Chapter 3 Externalities and Government Policy What are externalities? Externalities = Classifications 1. Negative Externalities (external costs) to third parties, other than the buyers or the sellers of an item, not reflected in the market price. E.g. industrial pollution, noise of aircraft, smoking, driving, drinking and driving, etc. 2. Positive Externalities (external benefits) to the third parties, other than the buyers or the sellers of a good of service, not reflected in prices. E.g. fire prevention, inoculation against a disease, education, bees and orchard, etc. Note: Effects of market exchanges on third parties are not externalities when those effects are included in prices. Econ 290 Chapter 3 Page 1
Externalities and Efficiency When externalities present, the market fails to achieve an efficient allocation of resources since the marginal costs (MC) or marginal benefits (MB) that market participants base their decision on from the actual marginal social costs or benefits. 1. Negative Externalities When there are negative externalities, the price of a good or service does not reflect the full marginal social cost (MSC) of resources allocated in its production. P < MSC The MSC will equal to the marginal private cost (MPC) plus the marginal external cost (MEC) MSC = MPC + MEC The MEC is the cost to resulting from production of another unit of a good or service, which in not reflected in the market price. The efficient allocation of resources will be where Econ 290 Chapter 3 Page 2
Example of a negative externality Paper Production: it creates a negative externality because it emits pollutants to streams and rivers. Assumption: perfectly competitive market, thus no one has power to affect the market price of paper. P Tones of paper per year 1) If there is no externality Market equilibrium price = Market equilibrium quantity = Econ 290 Chapter 3 Page 3
2) If there is externality that is associated with damages done by pollutants Assume that MEC = $10 per tone MSC = MSB = Socially efficient price = Socially efficient quantity = DWL = Conclusion: when a negative externality exists, output is produced and sold in a competitive market relative to the efficient amount. 2. Positive Externalities When there are positive externalities, the price of a good or service does not equal to the marginal social benefit (MSB) of resources allocated in its production. P < MSB The MSB will equal to the marginal private benefit (MPB) plus the marginal external benefit (MEB) MSB = MPB + MEB The MEB is the benefit of additional output accruing to parties other than buyers or sellers of the good. Econ 290 Chapter 3 Page 4
The MPB is the marginal benefit that consumers base their decisions on without considering others. The efficient allocation of resources will be where Example of a positive externality Inoculation against a disease: it creates a positive externality because those who are vaccinated not only benefit themselves, but also reduce the probability of outbreaks of disease for the entire population. P Inoculations per year Econ 290 Chapter 3 Page 5
1) If there is no externality Market equilibrium price = Market equilibrium quantity = 2) If there is externality associated with benefit that reduces the number of people who will become hosts for the disease Assume that MEB = $20 per inoculation MSC = MSB = Socially efficient price = Socially efficient quantity = DWL = Conclusion: when a positive externality exists, output is produced and sold in a competitive market relative to the efficient amount. 3. 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. If MEB declines with output, the implication of this type of externality for market failure is quite important. Econ 290 Chapter 3 Page 6
Let s assume a perfectly competitive market: P Inoculation per year 1) The marginal social cost curve is S Market equilibrium price = Market equilibrium quantity = This market outcome is because DWL = 2) The marginal social cost curve is S Market equilibrium price = Market equilibrium quantity = Econ 290 Chapter 3 Page 7
This market outcome is because DWL = Conclusion: for positive externalities such as this, whose marginal external benefit declines with output, competitive markets fail to perform efficiently only at levels of output. Internalization of Externalities Internalization of an externality occurs when the MPB or MPC of goods and services is adjusted so that the users consider the actual MSB or MSC of their decision. Negative externality: Positive externality: 1. Internalizing negative externality: corrective taxes Corrective taxes = a tax designed to adjust the of a good or service in such a way as to internalize the externality. Tax = T = Econ 290 Chapter 3 Page 8
Example: Paper production T = MEC = $10 P Tones of paper per year Market equilibrium price = Market equilibrium quantity = This market outcome is because Tax revenue = Net gain in well-being allowed by tax = Note: the corrective tax does not reduce the pollutants in the streams to zero. It merely raises the cost of using the stream to reflect the marginal damage done to alternative users of the stream. Econ 290 Chapter 3 Page 9
Questions: Are there any winners or losers of the corrective tax? 2. Internalizing positive externality: corrective subsidies Corrective subsidies = 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. Subsidy = Example: Inoculation Subsidy = MEB = $20 Econ 290 Chapter 3 Page 10
P Inoculation per year Market equilibrium price = Market equilibrium quantity = This market outcome is because Total subsidy payment = Net gain in well-being allowed by subsidy = 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: Econ 290 Chapter 3 Page 11
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. P Output per year Econ 290 Chapter 3 Page 12
1. Without the negative externality: MC = Monopolistic output = Monopolistic price = DWL = 2. With the negative externality: MC = Efficient output = Efficient price = In this case, the monopolistic output is the efficient output! In actuality, the efficient output can be greater or less than the monopolistic output. Conclusion: 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. Property Rights to Resource Use and Internalization of Externalities: The Coast Theorem Why externalities arise? When the property rights of some resource users are not considered in the marketplace by buyers or sellers of the products Econ 290 Chapter 3 Page 13
What does the Coase Theorem state? Governments, by merely establishing the to use resource, can internalize externalities when transactions costs of bargaining are. Transaction Cost = time, effort, and cash outlays involved in location someone to trade with, negotiating terms of trade, drawing contracts and assuming risks associated with the contracts. 1) It depends, in part, on to use resources. 2) It tends to be close to zero when the parties involved in trading the right are. Exchange of Property Rights to Internalize a Negative Externality Example: suppose that a cattle rancher and a wheat farmer operate in two adjoining plots of land P b Q b Econ 290 Chapter 3 Page 14
Assumption: both wheat and beef are sold in perfectly competitive markets, thus the D-curve for wheat and beef are both horizontal. Case1: the wheat producer has the right to cattle-free land There are 2 options for rancher: 1) pay the wheat producers a compensation payment which equals the MEC; 2) build a fence to eliminate the straying 1) MSC for rancher = Quantity of beef = 2) MSC = MPC Why? Building a fence will only affect AC but not MC Quantity of beef = Which option to choose by the rancher will depend on whichever option yields him/her the higher profit. Econ 290 Chapter 3 Page 15
Case 2: the beef rancher has the right to use unfenced land for grazing P w The MC for wheat producers depend on the size of the rancher s cattle herd. If the rancher produce Q b, MC = MC w Quantity of wheat = If the rancher produce Q b *, MC = MC w * Quantity of wheat = Q w TR for wheat producers increase with output of Q w *, the maximum amount of money that the farmer would pay for each unit reduction in beef output by the rancher =. Econ 290 Chapter 3 Page 16
Conclusion: we see from the above 2 cases that it does not matter whether the property right is assigned to wheat producers or ranchers. The mix of output produced on the adjoining lands will be exactly the same Q w * and Q b *. Significance of The Coase Theorem The efficient mix of output will result simply as a consequence of the establishment of. It makes no difference which party is assigned the right to use a resource. However, it makes a big difference to the parties involved in terms of their. The users who are initially granted the right are, because then 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 between the two parties using the resource. Applying the Coase Theorem: Pollution Rights Pollution Right = transferable permits to emit a certain amount of particular wastes into the atmosphere or water per year. Advantage: the regulatory authorities could strictly control the amount of emission by issuing a fixed number of permits. Econ 290 Chapter 3 Page 17
P Tones of annual emissions By changing the number of permits available in the market can affect the price. Efficient Pollution Abatement Levels The MSC of pollution abatement is increasing with increased abatement. The MSB of increased pollution abatement is declining as more pollution is abated. Econ 290 Chapter 3 Page 18
MSC or MSB Reduction in wastes emitted per year Emission Standards and Efficiency Emission Standard: it does not charge for emissions damages if the amounts emitted are than legally established standards. In reality, standard is not such a good policy: a). firms can pollute for free up to the level of standard no incentive to pollute below standard no incentive to improve pollution reduction technology b). firms cause different marginal external damage and have different pollution abatement costs should reduce pollution by different level base on their costs Econ 290 Chapter 3 Page 19
1. Uniform regulations would not achieve efficiency if the MSBs of emission abatement vary among firms Firm A: Costs and benefits Emissions per year Firm B: Costs and benefits Emissions per year The DWL to Firm A with uniform emission standard = The DWL to Firm B with uniform emission standard = Econ 290 Chapter 3 Page 20
2. Uniform regulations would not achieve efficiency if the MEC of emissions varied by region in a nation Urban areas: Costs and benefits Emissions per year Rural areas: Costs and benefits Emissions per year Econ 290 Chapter 3 Page 21
The DWL to Urban areas with uniform emission standard = The DWL to Rural areas with uniform emission standard = Conclusion: uniform standard for controlling emissions that result in negative externalities are unlikely to achieve efficiency. The total cost of a given level of pollution reduction is not minimized. Use of a standard approach to controlling negative externalities will have to be flexible to achieve an efficient outcome. A disadvantage of using standards, as compared with corrective taxes, is that standards do not generate any revenue. Econ 290 Chapter 3 Page 22