Public Finance ( MPA405 )

1. Public Finance (MPA405) Dr. Khurrum S. Mughal

2. Lecture 5 : Externalities and Public Policy (Contd…) Public Finance

3. 4- Property rights & Coase theorem • Property rights of some resource users are not identified. • Government can change property rights • Example: Pollution of a stream • Small-number externalities • Parties: Emitters & Receptors

4. 4- Property rights & Coase theorem • The theorem • An example • The significance of Coase Theorem • Application : Pollution rights

5. Coase's Theorem • By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.

6. An example. Figure 3.7 Coase’s Theorem A B MPCB + MEC = MSC MPCB MCW Price of Beef (Dollars) Price of Wheat (Dollars) MC* W PB PW Q* QB1 QW1 Q* B W Beef Output per Year Wheat Output per Year

7. Limitations of Coase’s Theorem • Transactions costs are not zero in many situations. • However you allocate the property right, the distribution of income is affected. • Plight of American Farmer • Agriculture Run-off • Problem of Urban Flooding • New land development

8. Applying Coase's Theorem • The Clean Air Act of 1990 allows for the sale of the "right to pollute." Firms face a tradeoff when they pollute. If they pollute they forgo the right to sell the emission permit to others. • With electricity this has motivated firms to shift to natural gas and away from coal as a means of producing electricity.

9. Figure 3.8 Pollution Rights and Emissions Price and Marginal Social Benefit $20 0 75,000 100,000 Tons of Annual Emissions and Number of Pollution Rights S = Supply of Pollution Rights D = MSB of Emitting Wastes

10. Figure 3.9 The Efficient Amount of Pollution Abatement Marginal Social Cost and Benefit A 0 * 100 Percent Reduction in Wastes Emitted per Year MSC E MSB

11. 6- Regulatory Solutions • Instead of using market forces to cause firms to internalize externalities we can use emission standards and apply these to all.

12. Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions Firm A B C 10 DQRA Cost and Benefit (Dollars) Q* Q* B A QA1 Tons of Emissions per Year Firm B F G 10 H DQRB 0 QR QB1 MEC = MSC A MSB MEC = MSC MSB

13. Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions Firm C Firm D X Y Cost and Benefit (Dollars) 20 Q Q* Q* Q C D R R S Z T R DQRC DQRD Tons of Emissions per Year MEC = MSC MEC = MSC MSB

14. Theory in Practice • Command and control Policies • Environmental Production Agency (EPA) • Discourages Innovation • Administrative Burden • Markets for Pollution Rights • Clean Air Act of 1990 tradable on Chicago Board of Exchange • Tradable Emission Permits (Allowances) • Option of cleaner burning fuels or Scrubbers

15. Theory in Practice • Cap & Trade Policies • Emission Offset Policy • Bubble Scheme • Banking of Emission Reduction • Self use • Sell to other firms

16. Global Externalities • CFC’s • Deforestation • Global Warming