Topic 3 Objectives

1. Topic 3 Objectives • Concept of externality • Externalities- cost or benefits of market transactions not reflected in prices • Explains why market fails to achieve efficiency when externalities exists • Prices fail to reflect MSB or MSC when positive or negative externalities exists in competitive markets. • Discuss alternative means of internalizing externalities to achieve efficiency.

2. Topic 3 Objectives • Externalities are internalized when MPC or MPB is adjusted so that resource users consider the actual MSB or MSC of their actions when making decisions • Alternative means of internalizing externalities: • Corrective taxes (or subsidies) • Emissions standards • Property rights assignment (the Coase theorem) • Advantage and disadvantage of each approach

3. Topic 3 Outline • Externalities : classification, examples • Externalities and efficiency : • Negative externalities • Positive externalities • Internalization of externalities: • Corrective taxes : a method of internalizing negative externalities • Internalizing negative externalities associated with goods sold in imperfectly competitive markets • Corrective subsidies: means of internalizing positive externalities

4. Topic 3 Outline…cont’d • Property rights to resource use and internalization of externalities: Coase Theorem • Exchange of property rights to internalize a negative externality: an example • An alternative property right assignment • Significance of the Coase Theorem • Applying the Coase Theorem: Pollution Rights • Efficient Pollution Abatement Levels

5. Major points on topic 3 • Externality – an unpriced cost or benefit or mkt activitiy. Nonmarket activities could also generate externalities • a negative externality prevents attainment of efficiency because the marginal social cost exceeds the marginal social benefit of output at the competitive equilibrium. • equilibrium occurs at the point at which MSB = MSC. Efficiency requires that MPC + MEC = MSB • common environmental problems such as pollution constitute externalities only if the MEC is in fact positive. If an environmental resource that has no alternative use is damaged by pollution, there is no externality because the MEC = 0.

6. Major points on topic 3 • when a positive externality exists, MSB > MSC at the market equilibrium. • To achieve efficiency, output must be increased up to the point at which MPBi + MEB = MSB. • To accomplish this, the price paid by consumers must decline to induce them to purchase more of the good. • However, the price received by sellers must increase, except in cases for which supply is perfectly elastic. • Figure 3.2 in the text shows the gains in efficiency possible from internalizing a positive externality.

7. Major points on topic 3 • Figure 3.3 shows how the market can achieve an efficient output for a positive externality whose marginal value declines with output. • It implies that no govt intervention is required in cases for which MEB = 0 at the market output. • There are information costs involved in identifying parties involved in externality and in measuring the monetary value of the MC and MB. • Corrective taxes- there are political problems involved in agreeing on the tax and its magnitude. • tax does not reduce emissions to zero. It merely forces emitters to pay the MEC of their emissions. • possible uses for the collected tax revenue, including compensation for the TEC remaining after the externality is internalized.

8. Major points on topic 3 • theory of second best with an analysis of internalization of externalities in non­competitive markets: • when monopolistic power results in < the efficient output, a corrective tax to internalize an externality must be < MEC • In the eg , the distortion due to monopolistic power exactly offsets the distortion due to the negative externality. • No corrective tax is necessary to achieve efficiency in this case. • analysis of corrective subsidies emphasizes how the subsidy must reduce the price paid by consumers by MEB to achieve efficiency: • Use Fig 3.3 – to determine the corrective tax required for efficiency for each of the supply curves S and S'.

9. Major points on topic 3 • Coase theorem – is used to understand • the source of externalities and • the role of government in controlling their undesirable effects: • govt can internalize externalities when the transactions costs of exchanging property rights are zero merely by assigning those rights and encouraging their exchange. • this assures efficiency independent of which competing user for the resource in dispute is assigned the property right. • Text example - uses land as the disputed resource. The two competing users -a beef producer and a wheat farmer.

10. Major points on topic 3 • Fig 3.7 -shows how the MC of wheat depends on the output of beef: • when the beef producer has the right to use all unfenced land for grazing, his costs include the foregone payment of the farmer to reduce the size of his herd. • This increases his MC in the same way as would be the case if he were liable for damages. • no matter who is assigned the rights, the users will choose the alternative to internalize the externality that gives them maximum profits. The mix of wheat and beef output on the land will be efficient no matter who is granted the property right.

11. Major points on topic 3 • Application of Coase Theorem to pollution rights-Clean Air Act 1990 established a market for pollution rights. • Emissions standards remain the dominant means of controlling externalities in the United States. • The graphs in Fig 3.10 and 3.11 show how rigid emissions standards cause losses in efficiency when the MSB of emissions (in terms of increased profits of emitters) differs among firms, or the MEC of emissions varies among regions. • standards allow emitters to emit wastes free of charge up to the point at which they reach the standards, then no more emissions are allowed no matter what the value of the right to emit to the firm. • that emissions standards are often difficult to enforce, as are most command and control policies.

12. Major points on topic 3 • When discussing pollution rights- trading of rights to emit can achieve a given reduction in pollution at lower cost than command and control policies. • international perspective on environmental problems: issues relating to ozone depletion and global warming. • Caution - recycling is not necessarily an efficient means of dealing with the problem of disposal of solid wastes.