Principles of MicroPrinciples of Micro

Chapter 10: ExternalitiesChapter 10: Externalities

by Tanya Molodtsova, Fall 2005

We Will Learn:We Will Learn: what an externality is what an externality is why externalities can make why externalities can make

market outcomes inefficient.market outcomes inefficient. how people can sometimes how people can sometimes

solve the problem of solve the problem of externalities on their own.externalities on their own.

why private solutions to why private solutions to externalities sometimes do externalities sometimes do not work.not work.

the various government the various government policies aimed at solving the policies aimed at solving the problem of externalities problem of externalities

Introduction Introduction

Recall: Adam Smith’s “invisible Recall: Adam Smith’s “invisible hand” of the marketplace leads hand” of the marketplace leads self-interested buyers and sellers self-interested buyers and sellers in a market to maximize the total in a market to maximize the total benefit that society can derive benefit that society can derive from a marketfrom a market

But market failures can still But market failures can still happen.happen.

Externalities and Market Externalities and Market InefficiencyInefficiency

externalityexternality: the : the uncompensated impact of uncompensated impact of one person’s actions on the one person’s actions on the well-being of a bystander. well-being of a bystander.

1.1. - If the effect on the - If the effect on the bystander is adverse, there is bystander is adverse, there is a a negativenegative externality. externality.

2.2. -- If the effect on the If the effect on the bystander is beneficial, there bystander is beneficial, there is a is a positivepositive externality externality

Externalities and Market Externalities and Market InefficiencyInefficiency

An externality arises...An externality arises.... . . when a person engages in an . . . when a person engages in an

activity that influences the well-activity that influences the well-being of a bystander and yet neither being of a bystander and yet neither pays nor receives any pays nor receives any compensation for that effect.compensation for that effect.

Externalities cause markets to be Externalities cause markets to be inefficient, and thus fail to maximize inefficient, and thus fail to maximize total surplus.total surplus.

Externalities and Market Externalities and Market InefficiencyInefficiency Negative ExternalitiesNegative Externalities

Automobile exhaustAutomobile exhaust Cigarette smokingCigarette smoking Barking dogs (loud pets)Barking dogs (loud pets) Loud stereos in an apartment Loud stereos in an apartment

buildingbuilding Positive ExternalitiesPositive Externalities

ImmunizationsImmunizations Restored historic buildingsRestored historic buildings Research into new technologiesResearch into new technologies

Welfare Economics: A Recap Welfare Economics: A Recap

The Market for Aluminum The Market for Aluminum The quantity produced and consumed The quantity produced and consumed

in the market equilibrium is efficient (it in the market equilibrium is efficient (it maximizes the sum of producer and maximizes the sum of producer and consumer surpluses).consumer surpluses).

If the aluminum factories emit pollution If the aluminum factories emit pollution (a negative externality), then the cost (a negative externality), then the cost to society of producing aluminum is to society of producing aluminum is larger than the cost to aluminum larger than the cost to aluminum producers.producers.

Welfare Economics: A Welfare Economics: A RecapRecap

For each unit of aluminum For each unit of aluminum produced, the produced, the social costsocial cost includes includes the private costs of the producers the private costs of the producers plus the cost to those bystanders plus the cost to those bystanders adversely affected by the pollutionadversely affected by the pollution

Pollution and the Social Pollution and the Social OptimumOptimum

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand(private value)

Supply(private cost)

Socialcost

QOPTIMUM

Optimum

Cost ofpollution

QMARKET

Negative ExternalitiesNegative Externalities The intersection of the demand The intersection of the demand

curve and the social-cost curve curve and the social-cost curve determines the optimal output determines the optimal output level.level.

The socially optimal output level The socially optimal output level is is less thanless than the market equilibrium the market equilibrium quantity.quantity.

Negative ExternalitiesNegative Externalities Achieving the Socially Optimal Achieving the Socially Optimal

Output:Output: The government can internalize The government can internalize

an externality by imposing a tax an externality by imposing a tax on the producer to reduce the on the producer to reduce the equilibrium quantity to the equilibrium quantity to the socially desirable quantity. socially desirable quantity.

internalizing an externalityinternalizing an externality: : altering incentives so that altering incentives so that people take account of the people take account of the external effects of their external effects of their actions.actions.

Positive ExternalitiesPositive Externalities When an externality When an externality benefitsbenefits the the

bystanders, a positive externality bystanders, a positive externality exists.exists. The social value of the good exceeds The social value of the good exceeds

the private value.the private value. technology spillover is a type of technology spillover is a type of

positive externality that exists when positive externality that exists when a firm’s innovation not only benefits a firm’s innovation not only benefits the firm, but enters society’s pool of the firm, but enters society’s pool of technological knowledge and technological knowledge and benefits society as a whole.benefits society as a whole.

Education and the Social Education and the Social OptimumOptimum

Quantity ofEducation

0

Price ofEducation

Demand(private value)

Socialvalue

Supply(private cost)

QMARKETQOPTIMUM

Positive ExternalitiesPositive Externalities

The intersection of the supply The intersection of the supply curve and the social-value curve curve and the social-value curve determines the optimal output determines the optimal output level.level.

The optimal output level is more than The optimal output level is more than the equilibrium quantity.the equilibrium quantity.

The market produces aThe market produces a smaller smaller quantity than is socially desirable. quantity than is socially desirable.

The social value of the good The social value of the good exceeds the private value of the exceeds the private value of the good.good.

Positive ExternalitiesPositive Externalities Internalizing Externalities: SubsidiesInternalizing Externalities: Subsidies

the primary method for attempting to the primary method for attempting to internalize positive externalities.internalize positive externalities.

Industrial Policies: government Industrial Policies: government intervention in the economy that aims to intervention in the economy that aims to promote technology-enhancing promote technology-enhancing industriesindustries

Patent laws: aPatent laws: a form of technology form of technology policy that give the individual (or policy that give the individual (or firm) with patent protection a firm) with patent protection a property rightproperty right over its invention. over its invention.

The patent is then said to The patent is then said to internalizeinternalize the externality. the externality.

Private Solutions to Private Solutions to Externalities Externalities

Government action is not always Government action is not always needed to solve the problem of needed to solve the problem of externalities.externalities.

The Types of Private The Types of Private SolutionsSolutions::

1.1. Moral codes and social sanctionMoral codes and social sanction

2.2. Charitable organizationsCharitable organizations

3.3. Integrating different types of Integrating different types of businessesbusinesses

4.4. Contracting between partiesContracting between parties

The Coase Theorem The Coase Theorem The Coase theoremThe Coase theorem: the proposition : the proposition

that if private parties can bargain that if private parties can bargain without cost over the allocation of without cost over the allocation of resources, they can solve the problem resources, they can solve the problem of externalities on their own.of externalities on their own.

Example: John owns a dog that Example: John owns a dog that disturbs a neighbor (Jane) with its disturbs a neighbor (Jane) with its barking.barking.

a.a. One possible solution: Jane pays One possible solution: Jane pays Dick to get rid of the dog.  Dick to get rid of the dog.  

b.b. Another solution: Dick could pay Another solution: Dick could pay Jane to let him keep the dog.Jane to let him keep the dog.

Why Private Solutions Do Why Private Solutions Do Not Always Work Not Always Work transaction costs: the costs that parties

incur in the process of agreeing and following through on a bargain.

 Coordination of all of the interested parties may be difficult so that bargaining breaks down. This is especially true when the number of interested parties is large.

Sometimes the private solution Sometimes the private solution approach fails because transaction approach fails because transaction costs can be so high that private costs can be so high that private agreement is not possible.agreement is not possible.

Public Policies toward Public Policies toward ExternalitiesExternalities When externalities are significant When externalities are significant

and private solutions are not and private solutions are not found, government may attempt found, government may attempt to solve the problem through . . .to solve the problem through . . .

Command and control policies: Command and control policies: regulate behavior directlyregulate behavior directly..

market-based policies: market-based policies: provide provide incentives so that private incentives so that private decisionmakers will choose to solve decisionmakers will choose to solve the problem on their own.the problem on their own.

Public Policies toward Public Policies toward ExternalitiesExternalities Command-and-Control PoliciesCommand-and-Control Policies

Usually take the form of Usually take the form of regulations: regulations:

Forbid certain behaviors.Forbid certain behaviors. Require certain behaviors.Require certain behaviors.

Examples:Examples: Requirements that all students be Requirements that all students be

immunized.immunized. Stipulations on pollution emission Stipulations on pollution emission

levels set by the Environmental levels set by the Environmental Protection Agency (EPA).Protection Agency (EPA).

Public Policies toward Public Policies toward ExternalitiesExternalities Market-Based PoliciesMarket-Based Policies

Government uses taxes and Government uses taxes and subsidies to align private incentives subsidies to align private incentives with social efficiency.with social efficiency.

Pigovian taxesPigovian taxes are taxes enacted to are taxes enacted to correct the effects of a negative correct the effects of a negative externality.externality.

Public Policies toward Public Policies toward ExternalitiesExternalities Examples of Regulation versus Examples of Regulation versus

Pigouvian Tax Pigouvian Tax If the EPA decides it wants to reduce If the EPA decides it wants to reduce

the amount of pollution coming from a the amount of pollution coming from a specific plant. The EPA could…specific plant. The EPA could…

tell the firm to reduce its pollution by a tell the firm to reduce its pollution by a specific amount (i.e. regulation).specific amount (i.e. regulation).

levy a tax of a given amount for each levy a tax of a given amount for each unit of pollution the firm emits (i.e. unit of pollution the firm emits (i.e. Pigovian tax).Pigovian tax).

Public Policies toward Public Policies toward ExternalitiesExternalities

Market-Based Policies:Market-Based Policies: Tradable pollution permitsTradable pollution permits allow theallow the

voluntary transfer of the right to voluntary transfer of the right to pollute from one firm to another. pollute from one firm to another. A market for these permits will A market for these permits will

eventually develop.eventually develop. A firm that can reduce pollution at a low A firm that can reduce pollution at a low

cost may prefer to sell its permit to a cost may prefer to sell its permit to a firm that can reduce pollution only at a firm that can reduce pollution only at a high cost. high cost.

The Equivalence of Pigovian The Equivalence of Pigovian Taxes and Pollution PermitsTaxes and Pollution Permits

Quantity ofPollution

0

Price ofPollution

Demand forpollution rights

P Pigoviantax

(a) Pigouvian Tax

2. . . . which, togetherwith the demand curve,determines the quantityof pollution.

1. A Pigoviantax sets theprice ofpollution . . .

Q

The Equivalence of Pigovian The Equivalence of Pigovian Taxes and Pollution PermitsTaxes and Pollution Permits

Quantity ofPollution

0

Demand forpollution rights

Q

Supply ofpollution permits

(b) Pollution Permits

Price ofPollution

2. . . . which, togetherwith the demand curve,determines the priceof pollution.

1. Pollutionpermits setthe quantityof pollution . . .

P

Pigouvian Taxes and Pigouvian Taxes and SubsidiesSubsidies These taxes are preferred over These taxes are preferred over

regulation, because firms that can regulation, because firms that can reduce pollution with the least cost reduce pollution with the least cost are likely to do so (to avoid the tax) are likely to do so (to avoid the tax) while firms that encounter high costs while firms that encounter high costs when reducing pollution will simply when reducing pollution will simply pay the tax.pay the tax.

Unlike other taxes, Pigouvian taxes Unlike other taxes, Pigouvian taxes do not cause a reduction in total do not cause a reduction in total surplus. In fact, they increase surplus. In fact, they increase economic well-being by forcing economic well-being by forcing decisionmakers to take into account decisionmakers to take into account the cost of all of the resources being the cost of all of the resources being used when making decisions. used when making decisions.

The Equivalence of Pigovian The Equivalence of Pigovian Taxes and Pollution PermitsTaxes and Pollution Permits

Tradable pollution permits and Tradable pollution permits and Pigouvian taxes are similar in effect. Pigouvian taxes are similar in effect. In both cases, firms must pay for the In both cases, firms must pay for the right to pollute.right to pollute.

In the case of the tax, the In the case of the tax, the government sets the price of government sets the price of pollution and firms then choose the pollution and firms then choose the level of pollution (given the tax) that level of pollution (given the tax) that maximizes their profit.maximizes their profit.

If tradable pollution permits are used, If tradable pollution permits are used, the government chooses the level of the government chooses the level of pollution (in total, for all firms) and pollution (in total, for all firms) and firms then decide what they are firms then decide what they are willing to pay for these permits.willing to pay for these permits.

SummarySummary

When a transaction between a buyer When a transaction between a buyer and a seller directly affects a third and a seller directly affects a third party, the effect is called an party, the effect is called an externality.externality.

Negative externalities cause the Negative externalities cause the socially optimal quantity in a market socially optimal quantity in a market to be less than the equilibrium to be less than the equilibrium quantity.quantity.

Positive externalities cause the Positive externalities cause the socially optimal quantity in a market socially optimal quantity in a market to be greater than the equilibrium to be greater than the equilibrium quantity.quantity.

SummarySummary

Those affected by externalities Those affected by externalities can sometimes solve the can sometimes solve the problem privately.problem privately.

The Coase theorem states that The Coase theorem states that if people can bargain without a if people can bargain without a cost, then they can always cost, then they can always reach an agreement in which reach an agreement in which resources are allocated resources are allocated efficiently.efficiently.

SummarySummary

When private parties cannot When private parties cannot adequately deal with externalities, adequately deal with externalities, then the government steps in.then the government steps in.

The government can either The government can either regulate behavior or internalize regulate behavior or internalize the externality by using Pigouvian the externality by using Pigouvian taxes or by issuing pollution taxes or by issuing pollution permits.permits.