The economics of externalities

1. The economics of externalities Today: Graphical analysis Private responses Public responses

2. More on the externality problem Marginal damage will not be constant Private responses The Coase Theorem Mergers Social conventions Public responses Taxes Subsidies Command-and-control Cap-and-trade programs Today

3. The externality problem • With externalities, quantity produced is typically not optimal • Finding optimal quantity when marginal damage is not constant • Deadweight loss of inefficient production

4. Graphical analysis of externalities MSC = MPC + MD $ MPC h d g c MD f b MB a e 0 Q* Q1 Q per year Socially efficient output Actual output

5. Graphical analysis of externalities Producer surplus lost going from Q1 to Q*

6. Graphical analysis of externalities Consumer surplus gained going from Q1 to Q*

7. Graphical analysis of externalities Net social gain going from Q1 to Q*

8. Pollution • Pollution is one of the biggest negative externalities around • Multiple steps needed to try to find optimal amount of pollution • Which pollutants actually do damage? • Are there pollutants that indirectly cause damage? • Example: CFCs on the ozone layer • How do we value the damage done? • Very difficult to do, due to lack of markets

9. Pollution and empirical studies • Empirical studies have been done to try to determine the damages caused by pollution • Remember from Chapter 2 that we need to use events that prevent bias

10. Pollution and empirical studies • Chay and Greenstone (2003, 2005) • Pollution on health • 1 percent reduction in total suspended particulates resulted in a 0.35 percent reduction in infant mortality rate • Pollution on housing prices • Improved air quality between 1970 and 1980 in pollution-regulated cities led to property value increases of $45 billion

11. Costly negotiation • Negotiation is typically costly • Remember, time is worth something • Even if a resource is owned by someone, costly negotiation can prevent better outcomes from occurring

12. Coase theorem • The Coase theorem tells us the conditions needed to guarantee that efficient outcomes can occur • People can negotiate costlessly • The right can be purchased and sold • Property rights • Given the above conditions, efficient solutions can be negotiated Ronald Coase

13. Coase theorem • Notice that the Coase theorem addresses efficiency • To get to efficiency, the quantity of most goods and services produced is still positive • Example: It is not efficient to get rid of all pollution • If all pollution was gone, we could not live (since we exhale CO2)

14. Bargaining and the Coase Theorem MB exceeds MPC in this range  Production will be Q1 without negotiation MSC = MPC + MD $ MPC h d g c MD MB 0 Q* Q1 Q per year

15. Bargaining and the Coase Theorem MSC exceeds MB here  With costless bargaining, consumers will pay to reduce production from Q1 to Q* MSC = MPC + MD $ MPC h d g c MD MB 0 Q* Q1 Q per year

16. Other private responses to externalities • Mergers • When negative externalities only affect other firms, two firms can merge to internalize the externalities • Social convention • Social pressure to be nice can lower the amount of certain negative externalities

17. Public responses to externalities • Four public responses • Taxes • Also known as emissions fee in markets with pollution • Subsidies • Command-and-control • Government dictates standards without regard to cost • Cap-and-trade policies • Also known as a permit system

18. Taxes • With no externalities, taxes on goods in complete and competitive markets lead to deadweight loss • Quantity is below the optimal amount with taxes • With negative externalities, taxes can improve efficiency • The optimal tax is known as the Pigouvian tax • Pigouvian tax equals marginal damage at the efficient output • Increased Pigouvian taxes can also lead to lower income taxes without sacrificing overall tax revenue • Double dividend hypothesis (More in Chapter 15)

19. Pigouvian taxes in action MSC = MPC + MD $ (MPC + cd) Pigouviantax revenues MPC d i j c MD MB 0 Q* Q1 Q per year

20. Emissions fee • One way to implement Pigouvian taxes is to charge a tax on each unit of pollution, rather than on each unit of output • This kind of tax is known as an emissions fee

21. Emissions fee in action $ MC of abatement f* MSB of abatement 0 e* Abatement quantity

22. Subsidies • An alternative to taxes is providing a subsidy to each firm for every unit that it abates • Problems with subsidies: • Efficient outcome only with a fixed number of firms • Increased profits of firms in the industry will encourage new entrants into the industry • Positive economic profits if new entry is not allowed • Revenue is needed to provide subsidies • Taxing income reduces inefficiencies • Ethical issues: Who has the right to pollute?

23. Subsidies in action MSC = MPC + MD $ (MPC + cd) MPC Pigouviansubsidy d k i f g j h c MD MB e 0 Q* Q1 Q per year

24. Command-and-control pollution reduction • Two firms • Each would pollute 90 units if there are no pollution controls • Suppose each firm was forced to reduce pollution by 50 units • Known as uniform pollution reduction • Usually not efficient

25. 50 50 75 75 90 90 Uniform pollution reductions MC is for abatement on these graphs Total abatement costs are in red for each firm MCH $ $ MCB 25 Bart’spollutionreduction Homer’spollutionreduction

26. Inefficiencies of uniform reductions Notice that MC of Homer’s last unit of abatement is higher than Bart’s  D’oh $ $

27. Inefficiencies of uniform reductions Overall abatement costs can be reduced if Homer reduces abatement by 1 unit and Bart increases abatement by 1 unit $ $

28. Command-and-control regulation • Command-and-control regulations can take many forms • Uniform reductions • Percentage reductions • Technology standards • Each firm must use a certain type of technology • This method may work best when emissions cannot be monitored easily • Performance standards • Government sets emissions goal for each polluter • Firm can use any technology it wants • Less expensive than technology standards

29. Lowering abatement costs • Going from command-and-control requirements to emissions fees can lower overall abatement costs • Marginal cost of abatement of the last unit is equal for each firm with an emissions fee

30. 50 50 75 75 90 90 Emissions fees MC is for abatement on these graphs MCH Bart’s TaxPayment Homer’s TaxPayment MCB f = $50 f = $50 25 Bart’spollutionreduction Homer’spollutionreduction

31. Cap-and-trade policies • Policy in which a permit is needed for each unit of pollution emitted • Permits can be traded • Policy is efficient if • Bargaining costs are negligible • Competitive permit markets exist • Number of permits matches efficient pollution level • Initial allocation of permits does not affect efficiency as long as the above criteria are met

32. 50 50 75 75 90 90 Cap-and-trade Bart and Homer will negotiate until they agree on a $50 price for permits Suppose Bart starts with 80 permits and Homer starts with none (see points a and b) MCH b MCB f = $50 f = $50 a 10 25 Bart’spollutionreduction Homer’spollutionreduction Bart sells 65 permits Homer buys 65 permits

33. Emissions fee versus cap-and-trade • Given certain conditions, we notice that an emissions fee and cap-and-trade policies lead to the same result for efficiency • $50 fee for each unit polluted (implicit fee under permits) • Bart reduces pollution by 75 units • Homer reduces pollution by 25 units

34. The real world is more complicated • We do not live in a world with perfect economic assumptions • Complicating factors • Inflation • Cost changes • Uncertainty • Distributional effects

35. Inflation • If emissions fees do not represent real prices, the amount of pollution will change as real price changes • Cap-and-trade policies do not need inflation factored in, since quantity limits are used

36. Cost changes • Suppose cost to abate decreases every year • Optimal amount of abatement will increase each year • If a new abatement technology is just being developed, future cost changes could be small or large • Potential solution: Impose a hybrid system • Permit market • Offer a high tax for pollution emitted without a permit

37. Uncertainty • Costs and benefits are typically not known with certainty • With uncertainty, too much or too little pollution can be produced (relative to the efficient outcome) • Two situations analyzed, with MC curve uncertain • Inelastic MSB • Elastic MSB

38. Inelastic MSB curve Marginal cost schedule could be as high as MC’ MC’ $ MC* Assume best guess of marginal cost schedule is MC* f* Permits are closer to efficient than fees in this case MSB 0 ef e’ e* Pollution reduction Too little pollution reduction with fees Too much pollution reduction with permits

39. Elastic MSB curve MC’ $ MC* f* Fees are closer to efficient than permits in this case MSB 0 ef e’ e* Pollution reduction Too little pollution reduction with fees Too much pollution reduction with permits

40. Distributional effects • Firms… • Lose when they pay a tax • Win when they are given permits • Government can generate revenue… • If a tax is imposed • If permits are sold • Double dividend hypothesis supports taxes or selling permits • Political pressure may encourage permit giveaways

41. Distributional effects • Since efficiency relates to willingness to pay, poor neighborhoods should have more pollution than rich neighborhoods • Displacement concerns • Job losses from environmental regulation: Does this increase income inequity? • Who bears the cost of pollution control? • Depends on who uses the good that has the pollution control • Example: Cars that are 15 or more years old

42. Externalities can be positive • Remember that not all externalities are negative • Some consumption leads to external benefits to others • Recall some examples • Planting flowers in your front lawn • Scientific research • Vaccination • Prevents others from getting a disease from you

43. Positive externalities and subsidies • Subsidies can be used to increase efficiency in the presence of positive externalities • Note that this money must be generated from somewhere, probably taxes • Recall that tax money used for subsidies has its own deadweight loss • Compare DWL with efficiency gains from the subsidy

44. Positive externality example $ MC MSB = MPB + MEB MPB MEB R1 R* Researchper year

45. In what direction are we heading? • Command-and-control policies often rely on states to enforce • States do not always comply with these measures • Fees and permits can often be controlled on the national level • US policies have generally moved from command-and-control to taxes and permits • Exceptions do still apply: Emissions hot spots

46. Summary • Many methods are used to try to increase efficiency when externalities are present • Negotiation • Mergers between firms • Social conventions • Taxes, including emissions fees • Subsidies • Command-and-control policies • Cap-and-trade programs using marketable permits

47. Summary • Distributional concerns are important for someone that thinks that social welfare is important • Who benefits and loses from taxes versus permits? • Firms? • The government? • Who benefits most when pollution is abated • High-income more than low-income?