Chapter 3

1. Chapter 3 Externalities and Public Policy

2. 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 .

3. 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. These occur when market transactions for a good produce negative externalities.

4. Social Costs MSC = MPC + MEC

5. 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)

6. Implications of Figure 3.1 • Market equilibrium occurs where MPC = MSB • Efficiency Requires that MSC = MPC + MEC = MSB

7. 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. These occur when the market for a good creates positive externalities.

8. Social Benefit MSB = MPB + MEB

9. 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

10. 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)

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

12. Corrective Taxes to Negative Externalities • Setting a tax equal to the MEC will internalize a negative externality.

13. 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)

14. 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.

15. Using a Corrective Tax • The greenhouse effect and a “Carbon Tax” • The greenhouse effect is caused by burning carbon-based fuels. A carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels. • It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.

16. Theory of the Second Best • When one condition for an optimum is violated, then maintaining the others will not guarantee a second-best solution.

17. A Polluting Monopolist • Chapter 2 showed that monopoly creates a loss to society. This chapter shows that 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.

18. 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

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

20. 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)

21. 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.

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

23. The Significance of Coase’s Theorem • The efficient mix of output will result simply as a consequence of the establishment of exchangeable property rights. • It makes no difference which party is assigned the right to use a resource. • If the transactions costs of exchanging the rights are zero, the efficient mix of outputs among competing uses of the resource will emerge.

24. Figure 3.7 Coase’s Theorem A B MPCB + MEC = MSC MPCB MCW Price of Beef (Dollars) Price of Wheat (Dollars) MCW* PB PW QB* QW* QB1 QW1 Beef Output per Year Wheat Output per Year

25. 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.

26. 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.

27. 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

28. 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

29. Recycling • Recycling may be a less efficient and more polluting use of labor, land and capital than simple land fill disposal because: • Collecting waste for recycling costs three times as much as collecting it for disposal. • Rural land is inexpensive. • Recycling paper creates more water pollution and does not “save” trees; it simply reduces the number that are planted.

30. 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.

31. 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

32. 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

33. Markets for Pollution Rights • The Clean Air Act of 1990 allowed firms the right to trade Sulfur Dioxide emissions allowances. • The market for the allowances began in 1991. • Firms must have the allowances to emit Sulfur Dioxide. • Firms increasing production can buy permits or use pollution controls to keep their total emissions constant. • Firms that reduce their emissions can sell their allowances to others.

34. Sulfur Dioxide Emission Prices

35. Global Externalities • CFC’s • Deforestation • Global Warming

36. 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.