CHAPTER 5

1. CHAPTER 5 Externalities

2. Externalities • Externality – An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism

3. The Nature of Externalities • Externalities can be produced by consumers as well as firms • Externalities are reciprocal in nature • Externalities can be positive • Public goods can be viewed as a special kind of externality

4. The Nature of Externalities-Graphical Analysis 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. What Pollutants Do Harm? • Empirical Evidence: What is the Effect of Pollution on Health? • What Activities Produce Pollutants? • What is the Value of the Damage Done? • Empirical Evidence: The Effect of Air Pollution on Housing Values

6. The Coase Theorem • Coase Theorem – Provided that transaction casts are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights • Assumptions necessary for Coase Theorem to work • The costs to the parties of bargaining are low • The owners of resources can identify the source of damages to their property and legally prevent damages

7. Other Private Solutions • Mergers • Social conventions

8. Public Responses to Externalities - Taxes MSC = MPC + MD $ (MPC + cd) Pigouviantax revenues MPC d i j c MD MB 0 Q* Q1 Q per year

9. Public Responses to Externalities - Subsidies MSC = MPC + MD $ (MPC + cd) MPC Pigouviansubsidy d k i f g j h c MD MB e 0 Q* Q1 Q per year

10. Cap-and-Trade v Emissions Fee MC’ $ MC* f* MSB 0 ef e’ e* Pollution reduction Too little pollution reduction Too much pollution reduction

11. Cap-and-Trade v Emissions Fee MC’ $ MC* f* MSB 0 ef e’ e* Pollution reduction Too little pollution reduction Too much pollution reduction

12. Emissions Fee v Cap-and-Trade • Responsiveness to Inflation • Responsiveness to Cost Changes • Responsiveness to Uncertainty

13. Command-and-Control Regulation • Incentive-based regulations • Command-and-control regulations • technology standard • performance standard • Is command-and-control ever better? • hot spots

14. The U.S. Response • Clean Air Act • Command-and-control in the 70s • How well did it work?

15. Progress with Incentive-based Approaches • Policy Perspective: Cap-and-Trade for Sulfur Dioxide • Policy Perspective: Cap-and-Trade to Protect Fisheries and Wildlife • individual transferable quotas

16. Implications for Income Distribution • Who Benefits? • Who Bears the Cost?

17. Positive Externalities $ MC MSB = MPB + MEB MPB MEB R1 R* Researchper year