Chapter 9 Externalities: When Prices Send the Wrong Signals

1. Chapter 9 Externalities: When Prices Send the Wrong Signals

2. Externalities Equilibrium in a free market yields a number of important results. Goods must be produced at the lowest possible cost. Goods must satisfy the highest valued demands. Total surplus (consumer plus producer surplus) is maximized. For most goods all the significant costs and benefits flow directly to the consumers and producers trading in the market creating the results above.

3. Externalities Reviewing Gains from Trade Price Supply $22 Market Equilibrium $13 $10 Demand Quantity 100 210

4. Externalities For some goods, however, the costs and benefits to consumers and producers are more complex. A Private Costis a cost paid by the consumer or producer. A Private Benefitis a benefit received by the consumer or the producer. An External Costis a cost paid by people other than the consumers or the producers trading in the market. An External Benefitis a benefit received by people other than the consumers or producers trading in the market. Externalities are external costs or benefits.

5. Externalities In markets with externalities, consumers and producers focus on the wrong margin when making their decisions. The Social Costis the cost to everyone, the private cost plus the external cost. The Social Benefitis the benefit to everyone, the private benefit plus the external benefit. When making decisions, consumers and producers typically focus on private costs and benefits while ignoring external costs and benefits.

6. Externalities When consumers and producers ignore externalities, the market equilibrium can be less than optimal. To evaluate market equilibrium in these cases, all costs and benefits must be accounted for. Social Surplusis consumer surplus plus producer surplus plus everyone else’s surplus. This is not maximized when externalities are present.

7. External Costs When consumers and producers ignore external costs, they base their decisions on private costs only. As such, costs are underestimated, and the market quantity is greater than the socially efficient level. At the higher market level of output, costs (all costs) exceed the private benefits to buyers. A deadweight loss emerges reducing social surplus.

8. External Costs When External Costs are Significant, Output is Too High Social Cost Deadweight Loss Price/Costs External Cost Social Cost Pefficient Supply Pmarket Demand Private Value Quantity Qmarket Qefficient overuse

9. External Costs When external costs are ignored, the market quantity is greater than the socially efficient level, and social surplus is reduced. Reducing output below the market quantity increases social surplus when the social cost exceeds buyers’ private benefit. Thus, to maximize social surplus output should be reduced to the socially efficient level.

10. External Benefits When consumers and producers ignore external benefits, they base their decisions on private benefits only. As such, benefits are underestimated, and the market quantity is less than the socially efficient level. At the lower market level of output, benefits (all benefits) exceed the private costs to sellers. A deadweight loss emerges reducing social surplus.

11. External Benefits When External Benefits are Significant, Market Output is Too Low Deadweight Loss Price Supply Social Value Pefficient Pmarket External Benefit Social Value Private Cost Demand Quantity Qmarket Qefficient underuse

12. External Benefits When external benefits are ignored, the market quantity is less than the socially efficient level and social surplus is reduced. Increasing output above the market quantity increases social surplus when the social value exceeds sellers’ private cost. Thus, to maximize social surplus output should be expanded to the socially efficient level.

13. Solving Problems Caused by Externalities When externalities are significant, the market equilibrium is no longer efficient. What can be done to resolve this problem? Private Solutions Government Solutions

14. Private Solutions to Externalities In certain situations the private sector can resolve externalities. The Coase Theoremstates that if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities. Transaction Costsare all costs necessary to reach an agreement.

15. Private Solutions to Externalities The Coase Theorem suggests bargaining, with the right conditions, ensures that just the right amount of the externality is produced. If there were either too little or too much of the externality, trading would push the quantity to the optimal level. Thus, the free market equilibrium will maximize social surplus.

16. Private Solutions to Externalities - Extra! Suppose that a railroad runs along a wheat field. Steam locomotives using the railroad emit hot cinders from their smokestacks that can burn the neighboring crops. To avoid this danger, the wheat farmer does not plant crops within two hundred feet of the railroad incurring losses of $3,000 per harvest. The railroad, thus, imposes an external cost on the farmer.

17. Private Solutions to Externalities - Extra! If the farmer has a right to grow crops without them being burned, then the railroad must bear the costs to the farmer. The railroad could pay the farmer $3,000 to cover the losses each harvest and continue to use the rail line. Or, the railroad could prevent the fires by installing spark arresters that cost $2,000 to maintain each harvest. In this situation all costs are now internalized, and the railroad will install the spark arresters (the least costly alternative).

18. Private Solutions to Externalities - Extra! If the railroad has a right to use the rail line, then the farmer must bear the costs of the losses. The farmer would be willing to pay the railroad up to $3,000 per harvest to cease using the rail line. Or, the farmer could purchase and maintain the spark arresters for the railroad at a cost of $2,000 per harvest. In this situation all costs are now internalized, and the farmer will install the spark arresters (the least costly alternative) for the railroad.

19. Private Solutions to Externalities - Extra! If the railroad and the farmer can negotiate without incurring any additional costs, an efficient outcome will arise. Note that regardless of who is initially assigned the property right, the same solution occurs – the spark arrester is installed.

20. Private Solutions to Externalities The conditions of the Coase Theorem, however, are unlikely to be met. Transaction costs for many externalities are high, and property rights are often not clearly defined. When these conditions do not hold, markets alone will not internalize all externalities. The Coase Theorem does suggest that if these conditions exist, a new market for externalities might develop that maximizes social surplus. Note that government can play a crucial role in defining property rights and reducing transaction costs.

21. You want to hold a Saturday night party at your house but are worried that your elderly neighbors will complain to the police about the noise. Suggest a solution to this problem using what you know about the Coase Theorem. • Consider a factory near you that pollutes. What are the transaction costs involved in you and your neighbors negotiating with the factory to reduce the pollution? Is a private solution possible?

22. Government Solutions to Externalities When private solutions are not able to emerge, the government can play a role in resolving externalities. Some options available to government are: Taxes and Subsidies; Command and Control; Tradeable Allowances.

23. Government Solutions to Externalities Governments often use taxes and subsidies to resolve externalities. When external costs are significant, governments impose taxes to reduce the market quantity to the efficient level where social costs equal buyers’ benefit. When external benefits are significant, governments offer subsidies to increase the market quantity to the efficient level where social benefits equal sellers’ costs.

24. Government Solutions to Externalities A Pigouvian Taxis a tax on a good with external costs. A Pigouvian Subsidyis a subsidy on a good with external benefits. These policies allow markets to send proper signals when externalities are present thus maximizing social surplus.

25. Government Solutions to Externalities A Pigouvian Tax Reduces Output to the Efficient Quantity Price Social Cost Deadweight Loss with No Tax Tax = External Cost Pefficient Supply Pmarket Demand Quantity Qefficient Qmarket

26. Government Solutions to Externalities A Pigouvian Subsidy Increases Output to the Efficient Quantity Price Deadweight Loss with No Subsidy Supply Pefficient External Benefit = Subsidy Pmarket Social Value Demand Quantity Qmarket Qefficient

27. In our discussion of Pigouvian taxes, we assumed that the government set the correct tax to achieve efficient equilibrium. What if government overshoots and adds a tax that is too high? Will the equilibrium quantity be higher or lower than the efficient equilibrium? • In our discussion of Pigouvian subsidies, we assumed that government set the correct subsidy amount to achieve the efficient equilibrium. What if the government undershoots and provides a subsidy that is too low? Will the equilibrium quantity be higher or lower than the efficient equilibrium?

28. Government Solutions to Externalities The most direct approach for government to resolve externalities is to impose command and control regulation. When external costs are significant, the government can mandate a lower quantity than the market level. When external benefits are significant, the government can mandate a higher quantity than the market level.

29. Government Solutions to Externalities Command and control regulations do not always bring about an efficient solution. Governments may not possess enough information to choose the least costly method to achieve the necessary reduction in quantity when external costs are present. Command and control regulations do not provide consumers and producers the flexibility to choose the least costly method of reducing quantity in these instances.

30. Government Solutions to Externalities While command and control regulations fail to harness private information and individual preferences, there could exist some situations where such an approach would be preferable. Command and control can be effective under the following conditions: The best approach to the problem is well known; Success requires very strong compliance.

31. Government Solutions to Externalities The government can address external costs by establishing a market for tradeable allowances. Under this approach, the government sets a maximum quantity and rations a portion of that level to players in the market. Consumers and producers individually choose the best (least costly) approach to limit their quantity.

32. Government Solutions to Externalities Tradeable allowances reduce external costs and avoid the problems of command and control regulation. Consumers and producers have much more flexibility in implementing cost control measures. Furthermore, the regime creates strong incentives for consumers and producers to reduce quantity since the allowances are tradeable.

33. Government Solutions to Externalities The Clean Air Act of 1990 created a system of tradeable allowances. Under this reform the Environmental Protection Agency (EPA) distributes pollution allowances to generators of electricity, with each allowance giving the owner the right to emit one ton of sulfur dioxide (SO2). Firms may trade allowances as they see fit, but no firm can emit more pollution than it has allowances. SO2 emissions have been reduced 35% since 1990 while electricity generation has increased.

34. Government Solutions to Externalities

35. Government Solutions to Externalities There is a close relationship between using taxes and tradeable allowances to internalize externalities. A tax set equal to the level of the external cost is equivalent to tradeable allowances when the number of allowances is set equal to the efficient quantity.

36. Government sets a total quantity of tradable pollution allowances and auctions them off. After the auction, the price for an individual allowance is high. Over time, the price falls dramatically. What does this tell you? • The local government has decided to set and apportion tradable allowances for pollution in your neighborhood. Name three groups that would press for a large total quantity of allowances. Name three groups that would press for a smaller total quantity of allowances. Consider these groups, how likely is it that government would set a total quantity of allowances that would achieve an efficient equilibrium?

37. Externalities are external costs or benefits. • An external cost is a cost paid by people other than the consumers or the producers trading in the market. • An external benefit is a benefit received by people other than the consumers or producers trading in the market. • When consumers and producers ignore externalities, the market equilibrium can be less than optimal.

38. When external costs are ignored, the market quantity is greater than the socially efficient level, and social surplus is reduced. • When external benefits are ignored, the market quantity is less than the socially efficient level and social surplus is reduced.

39. Both private and government solutions exist to resolve problems of externalities. • The Coase Theorem states that if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities. • Some options available to government are: • Taxes and Subsidies; • Command and Control; • Tradeable Allowances.