Introduction

1. 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. • Externalities can be negative or positive: • Acid rain, bad. Asking good questions in class, good.

2. 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. • Positive externalities are similar to negative externalities, except the actions have beneficial effects for others.

3. Negative Production Externalities Figure 2 SMC = PMC + MD Price of steel S=PMC The steel firm sets PMB=PMC to find its privately optimal profit maximizing output, Q1. The yellow triangle is the consumer and producer surplus at Q1. The socially optimal level of production is at Q2, the intersection of SMC and SMB. The steel firm overproduces from society’s viewpoint. p2 The marginal damage curve (MD) represents the fishery’s harm per unit. This framework does not capture the harm done to the fishery, however. The red triangle is the deadweight loss from the private production level. The social marginal cost is the sum of PMC and MD, and represents the cost to society. p1 MD D = PMB = SMB 0 Q2 Q1 QSTEEL

4. 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 3 illustrates each party’s incentives in the presence of a negative consumption externality.

5. Negative Consumption Externalities Figure 3 Price of cigarettes S=PMC=SMC The yellow triangle is the surplus to the smokers (and producers) at Q1. 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. This framework does not capture the harm done to non-smokers, however. The social marginal benefit is the difference between PMB and MD. The red triangle is the deadweight loss from the private production level. p1 The smoker consumes too many cigarettes from society’s viewpoint. The socially optimal level of smoking is at Q2, the intersection of SMC and SMB. MD p2 D=PMB SMB=PMB-MD 0 Q2 Q1 QCIGARETTES

6. Externalities Result in Underproduction or Overproduction • 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.

7. 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.

8. Negative Production Externalities and Bargaining: Giving the Fish People Property Rights Figure 5 SMC = PMC + MD Price of steel This bargaining process will continue until the socially efficient level. S = PMC 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. p2 If the fishery had property rights, it would initially impose zero steel production. The reason is because any steel production makes the fishery worse off. p1 MD But there is room to bargain. The steel firm gets a lot of surplus from the first unit. Thus, it is possible for the steel firm to “bribe” the fishery in order to produce the next unit. While the fishery suffers only a modest amount of damage. While the fishery suffers the same damage as from the first unit. 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. D = PMBSMB 0 1 2 Q2 Q1 QSTEEL

9. Negative Production Externalities and Bargaining: Steel Producers Have Property Rights Figure 6 SMC = PMC + MD Price of steel S = PMC This bargaining process will continue until the socially efficient level. The gain to society is this area, the difference between MD and (PMB -PMC) by cutting another unit. The gain to society is this area, the difference between MD and (PMB-PMC) by cutting back 1 unit. If the steel firm had property rights, it would initially choose Q1. This level of production maximizes the consumer and producer surplus. While the steel firm suffers a larger loss in profits. While the steel firm suffers only a modest loss in profits. p2 p1 MD Thus, it is possible for the fishery to “bribe” the steel firm to cut back another unit. The fishery gets the same surplus as cutting back from the first unit. The fishery gets a lot of surplus from cutting back steel production by one unit. Thus, it is possible for the fishery to “bribe” the steel firm to cut back. D=PMB=SMB 0 Q2 Q1 QSTEEL

10. 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

11. Pigouvian Tax Figure 7 SMC=PMC+MD S=PMC+tax Price of steel S=PMC The socially optimal level of production, Q2, then maximizes profits. 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. Imposing a tax equal to the MD shifts the PMC curve such that it equals SMC. p1 D = PMB = SMB 0 Q2 Q1 QSTEEL

12. Quantity Regulation Figure 9 SMC = PMC + MD Price of steel S = PMC p2 The firm has an incentive to produce Q1. Yet the government could simply require it to produce no more than Q2. p1 D = PMB = SMB 0 Q2 QSTEEL Q1

13. Model of Pollution Reduction Figure 10 Since it pays for the pollution reduction, the SMC is the same as PMC. While it faces increasing marginal costs from reducing its pollution level. PR Pollution reduction has a price associated with it. S=PMC S=PMC=SMC The optimal level of pollution reduction is therefore R*. While the benefit of pollution reduction is zero the firm, society benefits by MD. MD = SMB Thus, the x-axis also measures pollution levels as we move toward the origin. At some level of pollution reduction, the firm has achieved full pollution reduction. The steel firm’s private marginal benefit from pollution reduction is zero. The good that is being created is “pollution reduction.” Such an action maximizes its profits. On its own, the steel company would set QR=0 and QSteel=Q1. D = PMB 0 R* RFull QR PFull P* 0 More pollution

14. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES • 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 11 illustrates the situation.

15. Two Firms Emit Pollution Figure 11 PR Firm B has relatively inefficient pollution reduction technology. While Firm A’s is more efficient. PMCB To get the total marginal cost, we sum horizontally. For any given output level, PMCB>PMCA. PMCA S = PMCA + PMCB = SMC Efficient regulation is where the marginal cost of pollution reduction for each firm equals SMB. PMCB 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. The SMB curve is the same as before. The efficient level of pollution reduction is the same as before. PMCA MD=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. 0 RB RA,RB RA R* QR

16. Model with Uncertainty and Locally Flat Benefits Figure 12 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. PR PMC2 Suppose the true costs are PMC2. Then there is large deadweight loss. PMC1 This results in a much smaller DWL, and much less pollution reduction. If, instead, the government levied a tax, it would equal MD at QR = R1. First, assume the SMB is downward sloping, but fairly flat. This could be the case for global warming, for example. MD = SMB Regulation mandates R1. R1 0 R3 RFull QR PFull 0 More pollution

17. Model with Uncertainty and Locally Steep Benefits Figure 13 But it is possible for the firm’s costs to be PMC2. In addition, imagine that the government’s best guess of costs is PMC1. PR PMC2 Suppose the true costs are PMC2. Then there is small deadweight loss. PMC1 This results in a larger DWL, and much less pollution reduction. If, instead, the government levied a tax, it would equal MD at QR = R1. This could be the case for nuclear leakage, for example. First, assume the SMB is downward sloping, and fairly steep. Regulation mandates R1. MD = SMB R1 0 R3 RFull QR PFull 0 More pollution

18. DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO 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.