Professional Documents
Culture Documents
Chikako Yamauchi
Assistant Professor, GRIPS
Lecture 5
Externalities
Rosen, Ch. 5 (Externalities)
Outline
1.
2.
3.
4.
5.
Introduction
Paper mills produce the chemical dioxin as a byproduct, which ends up in human fat tissue and in the
milk of nursing mothers. Some scientists say that
dioxin is responsible for birth defects and cancer, etc.
Externality Defined
An externality is present when the
activity of one entity (person or firm)
directly affects the welfare of another
entity in a way that is not reflected in
the market price
Negative externality: These activities
impose damages on others.
Positive externality: These activities
create benefits for others.
Lisas production
inputs
-Fishing rod & line
-Bait
-Fishing basket
-Clean water
Examples of Externalities
Negative Externalities
Pollution
Noise
Littering
Car exhaust
Smoking
Positive Externalities
Research &
development
Vaccinations
A neighbors nice
landscape
Students asking good
questions in class
Nature of Externalities
Arise because there is no market price attached to
the good
Can be produced by people or firms
Can be positive or negative
Public goods are special case
An externality can be a public good if it is positive
and felt by everyone
E.g. a device for electrocuting mosquitoes in my
garden
If it kills all the mosquitoes in the community, public good
If it kills mosquitoes in a few neighbors, positive externality
2 Graphical Analysis
Implications
Q1[output level with negative externality] >
Q*[socially efficient output level]
Bart privately produces too much, because he does
not account for the damages to Lisa
When externalities exist, private markets do not
produce the socially efficient output level
3 Private Responses to
Externalities
Public Responses
1. Taxes
2. Subsidies
3. Incentive-based regulation
1. Emissions fees
2. Cap-and-trade programs
4. Command-and-control regulation
Coase Theorem
The Coase Theorem states that once property
rights are established and transaction costs are
small, then one of the parties will pay the other to
attain the socially efficient quantity.
The socially efficient quantity is attained regardless
of to whom the property rights were initially
assigned.
Once property rights are established, government
intervention is not required to deal with externalities
Insight: root of the inefficiencies from externalities is
the absence of property rights.
Source of externality
well defined
Example: Several
polluting firms
4 Public Responses to
Externalities
Public Responses
1. Taxes
2. Subsidies
3. Incentive-based regulation
1.Emissions fees
2.Cap-and-trade programs
4. Command-and-control regulation
the marginal
damage Bart
inflicts at the
efficient level of
output, Q*, = dc
With new
marginal cost =
MPC + cd, Bart
chooses to
produce less, at
Q*
Pigouvian tax =
dc
Pigouvian tax
revenue=dc*Q*
MSC = MPC + MD
Barts perceived cost (MPC + cd)
MPC
Pigouvian
subsidy
i
j
d
c
k
f
This incentive
continues till he
reaches Q*
h
MD
e
Q*
Q1
With Pigouvian
subsidy introduced at
Q1, Barts perceived
cost (MPC + cd)
exceeds MB, so he
has incentive to cut
back his production
level
MB
Q per year
Emissions Fee
e < e*: Barts cost of
reducing pollution,
MC, is smaller than
emission fee, f*, so
$
Bart has incentive to
reduce pollution
f*
Pollution reduction
$
MCB
50
90
Barts
pollution
reduction
50
90 Homers
pollution
reduction
$
MCB
50
90
Barts
pollution
reduction
50
90 Homers
pollution
reduction
If government tells each firm to cut emission by 50, MC for Bart is lower
than MC for Homer
If Bart reduces more and Homer reduces less, it would achieve the
same reduction at a lower (aggregate) cost
The total cost of emissions reduction is minimized only when the
marginal costs are equal across all polluters: cost effective outcome
Bs reduction
$
MCB
Hs reduction
Bs
tax
50 75 90
Suppose that
government wants to
reduce emission by 100
units
Hs tax
Barts
pollution
reduction
25 50
90 Homers
pollution
reduction
Cap-and-trade Scheme
MCH
$
MCB
10
90
Barts
pollution
reduction
Suppose government
decided to reduce
emission by 100, or
allow total pollution to be
80 units
Government gives Bart
80 permits to emit
As Bart was emitting 90,
with 80 permits, he has
to reduce emission by 10
90 Homers
pollution As Homer was emitting
reduction 90, with no permit, he
has to reduce emission
by 90
Responsiveness to Uncertainty
When the costs of reducing pollution is uncertain,
emission fees and cap-and-trade system could
lead to different outcomes
Implications differ depending on the elasticity of
marginal social benefit curve
Inelastic MSB
The reduction of the first unit is highly valued, but the
value for the additional units tapers off quickly
Elastic MSB
The value of reduction remains relatively constant
MSB
$
f*
Under cap-and-trade
scheme, government
produces enough
permits to reduce up
to e*, which is too
much.
ef
e*
Pollution reduction e* is closer to e
MC: true MC
MSB
e* is too much
compared to the
efficient allocation, e
ef
e*
Pollution reduction
Implications
When costs are uncertain and MSB is inelastic, a
cap-and-trade system is preferable to an
emissions fee
When costs are uncertain and MSB is elastic, an
emissions fee is preferable to a cap-and-trade
system
How to find out the shape of MSB?
Information from various fields is required
Distributional effects
Cap-and-trade system can produce no revenue to
government if permits are given to polluters for free
Command-and-control regulations
Require a given amount of pollution reduction with limited or no
flexibility with respect to how it may be achieved
Performance standard: firms must meet certain amounts of
pollution reduction
Technology standard: firms must use certain technology
E.g., U.S. Corporate average fuel economy standards
All new passenger cars must attain 27.5 miles per gallon
Manufacturers cannot shift the burden among each other to lower
overall cost
It is estimated that, if alternatively gasoline consumption is taxed,
the same reduction in gasoline consumption can be achieved with
$700 million less per year
Limitation of incentive-based
regulations
Incentive-based regulations may not work well if
Pollution reductions cannot be monitored well
There is a possibility of creating hot spots, or
localized concentrations of emissions
Who Benefits?
In reality, individuals in different areas suffer
differently from various externalities
Poor neighborhoods tend to have more exposure to air
pollution [Gayer, 2000]
Removing air pollution would benefit low-income families more
Cleaning recreational parks would benefit high-income families