Externalities

1. Externalities

2. Overview • Externalities • Negative: Action by one party imposes a cost on another party • Positive: Action by one party benefits another party • Ways of Correcting Market Failure

3. External Cost • Scenario • Steel plant dumping waste in a river • The entire steel market effluent can be reduced by lowering output (fixed proportions production function) • Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. • Marginal Social Cost (MSC) is MC plus MEC.

4. The differences is the marginal external cost MEC. The profit maximizing firm produces at q1 while the efficient output level is q*. When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. MSC MSCI MC S = MCI The industry competitive output is Q1 while the efficient level is Q*. Aggregate social cost of negative externality P* P1 P1 MECI MEC D q* q1 Q* Q1 External Costs Price Price =MEC Industry output Firm output

5. Externalities • Positive Externalities and Inefficiency • Externalities can also result in too little production, as can be shown in an example of home repair and landscaping. • Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

6. When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. MSB A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair. D P1 MC P* MEB q1 q* External Benefits Value DWL Is research and development discouraged by positive externalities? Repair Level

7. Ways of Correcting Market Failure in Pollution • Assumption: Fixed-proportion production technology • Must reduce output to reduce emissions • Use an output tax to reduce output • Input substitution possible by altering technology • Options for Reducing Emissions • Emission Standard • Set a legal limit on emissions at E* (12) • Enforced by monetary and criminal penalties • Increases the cost of production and the threshold price to enter the industry • Emissions Fee • Charge levied on each unit of emission

8. MSC At Eo the marginal cost of abating emissions is greater than the marginal social cost. At E1 the marginal social cost is greater than the marginal cost of abatement. The efficient level of emissions is 12 (E*) where MCA = MSC. MCA E0 E1 E* The Efficient Level of Emissions Why is this more efficient than zero emissions? Dollars per unit of Emissions 6 Assume: 1) Competitive market 2) Output and emissions decisions are independent 3) Profit maximizing output chosen 4 2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 Level of Emissions

9. MSC Cost is less than the fee if emissions were not reduced. Fee 3 MCA Total Fee of Abatement Total Abatement Cost E* 12 Standards and Fees Dollars per unit of Emissions Level of Emissions Level of abatement

10. The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA2 < MCA1. MCA1 MCA2 If a fee of $3 was imposed Firm 1 emissions would fall From 14 to 8. Firm 2 emissions would fall from 14 to 6. MCA1 = MCA2: efficient solution. 3.75 Firm 1’s Increased Abatement Costs 2.50 Firm 2’s Reduced Abatement Costs The Case for Fees Fee per Unit of Emissions 6 The cost minimizing solution would be an abatement of 6 for firm 1 and 8 for firm 2 and MCA1= MCA2 = $3. 5 4 3 2 1 Level of Emissions 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

11. Ways of Correcting Market Failure • Standards Versus Fees • Assumptions • Policymakers have asymmetric information • Administrative costs require the same fee or standard for all firms • Advantages of Fees • When equal standards must be used, fees achieve the same emission abatement at lower cost. • Fees create an incentive to install equipment that would reduce emissions further.

12. Based on incomplete information fee is $7 (12.5% reduction). Emission increases to 11. C Marginal Social Cost ABC is the increase in social cost less the decrease in abatement cost. E A D B Based on incomplete information standard is 9 (12.5% decrease). ADE < ABC Marginal Cost of Abatement The Case for Standards Fee per Unit of Emissions 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 Level of Emissions

13. Transferable Emissions Permits as a Way of Correcting Market Failure • Permits help develop a competitive market for externalities. • Agency determines the level of emissions and number of permits • Permits are marketable • High cost firm will purchase permits from low cost firms • Cost of Reducing (Sulfur Dioxide )Emissions: • Conversion to natural gas from coal and oil • Emission control equipment • Benefits of Reducing Emissions: • Health • Reduction in corrosion • Aesthetic

14. Marginal Social Cost Marginal Abatement Cost Sulfur Dioxide Emissions Reductions Dollars per unit of reduction 60 • Observations • MAC = MSC @ .0275 • .0275 is slightly below actual emission level • Economic efficiency improved 40 20 Sulfur dioxide concentration (ppm) 0 0.02 0.04 0.06 0.08

15. Emissions Trading and Clean Air • Bubbles • Firm can adjust pollution controls for individual sources of pollutants as long as a total pollutant limit is not exceeded. • Offsets • New emissions must be offset by reducing existing emissions • 2000 offsets since 1979

16. Emissions Trading and Clean Air • Cost of achieving an 85% reduction in hydrocarbon emissions for DuPont • Three Options • 85% reduction at each source plant (total cost = $105.7 million) • 85% reduction at each plant with internal trading (total cost = $42.6 million) • 85% reduction at all plants with internal and external trading (total cost = $14.6 million) • 1990 Clean Air Act • Since 1990, the cost of the permits has fallen from an expected $300 to below $100. • Causes of the drop in permit prices • More efficient abatement techniques • Price of low sulfur coal has fallen