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Chapter 3. Externalities and Public Policy. Externalities. Externalities are costs or benefits of market transactions not reflected in prices. Negative externalities are costs to third parties. Positive externalities are benefits to third parties . Externalities and Efficiency.
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Chapter 3 Externalities and Public Policy
Externalities • Externalities are costs or benefits of market transactions not reflected in prices. • Negative externalities are costs to third parties. • Positive externalities are benefits to third parties .
Externalities and Efficiency • The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good.
Social Costs MSC = MPC + MEC
Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency MPC + MEC = MSC G S = MPC 110 B 10 105 A 100 Price, Benefit, and Cost (Dollars) D = MSB 4.5 5 Tons of Paper Per Year (Millions)
Positive externalities • The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production or consumption of a good.
Social Benefit MSB = MPB + MEB
Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency Z 45 S = MSC 30 V Price, Benefit, and Cost (Dollars) 25 U H 10 MPB + MEB = MSB MPB 0 Inoculations Per Year (Millions) 10 12
Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output MPBi + MEB = MSB S = MSC F 30 B S' = MSC' A 25 C 20 Price, Benefit, and Cost (Dollars) MPBi 0 10 12 16 20 Inoculations per Year (Millions)
Internalization of Externalities • An externality can be internalized under policies that force market participants to account for the costs of benefits of their actions.
Corrective Taxes to Negative Externalities • Setting a tax equal to the MEC will internalize a negative externality.
Figure 3.4 A Corrective Tax S’ = MPC + T = MSC S = MPC G 110 B Net Gains in Well-Being 105 Tax Revenue = Total External Costs 100 A T 95 Price, Benefit, and Cost (Dollars) D = MSB 4.5 5 Tons of Paper Per Year (Millions)
Results of a Corrective Tax • Price rises. • The tax revenue is sufficient to pay costs to third parties. • Socially optimal levels of production are achieved.
A Polluting Monopolist • Monopoly creates a loss to society. • A negative externality causes a loss as well. • The losses do not necessarily add to one another. In fact, they can cancel each other out.
Figure 3.5 A Second Best Efficient Solution MPC + MEC = MSC F MPC A P M B Price C D = MSB MR Q Q* 0 M Output per Year
Theory of the Second Best • When two opposing factors contribute to efficiency losses, the can offset one another’s distortions.
Corrective Subsidies • Setting a subsidy equal to MEB will internalize a positive externality.
Figure 3.6 A Corrective Subsidy Z 45 S = MSC R 30 V Price, Benefit, and Cost (Dollars) 25 U Subsidy Payments X 10 = MSB D' = MPBi + $20 Y D = MPBi 0 10 12 Inoculations per Year (Millions)
Property Rights and Internalization of Externalities • Externalities arise because some resource users’ property rights are not considered in the marketplace by buyers or sellers of products. • Governments can give businesses the right to emit wastes in the air and water or it can give individuals the right to clean air and water.
Coase's Theorem • By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.
Limitations of Coase’s Theorem • Transactions costs are not zero in many situations. • However you allocate the property rights, the distribution of income is affected.
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 their emission permits to others. • In markets for electricity, Clean Air Act has motivated firms to shift to natural gas and away from coal as a means of producing electricity.
Figure 3.8 Pollution Rights and Emissions S = Supply of Pollution Rights Price and Marginal Social Benefit D = MSB of Emitting Wastes $20 0 75,000 100,000 Tons of Annual Emissions and Number of Pollution Rights
Figure 3.9 The Efficient Amount of Pollution Abatement MSC Marginal Social Cost and Benefit E MSB A* 0 100 Percent Reduction in Waste Emitted per Year
Regulatory Solutions • Instead of using market forces to force firms to internalize externalities, we can use emission standards and apply these to all market players.
Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions Firm A B MEC = MSC C 10 A DQRA MSB Cost and Benefit (Dollars) QA* QA1 Tons of Emissions per Year Firm B MEC = MSC F G 10 H DQRB MSB 0 QB* QR QB1
Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions Firm C Firm D MSB MEC = MSC X Y Cost and Benefit (Dollars) 20 S Z T MEC = MSC R MSB DQRC QC* QR QR DQRD QD* Tons of Emissions per Year
Costs and Benefits to the EPA • The EPA estimates that annual compliance costs could be in the range of $225 billion per year. • The EPA estimated in 1990 that the benefits of the Clean Air Act were nearly 50 times the costs. • Ninety percent of the benefits are estimated to come from laws pertaining to power plants and factories.
