Chapter 10 - Externalities
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Chapter 10: Externalities previously saw that market typically allocates resources efficiently however, sometimes fail and government intervention improves market outcomes externality: arises when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives any compensation for the effect negative externality: when the externality affects the bystander negatively positive externality: when the externality affects the by stander positively
I. Externalities and Market Inefficiency • examination of how externalities affect economic well-being • analysis shows why externalities cause markets to allocate resources inefficiently A. Welfare Economics: A Recap • e.g. aluminum market • demand curve reflects the willingness to pay of the marginal buyer; i.e. it shows the value to the consumer of the last unit of aluminum bought • supply curve reflects the costs of producing aluminum; i.e. it shows the cost to the producer of the last unit of aluminum sold • in the absence of government intervention, price adjusts to balance supply and demand • maximizes total value to consumers who buy and use aluminum minus total costs to the producers who make and sell aluminum B. Negative Externalities • aluminum factories emit pollution: each unit of aluminum, certain amount of smoke enters atmosphere and creates health risk for those who breathe air • this is a negative externality • because of the externality, the cost to society of producing aluminum is larger than the cost to aluminum producers • for each unit of aluminum produced, social cost includes private costs of aluminum producers plus costs of those bystanders affected • social-cost curve is above the S curve because takes into account the external costs imposed on society by aluminum production • difference in two curves reflects cost of pollution emitted • optimal Q produced is where the D curve intersects the social cost curve • do not produce more than this level because social cost of producing additional aluminum exceeds the value to customers • how to decrease consumption/raise P? • tax aluminum producers • the tax would shift the supply curve for aluminum upward by size of tax • if tax accurately reflect external cost of pollutants released into atmosphere, new supply curve would coincide with social-cost curve • use of such a tax is called internalizing the externality because gives buyers and sellers in market incentive to take into account external effects of actions • in essence causes producers to take costs of pollution into account when deciding how much aluminum to supply because tax makes them pay for external costs • because market price reflects tax on producers, consumers of aluminum have incentive to use smaller quantity C. Positive Externalities • e.g. education • although to large extent, education benefit is private, has positive externalities such as:
• more education population leads to more informed voters, which means better government for everyone • more educated population tends to mean lower crime rates • more educated population may encourage development and dissemination of technological advances, leading to higher productivity and wages for everyone because social value is greater than private value, the social value curve lies above the • demand curve • optimal quantity is where social-value curve and the supply curve (which represents costs) intersect • thus, socially optimal quanity is greater than Q determined by private market • government can correct by inducing market participants to internalize the externality • subsidizing goods/services helps increase Q to socially optimal level; for education, government subsidizes public schools and government scholarships II. Public Policies Towards Externalities • this section considers various governmental solutions to externalities • generally, governments can respond in two ways: • command-and-control policies: policies that regulate behaviour directly • market-based policies: policies that provide incentives so that private decision makers will choose to solve the problem on their own A. Command-and-Control Policies: Regulation • government can remedy externality by making certain behaviours either required or forbidden • e.g. it’s crime to dump poisonous chemicals in water supply • in this case, external costs to society far exceed benefits to polluter • thus, government institutes a command-and-control policy that prohibits act altogether however, some situations not as simple • • impossible to prohibit all polluting activity • e.g. virtually all forms of transportation produce some undesirable polluting by-products • not sensible to ban all transportation • create environmental regulations that dictates levels of allowed pollution • in all cases, to design good rules, government regulators need to know details about specific industries and about alternative technologies that those industries could adopt • information often difficult for government regulators to obtain • results in inefficiency B. Market-Based Policy 1: Corrective Taxes and Subsidies • corrective taxes: taxes enacted to deal with the effects of negative externalities • also called Pigovian taxes after Arthur Pigou, early advocate of their use economists usually prefer corrective taxes to regulations because can reduce pollution at lower • cost to society • e.g. 2 factories – paper mill & steel mill – that each dump 500 tons of flop into river annually; EPA decides that it wants to reduce the amount of pollution • considers 2 solutions: • regulation: EPA tells each factory to reduce its pollution 300 tons of glop next year • requires every factory reduce by same level • an equal reduction, however, is not necessarily the least expensive way to clean up water • possible that paper mill can reduce pollution at lower cost than steel mill
• if so, paper mill would respond to tax by reducing pollution substantially to avoid tax whereas steel mill would respond by reducing pollution less and paying the tax • corrective tax: EPA levies tax on each factory of $50,000 for each ton of glop it emits • higher the tax, larger the reduction in pollution • if tax high enough, factories will close down altogether, reducing pollution to 0 • more efficient • better for environment • under command-and-control policy, no reason to reduce emission further once reached target • by contrst, tax gives factories incentive to develop cleaner technologies • corrective tax essentially puts price on the right to pollute • just as markets allocate goods to buyers who value them most highly, corrective tax allocates pollution to those factories that face the highest cost of reducing it • corrective taxes unlike most other taxes • most taxes distort incentives and move allocation of resources away from social optimum • the reduction in economic well-being (that is, in consumer and producer surplus) exceeds the amount the government makes in revenue resulting in DWL • in contrast, when externalities present, society cares about well-being of affected bystanders; corrective taxes alter incentives to account for presence of externalities and thereby move allocation of resources closer to social optimum C. Market-Based Policy 2: Tradable Pollution Permits • e.g. paper and steel mill • trade-off benefits both companies • deal does not have external effects because total amount of pollution remains same • social welfare is enhanced by allowing permit trade • if EPA allows firms to make these delas, in essence created a new scarce resource: permits • market to trae will eventually develop • invisible hand ensures new market allocates right to pollute efficiently • the more costly it is for a firm to cut back on pollution, more willing to pay • advantage • initial allowance of permits does not matter from standpoint of economic efficiency • firms that can reduce at low cost will sell • as long as there is a free market for pollution rights, final allocation will be efficient regardless of initial allocation • reducing pollution using permits seems diff than corrective taxes, but much in common: • firms pay for their pollution • taxes: firms pay government • pollution permits: firms must pay to buy permit (even firms that already owns permits must pay to pollute: opportunity cost of polluting is what they could have received by selling permits on open market) • both internalize externality of pollution by making it costly for firms to pollute • in some cases, selling permits may be better than corrective tax • e.g. EPA wants no more than 600 tons of glop dumped into river • but because EPA doesn’t know demand curve for pollution, not sure what size tax would achieve goal • in this case, can simply auction off 600 pollution permits
D. Objections to the Economic Analysis of Pollution • some argue cannot give anyone option of polluting for fee • clean air and clean water arguably fundamental human rights that shouldn’t be debased by considering them in economic terms; how can put price on something priceles • economists have little sympathy for this type of argument • good environmental policy begins by acknowledging people face trade-offs • argue that some environmental activists hurt their own case by not thinking in economic terms • good environment like any other good • obey law of demand: the lower the price of environmental protection, the more the public will want III. Private Solutions to Externalities • in some cases, people can develop private solutions and avoid government intervention A. The Types of Private Solutions • sometimes problem of externalities solved with moral codes and social sanctions • e.g. why most people don’t litter – not really cause of law, because it is wrong charities: run on private donations • • e.g. nonprofit organizations, colleges and universities receiving gifts from alumni/ corporations/foundations because education has positive externalities for society • government encourages private solution to externalities through tax system by allowing an income tax deduction for charitable donations • private market can often solve problem of externalities by relying on self-interest of relevant parties • e.g. apple grower and beekeeper located next to each other • each business confers positive externality on other • nonetheless make decisions not taking that into account • as result, apple grower plants too few trees and beekeeper keeps too few bees • externalities could be internalized if beekeeper bought apple orchard or if apple grower bought beehives • both activities would then take place within the same firm, and this single firm could choose optimal number of trees and bees • entering a contract • creates obligation between people to do something without government intervention B. The Coase Theorem • the Coase Theorem: proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own • if private parties can bargain over allocation of resources at no cost, then private market will always wolve problem of externalities and allocate resources efficiently • e.g. Dick owns dog named Spot who barks and disturbs neighbor Jane • consider social efficiency: compare benefit that Dick gets from the dog to cost that Jane bears from it (namely its barking) • if benefits exceeds cost, keep dog; if cost exceeds benefits, get rid of dog • according to Coase Theorem, private market reach efficient outcome on its own; how? • Jane pays Dick to get rid of dog • if amount of money Jane offers is greater than benefit of keeping dog, then dog gotten rid of
• if Jane cannot pay how much Dick values the dog, the dog stays however, this is based on assumption that Dick has legal right to keep barking dog; but • what if Jane has legal right for living in peace and quiet? • according to theorem, initial distribution of rights does not matter for market’s ability to reach efficient outcome • e.g. supposed Jane can legally compel Dick to get rid of dog • having this right works to Jane’s advantage but will not change outcome • in this case, Dick can pay Jane to allow him to keep dog • although Jane and Dick can reach efficient outcomes regardless of how rights are initially distributed, the distribution of rights is not irrelevant • determines the distribution of economic well-being • whether Dick has right or Jane has right determines who pays whom in final bargain • in either case, two parties can bargain with each other and solve externality C. Why Private Solutions Do Not Always Work • despite appealing logic of theorem, individuals often fail to resolve problems caused by externalities • theorem only applies when interested parties have no trouble reaching and enforcing an agreement • in real world, bargaining does not always work, even when mutually beneficial agreement possible transaction costs: the costs that incur in the process of agreeing to and following through on • a bargain • this may cause private parties to fail to solve an externality problem • e.g. difference in language at • other times, bargaining simply breaks down • e.g. recurrence of wars and labor strikes • problem is often that each party tries to hold out for a better deal • reaching efficient bargain especially difficult when number of interested parties is large because coordinating everyone is costly • e.g. consider factory that pollutes water of nearby lake • pollution confers negative externality on local fishermen • according to Coase theorem, factory and fishermen could reach bargain • however, if many fishermen, trying to coordinate them all to bargain with factory may be almost impossible • when private bargaining doesn’t work, government can sometimes play a role • government is institution designed for collective action • in this example, government can act on behalf of fishermen IV. Conclusion • invisible hand is powerful but not omnipotent • market’s equilibrium maximizes sum of producer and consumer surplus • when buyers and sellers in market are only interested parties, outcome is efficient from standpoint of society as whole • when external affects appear, not efficient
Chapter 10: Externalities previously saw that market typically allocates resources efficiently however, sometimes fail and government intervention improves market outcomes externality: arises when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives any compensation for the effect negative externality: when the externality affects the bystander negatively positive externality: when the externality affects the by stander positively
I. Externalities and Market Inefficiency • examination of how externalities affect economic well-being • analysis shows why externalities cause markets to allocate resources inefficiently A. Welfare Economics: A Recap • e.g. aluminum market • demand curve reflects the willingness to pay of the marginal buyer; i.e. it shows the value to the consumer of the last unit of aluminum bought • supply curve reflects the costs of producing aluminum; i.e. it shows the cost to the producer of the last unit of aluminum sold • in the absence of government intervention, price adjusts to balance supply and demand • maximizes total value to consumers who buy and use aluminum minus total costs to the producers who make and sell aluminum B. Negative Externalities • aluminum factories emit pollution: each unit of aluminum, certain amount of smoke enters atmosphere and creates health risk for those who breathe air • this is a negative externality • because of the externality, the cost to society of producing aluminum is larger than the cost to aluminum producers • for each unit of aluminum produced, social cost includes private costs of aluminum producers plus costs of those bystanders affected • social-cost curve is above the S curve because takes into account the external costs imposed on society by aluminum production • difference in two curves reflects cost of pollution emitted • optimal Q produced is where the D curve intersects the social cost curve • do not produce more than this level because social cost of producing additional aluminum exceeds the value to customers • how to decrease consumption/raise P? • tax aluminum producers • the tax would shift the supply curve for aluminum upward by size of tax • if tax accurately reflect external cost of pollutants released into atmosphere, new supply curve would coincide with social-cost curve • use of such a tax is called internalizing the externality because gives buyers and sellers in market incentive to take into account external effects of actions • in essence causes producers to take costs of pollution into account when deciding how much aluminum to supply because tax makes them pay for external costs • because market price reflects tax on producers, consumers of aluminum have incentive to use smaller quantity C. Positive Externalities • e.g. education • although to large extent, education benefit is private, has positive externalities such as:
• more education population leads to more informed voters, which means better government for everyone • more educated population tends to mean lower crime rates • more educated population may encourage development and dissemination of technological advances, leading to higher productivity and wages for everyone because social value is greater than private value, the social value curve lies above the • demand curve • optimal quantity is where social-value curve and the supply curve (which represents costs) intersect • thus, socially optimal quanity is greater than Q determined by private market • government can correct by inducing market participants to internalize the externality • subsidizing goods/services helps increase Q to socially optimal level; for education, government subsidizes public schools and government scholarships II. Public Policies Towards Externalities • this section considers various governmental solutions to externalities • generally, governments can respond in two ways: • command-and-control policies: policies that regulate behaviour directly • market-based policies: policies that provide incentives so that private decision makers will choose to solve the problem on their own A. Command-and-Control Policies: Regulation • government can remedy externality by making certain behaviours either required or forbidden • e.g. it’s crime to dump poisonous chemicals in water supply • in this case, external costs to society far exceed benefits to polluter • thus, government institutes a command-and-control policy that prohibits act altogether however, some situations not as simple • • impossible to prohibit all polluting activity • e.g. virtually all forms of transportation produce some undesirable polluting by-products • not sensible to ban all transportation • create environmental regulations that dictates levels of allowed pollution • in all cases, to design good rules, government regulators need to know details about specific industries and about alternative technologies that those industries could adopt • information often difficult for government regulators to obtain • results in inefficiency B. Market-Based Policy 1: Corrective Taxes and Subsidies • corrective taxes: taxes enacted to deal with the effects of negative externalities • also called Pigovian taxes after Arthur Pigou, early advocate of their use economists usually prefer corrective taxes to regulations because can reduce pollution at lower • cost to society • e.g. 2 factories – paper mill & steel mill – that each dump 500 tons of flop into river annually; EPA decides that it wants to reduce the amount of pollution • considers 2 solutions: • regulation: EPA tells each factory to reduce its pollution 300 tons of glop next year • requires every factory reduce by same level • an equal reduction, however, is not necessarily the least expensive way to clean up water • possible that paper mill can reduce pollution at lower cost than steel mill
• if so, paper mill would respond to tax by reducing pollution substantially to avoid tax whereas steel mill would respond by reducing pollution less and paying the tax • corrective tax: EPA levies tax on each factory of $50,000 for each ton of glop it emits • higher the tax, larger the reduction in pollution • if tax high enough, factories will close down altogether, reducing pollution to 0 • more efficient • better for environment • under command-and-control policy, no reason to reduce emission further once reached target • by contrst, tax gives factories incentive to develop cleaner technologies • corrective tax essentially puts price on the right to pollute • just as markets allocate goods to buyers who value them most highly, corrective tax allocates pollution to those factories that face the highest cost of reducing it • corrective taxes unlike most other taxes • most taxes distort incentives and move allocation of resources away from social optimum • the reduction in economic well-being (that is, in consumer and producer surplus) exceeds the amount the government makes in revenue resulting in DWL • in contrast, when externalities present, society cares about well-being of affected bystanders; corrective taxes alter incentives to account for presence of externalities and thereby move allocation of resources closer to social optimum C. Market-Based Policy 2: Tradable Pollution Permits • e.g. paper and steel mill • trade-off benefits both companies • deal does not have external effects because total amount of pollution remains same • social welfare is enhanced by allowing permit trade • if EPA allows firms to make these delas, in essence created a new scarce resource: permits • market to trae will eventually develop • invisible hand ensures new market allocates right to pollute efficiently • the more costly it is for a firm to cut back on pollution, more willing to pay • advantage • initial allowance of permits does not matter from standpoint of economic efficiency • firms that can reduce at low cost will sell • as long as there is a free market for pollution rights, final allocation will be efficient regardless of initial allocation • reducing pollution using permits seems diff than corrective taxes, but much in common: • firms pay for their pollution • taxes: firms pay government • pollution permits: firms must pay to buy permit (even firms that already owns permits must pay to pollute: opportunity cost of polluting is what they could have received by selling permits on open market) • both internalize externality of pollution by making it costly for firms to pollute • in some cases, selling permits may be better than corrective tax • e.g. EPA wants no more than 600 tons of glop dumped into river • but because EPA doesn’t know demand curve for pollution, not sure what size tax would achieve goal • in this case, can simply auction off 600 pollution permits
D. Objections to the Economic Analysis of Pollution • some argue cannot give anyone option of polluting for fee • clean air and clean water arguably fundamental human rights that shouldn’t be debased by considering them in economic terms; how can put price on something priceles • economists have little sympathy for this type of argument • good environmental policy begins by acknowledging people face trade-offs • argue that some environmental activists hurt their own case by not thinking in economic terms • good environment like any other good • obey law of demand: the lower the price of environmental protection, the more the public will want III. Private Solutions to Externalities • in some cases, people can develop private solutions and avoid government intervention A. The Types of Private Solutions • sometimes problem of externalities solved with moral codes and social sanctions • e.g. why most people don’t litter – not really cause of law, because it is wrong charities: run on private donations • • e.g. nonprofit organizations, colleges and universities receiving gifts from alumni/ corporations/foundations because education has positive externalities for society • government encourages private solution to externalities through tax system by allowing an income tax deduction for charitable donations • private market can often solve problem of externalities by relying on self-interest of relevant parties • e.g. apple grower and beekeeper located next to each other • each business confers positive externality on other • nonetheless make decisions not taking that into account • as result, apple grower plants too few trees and beekeeper keeps too few bees • externalities could be internalized if beekeeper bought apple orchard or if apple grower bought beehives • both activities would then take place within the same firm, and this single firm could choose optimal number of trees and bees • entering a contract • creates obligation between people to do something without government intervention B. The Coase Theorem • the Coase Theorem: proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own • if private parties can bargain over allocation of resources at no cost, then private market will always wolve problem of externalities and allocate resources efficiently • e.g. Dick owns dog named Spot who barks and disturbs neighbor Jane • consider social efficiency: compare benefit that Dick gets from the dog to cost that Jane bears from it (namely its barking) • if benefits exceeds cost, keep dog; if cost exceeds benefits, get rid of dog • according to Coase Theorem, private market reach efficient outcome on its own; how? • Jane pays Dick to get rid of dog • if amount of money Jane offers is greater than benefit of keeping dog, then dog gotten rid of
• if Jane cannot pay how much Dick values the dog, the dog stays however, this is based on assumption that Dick has legal right to keep barking dog; but • what if Jane has legal right for living in peace and quiet? • according to theorem, initial distribution of rights does not matter for market’s ability to reach efficient outcome • e.g. supposed Jane can legally compel Dick to get rid of dog • having this right works to Jane’s advantage but will not change outcome • in this case, Dick can pay Jane to allow him to keep dog • although Jane and Dick can reach efficient outcomes regardless of how rights are initially distributed, the distribution of rights is not irrelevant • determines the distribution of economic well-being • whether Dick has right or Jane has right determines who pays whom in final bargain • in either case, two parties can bargain with each other and solve externality C. Why Private Solutions Do Not Always Work • despite appealing logic of theorem, individuals often fail to resolve problems caused by externalities • theorem only applies when interested parties have no trouble reaching and enforcing an agreement • in real world, bargaining does not always work, even when mutually beneficial agreement possible transaction costs: the costs that incur in the process of agreeing to and following through on • a bargain • this may cause private parties to fail to solve an externality problem • e.g. difference in language at • other times, bargaining simply breaks down • e.g. recurrence of wars and labor strikes • problem is often that each party tries to hold out for a better deal • reaching efficient bargain especially difficult when number of interested parties is large because coordinating everyone is costly • e.g. consider factory that pollutes water of nearby lake • pollution confers negative externality on local fishermen • according to Coase theorem, factory and fishermen could reach bargain • however, if many fishermen, trying to coordinate them all to bargain with factory may be almost impossible • when private bargaining doesn’t work, government can sometimes play a role • government is institution designed for collective action • in this example, government can act on behalf of fishermen IV. Conclusion • invisible hand is powerful but not omnipotent • market’s equilibrium maximizes sum of producer and consumer surplus • when buyers and sellers in market are only interested parties, outcome is efficient from standpoint of society as whole • when external affects appear, not efficient
