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Chapter 3. Externalities and Public Policy. 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 . Externalities and Efficiency.

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Chapter 3

Chapter 3

Externalities and Public Policy


Externalities
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 .


Externalities and efficiency
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.


Social costs
Social Costs

MSC = MPC + MEC


Figure 3 1 market equilibrium a negative externality and efficiency
Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency

MPC + MEC = MSC

G

S = MPC

110

B

10

105

A

100

Price, Benefit, and Cost (Dollars)

D = MSB

4.5

5

Tons of Paper Per Year (Millions)


Positive externalities
Positive externalities Efficiency

  • The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production or consumption of a good.


Social benefit
Social Benefit Efficiency

MSB = MPB + MEB


Figure 3 2 market equilibrium a positive externality and efficiency
Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency

Z

45

S = MSC

30

V

Price, Benefit, and Cost (Dollars)

25

U

H

10

MPB + MEB = MSB

MPB

0

Inoculations Per

Year (Millions)

10

12


Figure 3 3 a positive externality for which meb declines with annual output
Figure 3.3 A Positive Externality for Which MEB Declines With Annual Output

MPBi + MEB = MSB

S = MSC

F

30

B

S' = MSC'

A

25

C

20

Price, Benefit, and Cost (Dollars)

MPBi

0

10

12

16

20

Inoculations per Year (Millions)


Internalization of externalities
Internalization of Externalities With Annual Output

  • An externality can be internalized under policies that force market participants to account for the costs of benefits of their actions.


Corrective taxes to negative externalities
Corrective Taxes to Negative Externalities With Annual Output

  • Setting a tax equal to the MEC will internalize a negative externality.


Figure 3 4 a corrective tax
Figure 3.4 A Corrective Tax With Annual Output

S’ = MPC + T = MSC

S = MPC

G

110

B

Net Gains in

Well-Being

105

Tax Revenue = Total

External Costs

100

A

T

95

Price, Benefit, and Cost (Dollars)

D = MSB

4.5

5

Tons of Paper Per Year (Millions)


Results of a corrective tax
Results of a Corrective Tax With Annual Output

  • Price rises.

  • The tax revenue is sufficient to pay costs to third parties.

  • Socially optimal levels of production are achieved.


A polluting monopolist
A Polluting Monopolist With Annual Output

  • Monopoly creates a loss to society.

  • 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.


Figure 3 5 a second best efficient solution
Figure 3.5 A Second Best Efficient Solution With Annual Output

MPC + MEC = MSC

F

MPC

A

P

M

B

Price

C

D = MSB

MR

Q

Q*

0

M

Output per Year


Theory of the second best
Theory of the Second Best With Annual Output

  • When two opposing factors contribute to efficiency losses, the can offset one another’s distortions.


Corrective subsidies
Corrective Subsidies With Annual Output

  • Setting a subsidy equal to MEB will internalize a positive externality.


Figure 3 6 a corrective subsidy
Figure 3.6 A Corrective Subsidy With Annual Output

Z

45

S = MSC

R

30

V

Price, Benefit, and Cost (Dollars)

25

U

Subsidy Payments

X

10

= MSB

D' = MPBi +

$20

Y

D = MPBi

0

10

12

Inoculations per Year (Millions)


Property rights and internalization of externalities
Property Rights and Internalization of Externalities With Annual Output

  • Externalities arise because some resource users’ property rights are not considered in the marketplace by buyers or sellers of products.

  • Governments can give businesses the right to emit wastes in the air and water or it can give individuals the right to clean air and water.


Coase s theorem
Coase's Theorem With Annual Output

  • By establishing rights to use resources, government can internalize externalities when transactions or bargaining costs are zero.


Limitations of coase s theorem
Limitations of Coase’s Theorem With Annual Output

  • Transactions costs are not zero in many situations.

  • However you allocate the property rights, the distribution of income is affected.


Applying coase s theorem
Applying Coase's Theorem With Annual Output

  • 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 their emission permits to others.

  • In markets for electricity, Clean Air Act has motivated firms to shift to natural gas and away from coal as a means of producing electricity.


Figure 3 8 pollution rights and emissions
Figure 3.8 Pollution Rights and Emissions With Annual Output

S = Supply of Pollution Rights

Price and Marginal Social Benefit

D = MSB of

Emitting Wastes

$20

0

75,000

100,000

Tons of Annual Emissions

and Number of Pollution Rights


Figure 3 9 the efficient amount of pollution abatement
Figure 3.9 The Efficient Amount of Pollution Abatement With Annual Output

MSC

Marginal Social Cost and Benefit

E

MSB

A*

0

100

Percent Reduction in Waste Emitted per Year


Regulatory solutions
Regulatory Solutions With Annual Output

  • Instead of using market forces to force firms to internalize externalities, we can use emission standards and apply these to all market players.


Figure 3.10 Regulating Emissions: Losses in Efficiency From Differences in the Marginal Social Benefit of Emissions

Firm A

B

MEC = MSC

C

10

A

DQRA

MSB

Cost and Benefit (Dollars)

QA*

QA1

Tons of Emissions per Year

Firm B

MEC = MSC

F

G

10

H

DQRB

MSB

0

QB*

QR

QB1


Figure 3 11 losses in efficiency from emissions standards when mec differs among regions
Figure 3.11 Losses in Efficiency From Emissions Standards When MEC Differs Among Regions

Firm C

Firm D

MSB

MEC = MSC

X

Y

Cost and Benefit (Dollars)

20

S

Z

T

MEC = MSC

R

MSB

DQRC

QC*

QR

QR

DQRD

QD*

Tons of Emissions per Year


Costs and benefits to the epa
Costs and Benefits to the EPA When MEC Differs Among Regions

  • The EPA estimates that annual compliance costs could be in the range of $225 billion per year.

  • The EPA estimated in 1990 that the benefits of the Clean Air Act were nearly 50 times the costs.

  • Ninety percent of the benefits are estimated to come from laws pertaining to power plants and factories.


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