Public Economics Chikako Yamauchi Assistant Professor, GRIPS Lecture 5 “Externalities” Rosen, Ch. 5 (“Externalities”)
Outline 1. 2. 3. 4. 5.
The Natur ture of Externalities Graphical An Analysis Priva rivate te Resp Respon onse ses s to to Ext Exte ernal rnalit itie ies s Publ ublic Respo espons nses es to Exte Extern rnal aliities ties Imp Implica licati tion ons s for for Inco Income me Dist Distri ribu buti tio on
Outline 1. 2. 3. 4. 5.
The Natur ture of Externalities Graphical An Analysis Priva rivate te Resp Respon onse ses s to to Ext Exte ernal rnalit itie ies s Publ ublic Respo espons nses es to Exte Extern rnal aliities ties Imp Implica licati tion ons s for for Inco Income me Dist Distri ribu buti tio on
Introduction •
Paper mills produce the chemical dioxin as a byproduct, which ends up in human fat tissue and in i n the milk of nursing mothers. Some scientists say that dioxin is responsible for birth defects and cancer, etc.
•
The output choice of paper mills directly affects the utility of the neighboring people
•
This negative effect does not go through price changes. changes. •
Diff Differ erent ent from from the situ situat atio ion n wher where e an incr increa ease se in in the the pric price e of paper leads to a decrease in the level of utility among paper consumers
Externality Defined • An externality is present when the the activity of one entity (person or firm) directly affects the welfare of another entity in a way that is not reflected in the market price – Negative externality : These activities impose damages on others. – Posit os itiv ive e ext exte erna rn ality li ty : These activities create benefits for others.
1 The Nature of Externalities
Inefficient choice and ownership • Bart dumps industrial waste into a river no one owns • Lisa fishes from the river, and is worse off from Bart’s dumping without any reflection in prices • Does Bart produce and contaminate water “too much” or inefficiently? Why? Bart’s production inputs -Land -Labor -Capital -Materials -Water
Lisa’s production inputs -Fishing rod & line -Bait -Fishing basket -Clean water
Inefficient choice and ownership • Efficiency requires that Bart pays a price that reflects the water’s value as a scarce resource that can be used for other activities (such as fishing) • BUT no one owns the river – No market for clean water; anyone can use it for free
• Externality is a consequence of the failure or inability to establish property rights – 1st welfare theorem assumes a market exists for all goods. This is because price carries information on how valuable the good is to society – Bart uses his other inputs efficiently because he must pay their owners prices that reflect their value in alternative uses
Inefficient choice and ownership • If someone owns a resource, its price reflects the value for alternative uses, and the resource is used efficiently – If Lisa owned the river • she could charge Bart a fee for polluting that reflected the damage to her catch • Bart would take the charges into account, and would no longer use the water inefficiently
– If Bart owned the river • he could make money by charging Lisa for fishing in it • Lisa’s willingness to pay for fishing in Bart’s river would depend on the amount of pollution. • Hence, Bart would have an incentive not to pollute excessively
• If resources are owned in common, they tend to be overused
Examples of Externalities Negative Externalities • Pollution • Noise • Littering • Car exhaust • Smoking
Positive Externalities • Research & development • Vaccinations • A neighbor’s nice landscape • Students asking good questions in class
Nature of Externalities • Arise because there is no market price attached to the good • Can be produced by people or firms • Can be positive or negative • Public goods are special case – An externality can be a public good if it is positive and felt by everyone – E.g. a device for electrocuting mosquitoes in my garden • If it kills all the mosquitoes in the community, public good • If it kills mosquitoes in a few neighbors, positive externality
2 Graphical Analysis
Figure 5.1: An externality problem Assumptions Marginal private cost to Bart has a fixed component, and increases as Q increases Marginal damage to Lisa increases as Q increases Marginal benefit to Bart decreases as Q increases [MB is a horizontal line if he is a price taker]
Figure 5.1: An externality problem Equilibrium Bart maximizes profits at MB=MPC. This quantity is denoted as Q1 in the figure. However, marginal social cost is MPC+MD. Social welfare is maximized at MB=MSC, which is denoted as Q* in the figure.
Implications • Q1[output level with negative externality] > Q*[socially efficient output level] – Bart privately produces “too much”, because he does not account for the damages to Lisa – When externalities exist, private markets do not produce the socially efficient output level
• What if Q=0? [Lisa’s damages are minimized] – But Bart cannot produce anything! – Q* is not the preferred quantity for either party, but is the best compromise – In general, socially efficient allocation entails some pollution
Figure 5.2: Gains and losses from moving to Q* The area between the MB and MPC curve going from Q1 to Q* is the loss to Bart
the area under the MD curve going from Q1 to Q* is the gain to Lisa [cdhg is the same as abfd]
The net gain to society from producing at Q* instead of Q1 is the triangle dgh
Reality is more complicated • Implementing the framework of Fig. 5.2 requires identifying real MD and MB curves • How large is the amount of pollution associated with each Q? – Which discharge creates harmful pollution?
• How should the damage from the pollution be priced? – There may be many fishermen – Each fisherman may be affected differently
3 Private Responses to Externalities
Potential Solutions for Externalities Private Responses 1. Assign Property Rights / Coase Theorem 2. Mergers 3. Social conventions
Public Responses 1. Taxes 2. Subsidies 3. Incentive-based regulation 1. Emissions fees 2. Cap-and-trade programs
4. Command-and-control regulation
Private Response #1: Suppose property Property Rights rights to the river are How the net gain dhg is divided depends on relative bargaining power
assigned to Bart, and it is costless for Bart and Lisa to bargain with each other regarding Q Bart will decrease Q if he is paid more than (MB – MPC) Lisa will pay for decreased Q if payment < MD
if MD > payment >MB – MPC, there is room for a bargain At efficient level, MD= MB –MPC
Coase Theorem • The Coase Theorem states that once property rights are established and transaction costs are small, then one of the parties will pay the other to attain the socially efficient quantity. • The socially efficient quantity is attained regardless of to whom the property rights were initially assigned. • Once property rights are established, government intervention is not required to deal with externalities • Insight: root of the inefficiencies from externalities is the absence of property rights.
When Is the Coase Theorem Relevant? • Low transaction costs – Few parties involved
• Source of externality well defined • Example: Several polluting firms
• Not relevant with high transaction costs or ill-defined externality • Example: Air pollution
Private Response #2: Mergers • Mergers between firms “internalize” the externality. • A firm that consisted of both Bart’s firm and Lisa’s fishery would only care about maximizing the joint profits of the two firms, not either’s profits individually. • Thus, it would take into account the effects of increased production on the fishery.
Private Response #3: Social Conventions • Certain social conventions can be viewed as attempts to force people to account for the externalities they generate. • Examples include conventions about not littering, not talking in a movie theater, etc.
4 Public Responses to Externalities
Potential Solutions for Externalities Private Responses 1. Assign Property Rights / Coase Theorem 2. Mergers 3. Social conventions
Public Responses 1. Taxes 2. Subsidies 3. Incentive-based regulation 1.Emissions fees 2.Cap-and-trade programs
4. Command-and-control regulation
Public Response #1: Taxes • Return to the Bart/Lisa example. • Bart produces inefficiently because the price of water incorrectly signals social costs. Natural solution is to levy a tax on a polluter. • A Pigouvian tax is a tax levied on each unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the efficient level of output.
Public Response #1: Taxes
How can we levy tax on Bart, so that he automatically chooses to produce Q*?
Public Response #1: Taxes Figure 5.4: Analysis of a Pigouvian tax
the marginal damage Bart inflicts at the efficient level of output, Q*, = dc With new marginal cost = MPC + cd, Bart chooses to produce less, at Q*
Pigouvian tax = dc Pigouvian tax revenue=dc*Q*
Public Response #1: Taxes • Note: Compensating the victim isn’t necessary and may cause more problems – More people will join the activity receiving compensation.
• Practical problems in implementing a Pigouvian tax system – How to find the correct tax rate or taxable goods? – Sensible compromises • Suppose we want to reduce emissions from automobiles • Instead of taxing on the number of miles driven at certain locations [polluted areas] and time [congested time], a gasoline tax could be levied
Public Response #2: Subsidies • Another solution is paying the polluter to not pollute. • Government announces that it will pay Bart a subsidy equal to the marginal damage at Q*, for each unit of output below Q1 he does not produce. • Now if Bart does not reduce Q, he will forgo the subsidy he could have obtained • i.e., perceived marginal cost is MPC + subsidy
Public Response #2: Subsidies $
MSC = MPC + MD Bart’s perceived cost (MPC + cd) MPC
Pigouvian subsidy i j
d c
This incentive continues till he reaches Q*
k f g h MD
0
e Q*
Q1
With Pigouvian subsidy introduced at Q1, Bart’s perceived cost (MPC + cd) exceeds MB, so he has incentive to cut back his production level
MB
For Q
Q per year
Public Response #2: Subsidies •
The solution assumes that Q 1 is known – firms might game the system by undertaking inefficient actions that increase Q 1
• The subsidy leads to a socially efficient Q, but different distributional consequences: now the polluter receives a payment rather than paying • Subsidy could induce new firms to enter the market, which might increase overall pollution. • Also, it may be ethically undesirable to pay polluters.
Public Response #3: Incentive-based regulation [emissions fee] • Taxes on each unit of output might not give Bart the incentives to search for ways to reduce pollution other than reducing output • How about levying a tax on each unit of emissions? • Emissions fee – Government levies an emissions fee, f*, for each unit of pollution emitted – f* is the marginal social benefit of pollution reduction at the efficient level
Emissions Fee e < e*: Bart’s cost of reducing pollution, MC, is smaller than emission fee, f*, so $ Bart has incentive to reduce pollution
e > e*: Bart’s cost of reducing pollution, MC, is larger than emission fee, f*, so Bart has incentive to increase pollution MC
MSB: Marginal Social Benefit of each unit of pollution Bart reduces Efficient level of emission reduction, e*, arises when MSB = MC
f*
0
MC: Marginal cost of reducing a unit of emission
Without fee, e=0 (no reduction). With fee f*, MSB Bart reduces emission by e* units e*
Pollution reduction
Emissions Fee to Multiple Firms MCH
$
$ MCB
Suppose Bart and Homer produce 90 units of emission, and Homer incurs higher cost than Bart in reducing a unit of emission Suppose that government wants to reduce emission by 100 units
50
90
Bart’s pollution reduction
50
90 Homer’s pollution reduction
• How can the government allocate the burden of emission reduction? • Is the equal allocation (50 to Bart and 50 to Homer) efficient?
Emissions Fee to Multiple Firms MCH
$
$ MCB
Suppose Bart and Homer produce 90 units of emission, and Homer incurs higher cost than Bart in reducing a unit of emission Suppose that government wants to reduce emission by 100 units
50
90
Bart’s pollution reduction
50
90 Homer’s pollution reduction
• If government tells each firm to cut emission by 50, MC for Bart is lower than MC for Homer • If Bart reduces more and Homer reduces less, it would achieve the same reduction at a lower (aggregate) cost • The total cost of emissions reduction is minimized only when the marginal costs are equal across all polluters: “cost effective” outcome
Emissions Fee to Multiple Firms MCH
$
f’
B’s reduction
$ MCB
H’s reduction
B’s tax 50 75 90
Suppose that government wants to reduce emission by 100 units
H’s tax Bart’s pollution reduction
25 50
Suppose Bart and Homer produce 90 units of emission, and Homer incurs higher cost than Bart in reducing a unit of emission
90 Homer’s pollution reduction
• If emissions fee, f’, is applied to both firms, each firm reduces emission up to the point where MC=f’ • Thus emissions fee achieves cost effective outcome: MCB=MCH • It also rewards firms with better technology (which can reduce emissions more) by charging less tax
Public Response #3: Incentive-based regulation [cap-and-trade scheme] • Alternative to Emissions fee • Cap-and-trade scheme – Government sets the desired pollution level, or the number of permits which allow polluters to emit pollution – Provide those permits to polluters – Let polluters trade the permits
• Even if firms incur differing costs to reduce emission, the cap-and-trade scheme also leads to cost-effective outcome
Cap-and-trade Scheme MCH
$
$ MCB
10
90
Bart’s pollution reduction
Suppose government decided to reduce emission by 100, or allow total pollution to be 80 units Government gives Bart 80 permits to emit As Bart was emitting 90, with 80 permits, he has to reduce emission by 10
90 Homer’s pollution As Homer was emitting reduction 90, with no permit, he has to reduce emission by 90
• Without trading of permits, Homer’s marginal cost is far higher than Bart’s marginal cost • As long as MCH > price of permit > MCB, there is a scope for trade • Trade settles when MCH =MCB , which is cost effective
Emissions Fee v.s. Cap-and-trade • Inflation lowers the real emissions fee and leads to less pollution reduction – Legislative adjustment is needed – the cap-and-trade scheme leads to the same amount of pollution reduction
• When marginal cost of reducing emission increases, – With the emissions fee, pollution reduction decreases – With the cap-and-trade scheme, the price of permits increases, but pollution reduction is constant
• Neither system automatically leads to an efficient outcome when the costs of pollution reductions change
Emissions Fee v.s. Cap-and-trade • Safety valve price – Combine the cap-and-trade system with the emissions fee system – Government sells as many additional permits as is demanded at a pre-established (HIGH) price (Safety valve price) – Likely to be used only when the cost of pollution reduction is much higher than expected
Responsiveness to Uncertainty • When the costs of reducing pollution is uncertain, emission fees and cap-and-trade system could lead to different outcomes • Implications differ depending on the elasticity of marginal social benefit curve • Inelastic MSB – The reduction of the first unit is highly valued, but the value for the additional units tapers off quickly
• Elastic MSB – The value of reduction remains relatively constant
Inelastic MSB Schedule Emission fee, f*, is determined by MSB = MC. Since it is based MC’: true MC on underestimated cost, f* is too low and ef too little compared MC*: government’s to the efficient guess on MC allocation, e’
MSB $
f*
0
Under cap-and-trade scheme, government produces enough permits to reduce up to e*, which is too much. ef
e’
e* Pollution reduction e* is closer to e’
Elastic MSB Schedule It remains the case that ef is too little and $
MC’: true MC
e* is too much
compared to the efficient allocation, e’
MSB
MC*: government’s But e is now closer to f guess on MC e* f*
0
ef
e’
e* Pollution reduction
Implications • When costs are uncertain and MSB is inelastic, a cap-and-trade system is preferable to an emissions fee • When costs are uncertain and MSB is elastic, an emissions fee is preferable to a cap-and-trade system • How to find out the shape of MSB? – Information from various fields is required
• Distributional effects – Cap-and-trade system can produce no revenue to government if permits are given to polluters for free
Public Response #4: Command-andcontrol regulation • Incentive-based regulations (emissions fees, cap-andtrade system) – Allow polluters great flexibility in how to reduce their emissions
• Command-and-control regulations – Require a given amount of pollution reduction with limited or no flexibility with respect to how it may be achieved – Performance standard: firms must meet certain amounts of pollution reduction – Technology standard: firms must use certain technology • E.g., U.S. Corporate average fuel economy standards • All new passenger cars must attain 27.5 miles per gallon • Manufacturers cannot shift the burden among each other to lower overall cost • It is estimated that, if alternatively gasoline consumption is taxed, the same reduction in gasoline consumption can be achieved with $700 million less per year
Limitation of incentive-based regulations • Incentive-based regulations may not work well if – Pollution reductions cannot be monitored well – There is a possibility of creating hot spots, or localized concentrations of emissions
• Command-and-control regulations may be the second-best, feasible solutions
5 Implications for Income Distribution
Who Benefits? • In reality, individuals in different areas suffer differently from various externalities – Poor neighborhoods tend to have more exposure to air pollution [Gayer, 2000] • Removing air pollution would benefit low-income families more • Cleaning recreational parks would benefit high-income families
• Larger damage may not lead to higher willingness to pay – A cleanup program may reduce the physical amount of pollution faced by low-income families – But high-income families might show higher willingness to pay for the program
