce pollution would be to allow one firm to reduce pollution more than the other. The corrective tax places a price on the right to pollute. It allocates pollution to those firms who have a highest cost of reducing it. Another reason for corrective taxes over command-and control policies: Under the command-and control policy, the firms have no incentive to reduce pollution further than the legal limit. Under the tax, they have an incentive to develop cleaner technology to pay less of the tax. 8

9 Unlike other taxes, corrective taxes may not have a deadweight loss. They restore efficiency instead of creating inefficiency. 2. Tradeable pollution permits Suppose the EPA adopts the limit requiring each factory to reduce pollution to 300 tons of glop each year. The firms propose a deal to the EPA: steel mill wants to increase its emissions by 100 tons. Paper mill will reduce emissions by 100 tons if steel mill pays it 5 million. The deal must improve the well-being of both factories because they agree to it. Therefore improves economic efficiency. No effect on pollution. This is the logic of tradeable pollution permits. 9