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Externalities

Externalities. Negative Action by one party imposes a cost on another party Scenario Steel plant dumping waste in a river The entire steel market effluent can be reduced by lowering output (fixed proportions production function)

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Externalities

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  1. Externalities • Negative • Action by one party imposes a cost on another party • Scenario • Steel plant dumping waste in a river • The entire steel market effluent can be reduced by lowering output (fixed proportions production function) • Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. • Marginal Social Cost (MSC) is MC plus MEC. • Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run. Chapter 18

  2. The difference is the marginal external cost, MEC. The profit maximizing firm produces at q1 while the efficient output level is q*. When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. MSC MSCI MC S = MCI The industry competitive output is Q1 while the efficient level is Q*. Aggregate social cost of negative externality P* P1 P1 MECI MEC D q* q1 Q* Q1 External Costs Price Price Industry output Firm output

  3. MSC At Eo the marginal cost of abating emissions is greater than the marginal social cost. At E1 the marginal social cost is greater than the marginal cost of abatement. The efficient level of emissions is 12 (E*) where MCA = MSC. MCA E0 E1 E* The Efficient Level of Emissions Assume: 1) Competitive market 2) Output and emissions decisions are independent 3) Profit maximizing output chosen Dollars per unit of Emissions 6 Why is this more efficient than zero emissions? 4 2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 Level of Emissions Chapter 18

  4. Ways of Correcting Market Failure • Options for Reducing Emissions to E* • Emission Standard: Set a legal limit on emissions at E* (12) which increases the cost of production and the threshold price to enter the industry. Enforced by monetary and criminal penalties. • Emissions Fee: Charge levied on each unit of emission. • Assumptions: • Policymakers have asymmetric information • Administrative costs require the same fee or standard for all firms Chapter 18

  5. The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA2 < MCA1. MCA1 MCA2 If a fee of $3 was imposed Firm 1 emissions would fall From 14 to 8. Firm 2 emissions would fall from 14 to 6. MCA1 = MCA2: efficient solution. 3.75 Firm 1’s Increased Abatement Costs 2.50 Firm 2’s Reduced Abatement Costs The Case for Fees Fee per Unit of Emissions 6 The cost minimizing solution would be an abatement of 6 for firm 1 and 8 for firm 2 and MCA1= MCA2 = $3. 5 4 3 2 1 Level of Emissions 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Chapter 18

  6. Based on incomplete information fee is $7 (12.5% reduction). Emission increases to 11. C Marginal Social Cost ABC is the increase in social cost less the decrease in abatement cost. E A D B Based on incomplete information standard is 9 (12.5% decrease). ADE < ABC Marginal Cost of Abatement The Case for Standards Fee per Unit of Emissions 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 Level of Emissions Chapter 18

  7. Ways of Correcting Market Failure • Advantages of Fees • When equal standards must be used, fees achieve the same emission abatement at lower cost. • Fees create an incentive to install equipment that would reduce emissions further. • Summary: Fees vs. Standards • Standards are preferred when MSC is steep and MCA is flat. • Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement. • Fees have certainty on cost and uncertainty on emissions. • Preferred policy depends on the nature of uncertainty and the slopes of the cost curves. Chapter 18

  8. Ways of Correcting Market Failure • Transferable Emissions Permits • Permits help develop a competitive market for externalities. • Agency determines the level of emissions and number of permits • Permits are marketable • High cost firm will purchase permits from low cost firms Chapter 18

  9. Externalities and Property Rights • Property Rights • Legal rules describing what people or firms may do with their property • For example: If residents downstream owned the river (clean water) they control upstream emissions. • Bargaining and Economic Efficiency • Economic efficiency can be achieved without government intervention when the externality affects relatively few parties and when property rights are well specified. • Coase Theorem • When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified. Chapter 18

  10. Example: Bargaining with Alternative Property Rights: Fishermen and a Factory! Right to Dump Right to Clean Water No Cooperation Profit of factory $500 $300 Profit of fishermen $200 $500 Cooperation Profit of factory $550 $300 Profit of fishermen $250 $500 Chapter 18

  11. Externalities and Property Rights • Costly Bargaining - The Role of Strategic Behavior • Bargaining requires clearly defined rules and property rights. • A Legal Solution - Suing for Damages • Fishermen have the right to clean water • Factory has two options • No filter, pay damages • Profit = $100 ($500 - $400) • Filter, no damages • Profit = $300 ($500 - $200) Chapter 18

  12. Externalities and Property Rights • A Legal Solution - Suing for Damages • Factory has the right to emit effluent • Fishermen have three options • Put in treatment plant • Profit = $200 • Filter and pay damages • Profit = $300 ($500 - $200) • No plant, no filter • Profit = $100 • Conclusion: A suit for damages results in an efficient outcome. • Question: How would imperfect information impact the outcome? Chapter 18

  13. Common Property Resources • Common Property Resource • Everyone has free access. • Likely to be overutilized • Examples: Air and water; Fish and animal populations • Solution: Private ownership • Question: When would private ownership be impractical? Chapter 18

  14. Without control the number of fish/month is FC where PC = MB. However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D) Marginal Social Cost Private Cost Demand F* FC Common Property Resources Benefits, Costs ($ per fish) Fish per Month Chapter 18

  15. Public Goods • Public Good Characteristics • Nonrival: For any given level of production the marginal cost of providing it to an additional consumer is zero. • Nonexclusive: People cannot be excluded from consuming the good. • Free Riders: enjoy the benefit of a good or service without paying for it. Chapter 18

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