Chapter 10 Economics: Externalities ⢠Externality: the uncompensated ...
Chapter 10 Economics: Externalities •
Externality: the uncompensated impact of one person’s actions on the well-being of a bystander o Negative externality: if the side effect is adverse
Exhaust from automobiles b/c it creates smog; drivers pollute too much, so the government taxes gasoline to reduce the amount that people drive
o Positive externality: if the side effect is beneficial
Restored historic buildings b/c people who walk by them get to enjoy the beauty and history of the building; many governments regulate the destruction of old buildings (which benefits the owners) by providing tax breaks to owners who restore them
o Because buyers and sellers neglect the negative external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when it comes to externalitiesthe equilibrium fails to maximize the total benefit to society •
The height of the demand curve shows the willingness to pay of the marginal buyer (the value to the consumer of the last unit bought)
•
The height of the supply curve shows the cost to the marginal seller (the cost of producing the last unit sold)
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Because of the negative externality, the cost to society of producing the good is larger than the cost to the producers o The social cost includes the private cost of producers o The social cost curve is above the supply curve because it takes into account the external costs imposed on society by the production of the good (with the negative externality)
The difference of these curves is the cost of the externality
o The optimal level of the good with the negative externality is the place at which the demand curve crosses the social-cost curve
Below this, the value of the good to the consumers exceeds the social cost of producing the good
Above this, the social cost of the producing the good exceeds the value to consumers
o QMarket > QOptimum: this inefficiency occurs because market equilibrium reflects only the private costs of production o A planner could achieve the optimal outcome by taxing the producers by an amount that accurately reflected the external cost of the externality
•
This is called internalizing the externality: alerting incentives so that people take account of the external effects of their actions
Positive Externality: educationnot only does education yield a more productive worker who earns higher wages, but it also leads to more informed voters, a lower crime rate, and better dissemination of technological advances o Beause the social value is greater than the private value, the social-value curve lies above the demand curve o The optimal quantity is found where the social-value curve and supply curve (the cost to society) intersect
The socially optimal quantity is greater than the quantity determined by the private market
o The government can correct the market failure (meaning the distance between QMarket and QOptimum) by internalizing the externality through a subsidy
Case in point: education is heavily subsidized
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Summary of Positive and Negative Externalities: o Positive externalities lead markets to produce a smaller quantity than what is socially desirable o Negative externalities lead markets to produce a larger quantity that is socially desirable o To fix these market failures, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities
•
Technology spillover: a type of positive externality in which the impact of one firm’s research and production efforts on other firms’ access to technological advance o The government subsidizes industries or provides tax breaks for research and development in order to promote technology spillover o Patent protection also internalizes the externality by giving the firm a property right over its inventions, effectively incentivizing research and other activities that advance technology
•
All public policies regarding externalities share the goal of moving the allocation of resources toward the social optimum, thereby increasing efficiency
•
Command-and-control policies: regulate behavior directly by making certain behaviors required or forbidden o Society has to way the costs and benefits to decided the types and quantity of pollution that it will allow
•
Market-based policies: provide incentives so that private decision makers will choose to solve the problem on their own o Corrective/Pigovian tax: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality; ideally should equal the external cost from an activity with negative externalities
Can also be a corrective subsidy, which would equal the external benefit from an activity with positive externalities
Corrective taxes reduce negative externalities more efficiently than regulation; it places a price on the right to pollute
A corrective tax allocates a negative externality to those producers that face the highest cost of reducing it
A corrective tax gives a producer an incentive to develop better technology because better technology would reduce the amount of tax that a producer has to pay
o Tradable Pollution permits: There is a max amount of pollution that can be emitted. If a factory emits less than their quota, then they can sell the extra amount to another company. As long as there is a free market for the pollution rights, the final allocation will be efficient regardless of the initial allocation.
o
Firms must pay for their pollution as with corrective taxesstill internalizing the externality
The opportunity cost of polluting is what they could have made by selling their permits on the open market
Figure 4:
The corrective tax creates a supply curve that is perfectly elastic (because firms can pollute as much as they want by paying the tax) and the position of the demand curve determines the quantity of pollution
The pollution permits create a supply curve that is perfectly inelastic (because the quantity of pollution is fixed by the number of permits), and the position of the demand curve determines the price of pollution
In some circumstances, selling pollution permits is better than levying a corrective tax because the EPA can not know the optimal tax size to achieve the goal
A clean environment has positive income elasticity (richer countries can afford cleaner environments and better regulations)
The lower the price of environmental protection, the more that the public will want it
•
Private Solutions for Externalities o Can be solved with moral codes and social sanctions (i.e. littering) o Charities (i.e. Sierra Club or universities)
The government encourages this solution to taxes through income tax deductions for charitable donations
o Internalizing the externalities by relying on the self-interest of the relevant parties; vertical integration can be helpful o Having parties who can help each other enter into contractual agreements, which can often solve the inefficiency that normally arises from externalities, making both parties better off
In the case of a beekeeper and an apple orchard owner: Bees pollinate flowers and use the nectar to make honey; apple orchard owner benefits from pollination
o Coase theorem: the 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 benefit exceeds the cost, then it is socially efficient
The Coase theorem states that the private market will reach this efficient outcome on its own
The initial distribution of rights does not matter for the market’s ability to reach the efficient outcomethe private economic actors can reach a bargain in which everyone is better off and the outcome is efficient
•
•
It determines the distribution of economic well-being; it determines who will pay whom in the final bargain in their attempt to solve the externality problem
Why Private Solutions Do Not Always Work: o The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement; bargaining does not always work even when a mutually beneficial agreement is possible o Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargain; sometimes they prevent interested parties from solving an externality o Sometimes haggling causes bargains to break down, creating an inefficient outcome o The larger the number of interested parties, the more difficult it is to coordinate an agreement o The government can sometimes help with bargaining as well
Externality: the uncompensated impact of one person’s actions on the well-being of a bystander o Negative externality: if the side effect is adverse
Exhaust from automobiles b/c it creates smog; drivers pollute too much, so the government taxes gasoline to reduce the amount that people drive
o Positive externality: if the side effect is beneficial
Restored historic buildings b/c people who walk by them get to enjoy the beauty and history of the building; many governments regulate the destruction of old buildings (which benefits the owners) by providing tax breaks to owners who restore them
o Because buyers and sellers neglect the negative external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when it comes to externalitiesthe equilibrium fails to maximize the total benefit to society •
The height of the demand curve shows the willingness to pay of the marginal buyer (the value to the consumer of the last unit bought)
•
The height of the supply curve shows the cost to the marginal seller (the cost of producing the last unit sold)
•
Because of the negative externality, the cost to society of producing the good is larger than the cost to the producers o The social cost includes the private cost of producers o The social cost curve is above the supply curve because it takes into account the external costs imposed on society by the production of the good (with the negative externality)
The difference of these curves is the cost of the externality
o The optimal level of the good with the negative externality is the place at which the demand curve crosses the social-cost curve
Below this, the value of the good to the consumers exceeds the social cost of producing the good
Above this, the social cost of the producing the good exceeds the value to consumers
o QMarket > QOptimum: this inefficiency occurs because market equilibrium reflects only the private costs of production o A planner could achieve the optimal outcome by taxing the producers by an amount that accurately reflected the external cost of the externality
•
This is called internalizing the externality: alerting incentives so that people take account of the external effects of their actions
Positive Externality: educationnot only does education yield a more productive worker who earns higher wages, but it also leads to more informed voters, a lower crime rate, and better dissemination of technological advances o Beause the social value is greater than the private value, the social-value curve lies above the demand curve o The optimal quantity is found where the social-value curve and supply curve (the cost to society) intersect
The socially optimal quantity is greater than the quantity determined by the private market
o The government can correct the market failure (meaning the distance between QMarket and QOptimum) by internalizing the externality through a subsidy
Case in point: education is heavily subsidized
•
Summary of Positive and Negative Externalities: o Positive externalities lead markets to produce a smaller quantity than what is socially desirable o Negative externalities lead markets to produce a larger quantity that is socially desirable o To fix these market failures, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities
•
Technology spillover: a type of positive externality in which the impact of one firm’s research and production efforts on other firms’ access to technological advance o The government subsidizes industries or provides tax breaks for research and development in order to promote technology spillover o Patent protection also internalizes the externality by giving the firm a property right over its inventions, effectively incentivizing research and other activities that advance technology
•
All public policies regarding externalities share the goal of moving the allocation of resources toward the social optimum, thereby increasing efficiency
•
Command-and-control policies: regulate behavior directly by making certain behaviors required or forbidden o Society has to way the costs and benefits to decided the types and quantity of pollution that it will allow
•
Market-based policies: provide incentives so that private decision makers will choose to solve the problem on their own o Corrective/Pigovian tax: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality; ideally should equal the external cost from an activity with negative externalities
Can also be a corrective subsidy, which would equal the external benefit from an activity with positive externalities
Corrective taxes reduce negative externalities more efficiently than regulation; it places a price on the right to pollute
A corrective tax allocates a negative externality to those producers that face the highest cost of reducing it
A corrective tax gives a producer an incentive to develop better technology because better technology would reduce the amount of tax that a producer has to pay
o Tradable Pollution permits: There is a max amount of pollution that can be emitted. If a factory emits less than their quota, then they can sell the extra amount to another company. As long as there is a free market for the pollution rights, the final allocation will be efficient regardless of the initial allocation.
o
Firms must pay for their pollution as with corrective taxesstill internalizing the externality
The opportunity cost of polluting is what they could have made by selling their permits on the open market
Figure 4:
The corrective tax creates a supply curve that is perfectly elastic (because firms can pollute as much as they want by paying the tax) and the position of the demand curve determines the quantity of pollution
The pollution permits create a supply curve that is perfectly inelastic (because the quantity of pollution is fixed by the number of permits), and the position of the demand curve determines the price of pollution
In some circumstances, selling pollution permits is better than levying a corrective tax because the EPA can not know the optimal tax size to achieve the goal
A clean environment has positive income elasticity (richer countries can afford cleaner environments and better regulations)
The lower the price of environmental protection, the more that the public will want it
•
Private Solutions for Externalities o Can be solved with moral codes and social sanctions (i.e. littering) o Charities (i.e. Sierra Club or universities)
The government encourages this solution to taxes through income tax deductions for charitable donations
o Internalizing the externalities by relying on the self-interest of the relevant parties; vertical integration can be helpful o Having parties who can help each other enter into contractual agreements, which can often solve the inefficiency that normally arises from externalities, making both parties better off
In the case of a beekeeper and an apple orchard owner: Bees pollinate flowers and use the nectar to make honey; apple orchard owner benefits from pollination
o Coase theorem: the 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 benefit exceeds the cost, then it is socially efficient
The Coase theorem states that the private market will reach this efficient outcome on its own
The initial distribution of rights does not matter for the market’s ability to reach the efficient outcomethe private economic actors can reach a bargain in which everyone is better off and the outcome is efficient
•
•
It determines the distribution of economic well-being; it determines who will pay whom in the final bargain in their attempt to solve the externality problem
Why Private Solutions Do Not Always Work: o The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement; bargaining does not always work even when a mutually beneficial agreement is possible o Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargain; sometimes they prevent interested parties from solving an externality o Sometimes haggling causes bargains to break down, creating an inefficient outcome o The larger the number of interested parties, the more difficult it is to coordinate an agreement o The government can sometimes help with bargaining as well
