Chapter 5 Externalities Problems and Solutions Jonathan Gruber Public Finance and Public Policy...

Chapter 5ExternalitiesProblems and

Solutions

Jonathan GruberPublic Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction

Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.

As we will see, this represents a market failure for which government action could be appropriate and improve welfare.

Introduction

Externalities can be negative or positive: Acid rain, global warming, pollution, or

a neighbor’s loud music are all negative externalities.

Research and development or asking good questions in class are positive externalities.

Introduction

Consider global warming, a negative externality. Many scientists believe this warming trend is caused by human activity, namely the use of fossil fuels.

These fuels, such as coal, oil, natural gas, and gasoline produce carbon dioxide that in turn traps heat from the sun in the earth’s atmosphere.

Figure 1Figure 1 shows the trend in warming over the last century.

Figure 1

Global Average Temperature Over Time

56

56.5

57

57.5

58

58.5

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Year

Glo

bal

ave

rag

e te

mp

erat

ure

This table shows the global temperature during the 20th century.

There has been a distinct trend upward in temperature

Introduction Although this warming trend has negative

effects overall on society, the distributional consequences vary. In much of the United States, warmer

temperatures will improve agricultural output and quality of life.

In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea levels.

If you’re wondering why you should care about Bangladesh, then you have identified the market failure that arises from externalities.

From your private perspective, you shouldn’t!

EXTERNALITY THEORY

Externalities can either be negative or positive, and they can also arise on the supply side (production externalities) or the demand side (consumption externalities).

A negative production externality is when a firm’s production reduces the well-being of others who are not compensated by the firm.

A negative consumption externality is when an individual’s consumption reduces the well-being of others who are not compensated by the individual.

The basic concepts in positive externalities mirror those in negative externalities.

Economics of Negative Production Externalities

To understand the case of negative production externalities, consider the following example: A profit-maximizing steel firm, as a by-product of

its production, dumps sludge into a river. The fishermen downstream are harmed by this

activity, as the fish die and their profits fall. This is a negative production externalities

because: Fishermen downstream are adversely affected. And they are not compensated for this harm.

Figure 2Figure 2 illustrates each party’s incentives in this situation.

Price of steel

p1

p2

0 Q2 Q1

This framework does not capture the harm done to

the fishery, however.

The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q1.

QSTEEL

D = PMB = SMB

S=PMCSMC = PMC + MD

MD

Figure 2 Negative Production Externalities

The socially optimal level of production is at Q2, the

intersection of SMC and SMB.

The yellow triangle is the consumer and producer

surplus at Q1.The marginal damage

curve (MD) represents the fishery’s harm per unit.

The social marginal cost is the sum of PMC and MD, and represents the cost to society.

The red triangle is the deadweight loss from the private production level.

The steel firm overproduces from society’s viewpoint.


The steel firm’s privately optimal production solves:

This yields a quantity of steel Q1 at a price of P1.

PMB PMC


The steel firm’s emits pollution causing damage to the fishery. This is represented by the marginal damage curve. Ideally, the fishery prefers:

This would yield zero steel production, which is obviously not in the steel firm’s best interests.

MD 0


The social marginal cost accounts for both the direct costs to the steel firm and the indirect harm to the fishery:

We find the socially optimal quantity of steel Q2 at a price of P2, by solving:

SMC PMC MD

SMC SM B


The socially optimal quantity entails less production of steel. By doing so, the steel firm would be worse off but the fishery would be better off. Graphically, this triangle in between the

PMB and PMC curves from Q2 to Q1.

The damage to the fishery is reduced as well. Graphically, this is the area under the

MD curve from Q2 to Q1.


The deadweight loss from the original production level Q1 is graphically illustrated as the triangle in between the SMC and SMB curves from Q2 to Q1.

Note that the SMB equals the PMB curve in this case.

Negative Consumption Externalities

We now move on to negative consumption externalities. Consider the following example: A person at a restaurant smokes cigarettes. That smoking has a negative effect on your

enjoyment of the restaurant meal. In this case, the consumption of a good

reduces the well-being of someone else. Figure 3Figure 3 illustrates each party’s incentives

in the presence of a negative consumption externality.

QCIGARETTES

Price of cigarettes

0 Q2

D=PMB

Q1

p1

S=PMC=SMC

SMB=PMB-MD

MDp2

The yellow triangle is the surplus to the smokers (and producers) at Q1.

This framework does not capture the harm done to non-smokers, however.

The smoker sets PMB=PMC to find his

privately optimal quantity of cigarettes, Q1.The MD curve represents

the nonsmoker’s harm per pack of cigarettes.

The social marginal benefit is the difference between PMB

and MD.

The socially optimal level of smoking is at Q2, the

intersection of SMC and SMB.

The smoker consumes too many cigarettes from society’s

viewpoint.


Figure 3 Negative Consumption Externalities


The smoker’s privately optimal quantity solves:

This yields a quantity of cigarettes Q1 at a price of P1. The surplus is the same as before.

PMB PMC


The smoker’s consumption causes damage to the other restaurant patrons. They would prefer:

This would yield zero cigarette smoking, which is detrimental to the smoker.

MD 0


The social marginal benefit accounts for both the direct benefit to the smoker and the indirect harm to the other patrons:

We find the socially optimal quantity of cigarettes Q2 at a price of P2, by solving:

SM B PMB MD

SMC SM B


The socially optimal quantity entails less smoking. By doing so, the cigarette smoker is worse off, but the other patrons are better off. The surplus to the smoker (and tobacco companies) falls. Graphically, this is the triangle in between

the PMB and PMC curves from Q2 to Q1.

The harm to other restaurant patrons is reduced as well. Graphically, this is the area under the MD

curve from Q2 to Q1.


The deadweight loss from the original consumption level Q1 is illustrated graphically as the triangle in between the SMC and SMB curves from Q2 to Q1.

Note that the SMC equals the PMC curve in this case.

The Externality of SUVsThe Externality of SUVs

Consider a real-life example: the use of sport utility vehicles (SUVs). They create three sorts of externalities: Environmental externalities: They consume

a lot of gasoline and create more pollution. Wear and tear on roads: SUV drivers do

not bear the costs that result from their vehicles.

Safety externalities: When SUVs are in accidents, the other drivers are often more severely injured.

Applicati

Applicati

onon

Positive Externalities

Positive externalities can occur in production or consumption.

A positive production externality is when a firm’s production increases the well-being of others, but the firm is not compensated by those others. Research and development is a production

externality. A positive consumption externality is when an

individual’s consumption increases the well-being of others, but the individual is not compensated by those others. Nice landscaping could be a consumption externality.


Let’s consider positive production externalities. Consider the following example: A policeman buys donuts near your home. As a consequence, the neighbors are safer

because of the policeman’s continued presence. In this case, the production of donuts increases

the well-being of the neighbors. Figure 4Figure 4 illustrates each party’s incentives in

the presence of a positive production externality.

QDONUTS

Price of donuts

0 Q2

D = PMB = SMB

Q1

p1

S = PMC

SMC = PMC -EMB

EMB

p2

The social marginal cost subtracts EMB from PMC.

The socially optimal level of donuts is at Q2, the intersection

of SMC and SMB.

This framework does not capture the benefit to the

neighbors, however.

The yellow triangle is the consumer and producer

surplus at Q1.

The donut shop sets PMB = PMC to find its privately optimal profit maximizing

output, Q1.The external marginal benefit (EMB) represents

the neighbor’s benefit.The donut shop underproduces

from society’s viewpoint.


Figure 4 Positive Production Externalities


The donut shop’s privately optimal production solves:

This yields a quantity of donuts Q1 at a price of P1.

PMB PMC


The shop creates positive externalities to the neighbors through the presence of police. This is represented by the external marginal benefit. Ideally, the neighbors prefer:

This would yield much more donut production, which is obviously not in shop’s best interests.

EMB 0


The social marginal cost accounts for both the direct costs to the donut shop and the indirect benefit to the neighbors:

We find the socially optimal quantity of donuts Q2 at a price of P2, by solving:

SMC PMC EMB

SMC SM B


The socially optimal quantity entails more production of donuts. By doing so, the donut shop would be worse off but the neighbors would be better off. The consumer and producer surplus fall. Graphically, this triangle is between the

PMC and PMB curves from Q1 to Q2.

The benefit to the neighbors is increased as well. It goes up. Graphically, this is the area under the EMB

curve from Q1 to Q2.


The deadweight loss from the original donut production level Q1 is graphically illustrated by the triangle in between the SMB and SMC curves from Q1 to Q2.

Note that the SMB equals the PMB curve in this case.


Finally, there can be positive consumption externalities.

A neighbor’s improved landscape is a good example of this.

The graphical analysis is similar to negative consumption externalities, except that the SMB curve shifts outward, not inward.


The theory shows that when a negative externality is present, the private market will produce too much of the good, creating deadweight loss.

When a positive externality is present, the private market produces too little of the good, again creating deadweight loss.

The Solution (Coase Theorem)

The Coase Theorem: When there are well-defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level.

Thus, the role of government intervention may be very limited—that of simply enforcing property rights.


Consider the Coase Theorem in the context of the negative production externality example from before.

Give the fishermen property rights over the amount of steel production.

Figure 5Figure 5 illustrates this scenario.

QSTEEL

Price of steel

0 Q2

D = PMB SMB

Q1

p1

S = PMCSMC = PMC + MD

MD

p2

But there is room to bargain. The steel firm gets a lot of surplus from the first unit.

1 2

This bargaining process will continue until the socially

efficient level.

There is still room to bargain. The steel firm gets a bit less surplus from the second unit.

Thus, it is possible for the steel firm to “bribe” the fishery in

order to produce the first unit.

The reason is because any steel production makes the

fishery worse off.

Thus, it is possible for the steel firm to “bribe” the fishery in

order to produce the next unit.

If the fishery had property rights, it would initially impose

zero steel production.

While the fishery suffers only a modest amount of damage.

While the fishery suffers the same damage as from the

first unit.

Figure 5 Negative Production Externalities and Bargaining

The gain to society is this area, the difference between (PMB -PMC)

and MD for the second unit.

The gain to society is this area, the difference between (PMB -PMC) and MD for the first unit.

The Solution (Coase theorem)

Through a process of bargaining, the steel firm will bribe the fishery to arrive at Q2, the socially optimal level.

After that point, the MD exceeds (PMB - PMC), so the steel firm cannot come up with a large enough bribe to expand production further.


Another implication of the Coase Theorem is that the efficient solution does not depend on which party is assigned the property rights, as long as someone is assigned them.

The direction in which the bribes go does depend on the assignment, however.

Now, let’s give the property rights to the steel firm over the amount of steel production.

Figure 6Figure 6 illustrates this scenario.

Figure 6 Negative Production Externalities and Bargaining

QSTEEL

Price of steel

0 Q2

D=PMB=SMB

Q1

p1


MD

p2

The fishery gets a lot of surplus from cutting back

steel production by one unit.

This level of production maximizes the consumer and

producer surplus.

If the steel firm had property rights, it would initially choose

Q1.

While the steel firm suffers a larger loss in profits.

The gain to society is this area, the difference between MD and (PMB-

PMC) by cutting back 1 unit.While the steel firm suffers

only a modest loss in profits.

The gain to society is this area, the difference between MD and (PMB -

PMC) by cutting another unit.

This bargaining process will continue until the socially

efficient level.

Thus, it is possible for the fishery to “bribe” the steel firm

to cut back another unit.

Thus, it is possible for the fishery to “bribe” the steel firm

to cut back.

The fishery gets the same surplus as cutting back from

the first unit.


Figure 6Figure 6 shows that even though the bargaining process is somewhat different, the socially efficient quantity of Q2 is achieved.

Problems with Coasian Solutions

There are several problems with the Coase Theorem, however. The assignment problem The holdout problem The free rider problem Transaction costs and negotiating

problems


The “assignment problem” relates to two issues: It can be difficult to truly assign blame. It is hard to value the marginal damage

in reality.


The “holdout problem” arises when the property rights in question are held by more than one party. The shared property rights give each

party power over all others. This could lead to a breakdown in

negotiations.


The “free rider” problem is that when an investment has a personal cost but a common benefit, individuals will underinvest. For example, if the steel firm were

assigned property rights and you are the last (of many) fishermen to pay, the bribe is larger than the marginal damage to you personally.


Finally, it is hard to negotiate when there are large numbers of individuals on one or both sides.


In summary, the Coase Theorem is provocative, but perhaps not terribly relevant to many of the most pressing environmental problems.

PUBLIC-SECTOR REMEDIES FOR EXTERNALITIES

Coasian solutions are insufficient to deal with large scale externalities. Public policy makes use of three types of remedies to address negative externalities: Corrective taxation Subsidies Regulation

Corrective Taxation

The government can impose a “Pigouvian” tax on the steel firm, which lower its output and reduces deadweight loss.

If the per-unit tax equals the marginal damage at the socially optimal quantity, the firm will cut back to that point.

Figure 7Figure 7 illustrates such a tax.

QSTEEL

Price of steel

0 Q2

D = PMB = SMB

Q1

p1

S=PMCSMC=PMC+MD

p2

The steel firm initially produces at Q1, the intersection of PMC

and PMB.Imposing a tax shifts the PMC

curve upward and reduces steel production.

S=PMC+tax

Imposing a tax equal to the MD shifts the PMC curve such that

it equals SMC.

The socially optimal level of production, Q2, then maximizes

profits.

Figure 7 Pigouvian Tax

Corrective Taxation

The Pigouvian tax essentially shifts the private marginal cost.

The firm cuts back output, which is a good thing when there is a negative externality.

Corrective Taxation

The steel firm’s privately optimal production solves:

When the tax equals MD, this becomes:

But this last equation is simply the one used to determine the efficient level of production.

PMB PMC tax

PMB PMC MD SMC

Subsidies

The government can impose a “Pigouvian” subsidy on producers of positive externalities, which increases its output.

If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point.

Figure 8Figure 8 illustrates such a subsidy.

QDONUTS

Price of donuts

0 Q2

D = PMB = SMB

Q1

p1

S = PMC

SMC=PMC-EMB

p2

The donut shop initially chooses Q1, maximizing its

profits.

Providing a subsidy shifts the PMC curve downward.

The socially optimal level of donuts, Q2, is achieved by such

a subsidy.

Providing a subsidy equal to EMB shifts the PMC

curve downward to SMC.

Figure 8 Pigouvian Subsidy

Subsidies

The subsidy also shifts the private marginal cost.

The firm cuts expand output, which is a good thing when there is a positive externality.

Subsidies

The donut shop’s production solves:

When the subsidy equals EMB, this becomes:

But this last equation is simply the one used to determine the efficient level of production.

PMB PMC subs idy

PMB PMC EMB SMC

Regulation

Finally, the government can impose quantity regulation, rather than relying on the price mechanism.

For example, return to the steel firm in Figure 9Figure 9.

QSTEEL

Price of steel

0 Q2

D = PMB = SMB

Q1

p1


p2

The firm has an incentive to produce Q1.

Yet the government could simply require it to produce no

more than Q2.

Figure 9 Quantity Regulation

Regulation

In an ideal world, Pigouvian taxation and quantity regulation give identical policy outcomes.

In practice, there are complications that may make taxes a more effective means of addressing externalities.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO

ADDRESSING EXTERNALITIES

The key goal is, for any reduction in pollution, to find the least-cost means of achieving that reduction.

One approach could simply be to reduce output.

Another approach would be to adopt pollution-reduction technology.



The models we have relied on so far have examined reductions in output. Thus, we will modify this.

Our basic model now examines pollution reduction, rather than say, steel production.

Figure 10Figure 10 illustrates its features.

Figure 10 Model of Pollution Reduction

On its own, the steel company would set QR=0 and QSteel=Q1.

QR

PR

0

MD = SMB

R*

S=PMC=SMC

D = PMB

S=PMC

While it faces increasing marginal costs from reducing

its pollution level.

While the benefit of pollution reduction is zero the firm, society benefits by MD.

The good that is being created is “pollution reduction.”

Since it pays for the pollution reduction, the SMC is the same

as PMC.

Pollution reduction has a price associated with it.

The steel firm’s private marginal benefit from pollution

reduction is zero.Such an action maximizes its profits.

The optimal level of pollution reduction is therefore R*.

RFull

At some level of pollution reduction, the firm has achieved

full pollution reduction.

More pollution

P*PFull 0

Thus, the x-axis also measures pollution levels as we move

toward the origin.


ADDRESSING EXTERNALITIES As Figure 10Figure 10 shows, the private market

outcome is zero pollution reduction, while the socially efficient level is higher.

In the figure, the optimal tax would simply be MD– the firm would reduce pollution levels to R*, because its MC is less than the tax up until that point, but no further.

Quantity regulation is even simpler–just mandate pollution reduction of R*.



Assume now there are two firms, with different technologies for reducing pollution.

Assume firm “A” is more efficient than firm “B” at such reduction.

Figure 11Figure 11 illustrates the situation.

QR

PR

0

MD=SMB

R*

S = PMCA + PMCB = SMC

Firm B has relatively inefficient pollution

reduction technology.

PMCB PMCA

PMCB

PMCA

For any given output level, PMCB>PMCA.

While Firm A’s is more efficient.

The SMB curve is the same as before.

RA,RB

Quantity regulation in this way is clearly inefficient,

since Firm B is “worse” at reducing pollution.

If, instead, we got more reduction from Firm A, we could lower the total social

cost.

RARB

The efficient level of pollution reduction is the same as before.

To get the total marginal cost, we sum

horizontally.Efficient regulation is

where the marginal cost of pollution reduction for each firm equals SMB.

Quantity regulation could involve equal reductions in

pollution by both firms, such that R1 + R2 = R*.

Imposing a Pigouvian tax equal to MD induces these

levels of output.

Figure 11 Two Firms Emit Pollution



Figure 11Figure 11 shows that price regulation through taxes is more efficient than is quantity regulation.

A final option is quantity regulation with tradable permits. Idea is to: Issue permits that allow firms to pollute And allow firms to trade the permits


ADDRESSING EXTERNALITIES As in the previous figure, initially the permits

might be assigned as quantity regulation was assigned. This means that initially RA = RB.

But now Firm B has an interest in buying some of Firm A’s permits, since reducing its emissions costs PMCB (>PMCA). Both sides could be made better off by Firm A selling a permit to Firm B, and then Firm A simply reducing its pollution level. This trading process continue until PMCB=PMCA.



Finally, the government may not always know with certainty how costly it is for a firm to reduce its pollution levels.

Figure 12Figure 12 shows the case when the social marginal benefit is “locally flat.”

Figure 12 Model with Uncertainty and Locally Flat Benefits

QR

PR

0

MD = SMB

R1

PMC1

First, assume the SMB is downward sloping, but fairly

flat.

RFull

More pollution

PFull 0

This could be the case for global warming, for

example.

In addition, imagine that the government’s best

guess of costs is PMC1.

But it is possible for the firm’s costs to be PMC2.

PMC2

Regulation mandates R1.

If, instead, the government levied a tax, it would equal

MD at QR = R1.

Suppose the true costs are PMC2.

Then there is large deadweight loss.

This results in a much smaller DWL,

and much less pollution reduction.

R3



Figure 13Figure 13 shows the case when the social marginal benefit is “locally steep.”

Figure 13Model with Uncertainty and Locally Steep Benefits

QR

PR

0

MD = SMB

R1

PMC1

RFull

More pollution

PFull 0

In addition, imagine that the government’s best

guess of costs is PMC1.

But it is possible for the firm’s costs to be PMC2.

PMC2

Regulation mandates R1.

If, instead, the government levied a tax, it would equal

MD at QR = R1.

This results in a larger DWL, and

much less pollution reduction.

R3

First, assume the SMB is downward sloping, and fairly

steep.

This could be the case for nuclear

leakage, for example.

Suppose the true costs are PMC2.

Then there is small deadweight loss.


ADDRESSING EXTERNALITIES These figures show the implications for

choice of quantity regulation versus corrective taxes. The key issue is whether the government

wants to get the amount of pollution reduction correct, or to minimize firm costs.

Quantity regulation assures the desired level of pollution reduction. When it is important to get the right level (such as with nuclear leakage), this instrument works well.

However, corrective taxation protects firms against large cost overruns.

Recap of Externalities:Problems and Solutions

Externality theory Private-sector solutions Public-sector solutions Distinctions between price and quantity

approaches to addressing externalities

Chapter 5 Externalities Problems and Solutions Jonathan Gruber Public Finance and Public Policy...

Documents

Transcript of Chapter 5 Externalities Problems and Solutions Jonathan Gruber Public Finance and Public Policy...