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Topic 2: Production Externalities. EC = areas H+E = $9,000 Recall that without the tax EC = H+E+C+F+J = $12,000. c. New MPC = MEC. 12. NB = CS + PS - EC + REV. MPC (S). J. 9. C. 8. F. E. 6. H. 3. MB. Q (thousands kwh). 400. 300. 1,200.
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Topic 2: Production Externalities EC = areas H+E = $9,000 Recall that without the tax EC = H+E+C+F+J = $12,000 c New MPC = MEC 12 • NB = CS + PS - EC + REV MPC (S) J 9 C 8 F E 6 H 3 MB Q (thousands kwh) 400 300 1,200 EC decrease by areas C+F+J = $3,000 Less output less pollution fewer environmental costs Note: Efficient emissions ≠0!
Topic 2: Production Externalities REV = areas B+D+E = $9,000 Without the tax REV = 0 (obviously) c New MPC = MEC 12 • NB = CS + PS - EC + REV MPC (S) 9 B 8 D E 6 Tax-payers gain $9,000. 3 MB Q (thousands kwh) 400 300 1,200 Note that REV = t Q = MEC Q Recall that EC = MEC Q REV = EC (because MEC is constant in Q)
Topic 2: Production Externalities Combined gains in terms of EC and REV: c New MPC = MEC EC + REV = areas B+C+D+E+F+J = $3,000 + $9,000 = $12,000 12 MPC (S) J 9 B C 8 F D E 6 3 MB Q (thousands kwh) 400 300 1,200 Recall: combined losses to CS and PS were = B+C+D+E+F = $10,500. Gains exceed losses by $1,500 = J. Area J was DWL.
Topic 2: Production Externalities • Summary of effects of per unit tax on output: • If we set t = MEC: • The efficient Q is achieved. • Losses in terms of CS and PS • Gains in terms of REV and EC • Relevant question for policy: • What information does the environmental regulator need in order to be able to implement this policy? • If MEC is constant in Q, then we just need to know what that MEC is equal to. • No requirement to know MPC or MB (demand). Gains > Losses NB
Topic 2: Production Externalities • Exercise (more difficult): • Suppose we have the same MB and same MPC curves as in the previous example, but now suppose that MEC = (1/100)Q (that is, as Q , MEC ). • Questions: • What is the efficient level of output? Draw a diagram. • Calculate the DWL that results at the equilibrium if there is no policy to correct the market failure. • If the government wishes to correct the market failure by setting a constant per unit output tax, what will that tax need to be? • Calculate the CS, PS, EC, REV as result of this tax. • What new information does the regulator need in this case (relative to the case of constant MEC) in order to achieve efficiency?
Topic 2: Production Externalities • Quota on production • Now suppose we want to achieve efficiency, but through a quota on production rather than a per unit output tax. • If we limit output per power plant to 3,000 kwh, then aggregate Q cannot exceed 300,000 (the efficient Q). • Questions: • What is the new equilibrium P and Q? • Who gains and who loses as a result of the quota? • What information does the regulator need in order to achieve the efficient Q?
Topic 2: Production Externalities Effect of a quota on the market for electricity: If aggregate Q cannot exceed 300, then P to $0.09. Effect on CS identical to effect of t=$0.03. c MEC 12 MPC 9 8 3 MB Q (thousands kwh) 400 300 1,200 Effect on EC identical to effect of t=$0.03. What about PS? Exercise: Calculate the PS and show that PS + EC > CS by an amount equal to the initial DWL. Also, what information does the regulator need in this case?
Topic 2: Production Externalities • Per unit subsidy on output reduction. • Finally, suppose we want to achieve efficiency, but by paying producers to reduce their output. • Key point to understand: • A subsidy on Q increases the firm’s MPC in (more or less) the same way a tax does. • The subsidy increases the opportunity cost to the firm. • If the firm decides to produce an extra unit of Q, the firm must pay its MPC, but now must also forgo the subsidy.
Topic 2: Production Externalities • In our example, each firm chooses Q = 4,000 with no regulation. • Suppose the govt offers to pay each firm $0.03 for every unit it doesn’t produce, below the baseline output of Q = 4,000. • Example: if a firm chooses Q = 3,800, it receives the subsidy on 200 units (i.e., it receives a payment of $6.00), etc.
Topic 2: Production Externalities Effect on an individual firm of a subsidy on Q reduction: c MPC with sub on Q MSC Govt pays firm $0.03 per kwh not produced below 4000. MPC for all Q < 4,000. MPC 3 Q (thousands kwh) 4 If Q < 4,000, the cost to the firm of an extra Q = MPC + subsidy forgone = MPC + $0.03 = MSC
Topic 2: Production Externalities Effect on electricity market of a subsidy on Q reduction: New equilibrium is at Q = 300, with consumers paying P =$0.09 per unit. c MSC 12 9 MPC Effect on CS and EC will be the same as with the tax and quota. 3 MB Q (thousands kwh) 300 400 Exercise: By how much does PS? How much does REV? Identify the areas corresponding to PS & REV. Show that PS + EC > CS + REV by an amount equal to the initial DWL. What info does the regulator need in this case?
