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Chapter 3
Externalities and Public Policy
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ISBN 0-03-033652-X
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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 .
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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. This occurs when there is a negative externality.
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Social Costs
MSC = MPC + MEC
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Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency
D = MSB
S = MPC
MPC + MEC = MSC
10
Pri
ce,
Ben
efit
, an
d C
ost
(D
oll
ars)
Tons of Paper Per Year (Millions)
110
105
100
4.5 5
A
B
G
10
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Implications of Figure 3.1
Market equilibrium occurs where
MPC = MSBEfficiency Requires that
MSC = MPC + MEC = MSB
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Positive externalities
The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.
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Social Benefit
MSB = MPB + MEB
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Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency
S = MSC
MPB + MEB = MSBH
Z
U
V
Pri
ce,
Ben
efit
, an
d C
ost
(D
oll
ars)
Inoculations Per Year (Millions)
10
25
30
45
10 120
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Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output
S' = MSC'
C
B F
A
S = MSC
MPBi
MPBi + MEB = MSB
Pri
ce
, B
en
efi
t, a
nd
Co
st
(Do
llars
)
Inoculations per Year (Millions)
0
30
25
20
10 12 16 20
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Internalization of Externalities
An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions.
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Corrective Taxes to Negative Externalities
Setting a tax equal to the MEC will internalize a negative externality.
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Figure 3.4 A Corrective TaxP
rice
, B
enef
it,
and
Co
st (
Do
llar
s)
Tons of Paper Per Year (Millions)
100
5
110
105
95
4.5
D = MSB
S = MPC
A
S’ = MPC + T = MSC
Tax Revenue = TotalExternal Costs
T
Net Gains in Well-Being
GB
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Results of a Corrective Tax
Socially optimal levels of production are achieved.
The tax revenue is sufficient to pay costs to third parties.
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Using a Corrective Tax
The greenhouse effect and a “Carbon Tax” If it is accepted that the greenhouse effect
is caused by burning carbon-based fuels, a carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels.
It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.
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Theory of the Second Best
When one condition for an optimum is violated then maintaining the others will not guarantee a second-best solution.
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A Polluting Monopolist
In Chapter 2 it was shown that monopoly created a loss to society. In this chapter it was shown that 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.
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Figure 3.5 A Second Best Efficient Solution
D = MSB
MPC
MPC + MEC = MSC
MR
Pri
ce
Output per Year 0 Q M Q*
P M
A F
B
C
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Corrective Subsidies
Setting a subsidy equal to MEB will internalize a positive externality
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Subsidy Payments
Figure 3.6 A Corrective Subsidy
i
i
Y
D = MPB
D' = MPB + $20 = MSB
S = MSC
Pric
e, B
en
efit
, an
d C
ost
(D
olla
rs)
Inoculations per Year (Millions) 0
45
30
25
10
10 12
Z
V R
X
U
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Coase's Theorem
By establishing rights to use resources government can internalize externalities when transactions or bargaining costs are zero.
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Figure 3.7 Coase’s Theorem
B A
MCW MC* W
MPCB + MEC = MSC
MPCB
Pri
ce o
f B
eef
(Do
llar
s)
Pri
ce
of
Wh
eat
(D
olla
rs)
Wheat Output per Year
PW
Q* W QW1 Beef Output per Year
Q* B
QB1
PB
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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.
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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.
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Figure 3.8 Pollution Rights and Emissions
S = Supply of Pollution Rights
D = MSB of Emitting Wastes
Pri
ce
an
d M
arg
ina
l So
cia
l Be
ne
fit
Tons of Annual Emissions and Number of Pollution Rights
0
$20
75,000 100,000
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Figure 3.9 The Efficient Amount of Pollution Abatement
E
MSB
MSC M
arg
ina
l So
cia
l Co
st
an
d B
en
efi
t
Percent Reduction in Wastes Emitted per Year 0 A* 100
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Regulatory Solutions
Instead of using market forces to cause firms to internalize externalities we can use emission standards and apply these to all.
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Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of
Emissions
A MEC = MSC
MSB
MEC = MSC
MSB
B
C
F
QRB
QRA
G
H
0 QR
10
Firm A
10 Co
st a
nd
Ben
efit
(D
oll
ars)
Firm B
Q* A
Q* B
QB1
QB1
Tons of Emissions per Year
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Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions
MEC = MSC
MSB MEC = MSC
S
Y
Z T R
X
QRD
QRC
Firm C
Tons of Emissions per Year
Firm D
20
Q* C
QR
Q* D
QRC
ost
an
d B
enef
it (
Do
llar
s)
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Sulfur Dioxide Emission Prices
SOURCE: United States Environmental Protection Agency
250
200
150
100
50
0 8/1/94
Allo
wa
nc
e P
ric
e (
Do
llars
)
Month/Year
8/1/95 8/1/95 8/1/958/1/95 8/1/95
Fieldston Publications Price Index Cantor Fitzgerald Market Price Index
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Global Externalities
CFC’sDeforestationGlobal Warming
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