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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
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

external costs

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

the efficient level of emissions

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

ways of correcting market failure
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

the case for fees

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

the case for standards

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

ways of correcting market failure7
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

ways of correcting market failure8
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

externalities and property rights
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

example bargaining with alternative property rights fishermen and a factory
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

externalities and property rights11
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

externalities and property rights12
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

common property resources
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

common property resources14

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

public goods
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