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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

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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

  • 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

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

  • 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

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


Figure 3 4 a corrective tax

Figure 3.4 A Corrective Tax

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

  • 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

  • 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

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

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


Corrective subsidies

Corrective Subsidies

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


Figure 3 6 a corrective subsidy

Figure 3.6 A Corrective Subsidy

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

  • 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

  • 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

  • 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

  • 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

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

MSC

Marginal Social Cost and Benefit

E

MSB

A*

0

100

Percent Reduction in Waste Emitted per Year


Regulatory solutions

Regulatory Solutions

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


Externalities and public policy

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

  • 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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