Externalities and Public Policy

• The chapter is about externalities and what public policies aim to solve externalities
• Also covering how people can sometimes solve externalities on their own

Externalities

• Markets are usually a good way to organize economic activity
• In the absence of market failures, the competitive market outcome is efficient and maximizes total surplus
• Externality is one type of market failure
• It is the uncompensated impact of one person's actions on the well-being of a bystander
• Negative externalities adversely impact bystanders
• Positive externalities beneficially impact bystanders
• Self-interested buyers and sellers neglect external costs or benefits in their actions
• Market outcome is not efficient when externalities are present

Vaccinations as Example

• Declining vaccination against contagious diseases, like measles, imposes costs on other people
• It creates a negative externality

Examples of Negative Externalities

• Include air pollution from a factory and a neighbor's barking dog
• Late-night stereo blasting from a dorm room
• Noise pollution from construction projects and health risks from second-hand smoke
• Talking on a cell phone while driving

Recap of Welfare Economics

• The market equilibrium maximizes consumer and producer surplus
• The supply curve shows private cost or the costs directly incurred by sellers
• The demand curve shows private value or the value to buyers, specifically prices they are willing to pay

Analysis of a Negative Externality

• Social cost equals private cost plus external cost
• External cost is the value of the negative impact on bystanders
• Example of external cost can be $1 per gallon from smog and greenhouse gasses
• At any quantity less than 20, the value of additional gas exceeds social cost
• At any quantity more than 20, the social cost of the last gallon exceeds its value to society
• The socially optimal quantity is 20 gallons
• The market equilibrium (Q =25) is greater than social optimum (Q = 20)
• One solution is to tax sellers $1/gallon, which shifts the supply curve up $1

Internalizing the Externality

• This involves altering incentives to account for external effects
• A $1/gallon tax on sellers makes sellers' costs equal to social costs in the given example
• Equilibrium can match social optimum if market participants pay social costs

Positive Externalities

• Examples include being vaccinated against contagious diseases, research and development, and people going to college

Positive Externality Impact

• The social value includes the private value and external benefit
• Socially optimal quantity maximizes welfare
• At any lower quantity, the social value of additional units exceeds their cost
• At any higher quantity, the cost of the last unit exceeds its social value

Analysis of a Positive Externality

• External benefit is $10 per shot in the flu shots market
• Use a subsidy of $10 to internalize the externality

Summary of Externalities

• Negative externalities lead to a market quantity larger than socially desirable
• Positive externalities lead to a market quantity smaller than socially desirable
• The problem can be remedied by internalizing externalities through taxes on goods with negative externalities and subsidies for goods with positive externalities

Public Policies Toward Externalities

• Command-and-control policies regulate behavior directly
• Examples are limits on pollution or requirements for firms to adopt specific emissions-reducing technologies
• Market-based policies use incentives for private decision-makers to solve the problem
• Corrective taxes and subsidies, along with tradable pollution permits

Corrective Taxes and Subsidies

• These are also known as Pigovian Taxes
• They encourage private decision-makers to take into account social costs
• A price is placed on the right to pollute
• Reduces pollution at a lower cost to society, raises revenue for the government, and enhances economic efficiency

Corrective Taxes vs. Regulations

• Different firms have different pollution abatement costs
• Efficient outcome has firms with the lowest abatement costs reducing pollution the most
• A pollution tax is efficient because firms with low abatement costs will reduce pollution to lower their tax burden and firms with high abatement costs will have greater willingness to pay the tax
• Regulation is not efficient when requiring all firms to reduce pollution by a specific amount
• Corrective tax provides firms incentive to continue reducing pollution as long as the cost of doing so is less than the tax.
• Cleaner technology gives firms an incentive to adopt it
• Firms don't have an incentive for further reduction beyond the level specified in a regulation

Corrective Tax Example

• A gas tax impacts 3 externalities: congestion, accidents, and pollution
• Contributes to congestion the more you drive
• Larger vehicles cause more damage in an accident
• Burning fossil fuels produces greenhouse gasses

Carbon Taxes

• Economists say a tax on the carbon content of fuels would be a less expensive way to reduce carbon-dioxide emissions and corporate average fuel economy' requirements for automobiles

Active Learning

• Acme and US Electric run coal-burning plants which each emit 40 tons of sulfur dioxide per month
• The goal is to Reduce SO2 emissions 25%, to 60 tons/month
• The cost of reducing emissions is $100/ton for Acme and $200/ton for US Electric
• A policy option is that every firm must cut its emissions 25% (10 tons)
• The cost to Acme is $1000, to USE is $2000
• In total, that is $3000 Issue 60 permits and give 30 permits to each firm
• The company may use less than 30 or more than 30 tons a month
• The firms can buy and sell credits
• Using tradable permits achieves the goal at lower total and individual costs compared to regulations

Tradable Pollution Permits System

• This reduces pollution at a lower cost than regulation
• Firms with low cost of reducing pollution sell unused permits
• Firms with high cost of reducing pollution buy permits
• Pollution reduction is concentrated among firms with the lowest costs

Public Policies Toward Externalities

• Firms pay for pollution through corrective taxes or pollution permits
• Pay to the government when taxed and pay to buy permits
• The externality of pollution gets internalized.

Objections to the Economic Analysis of Pollution

• Giving people the option of polluting for a fee
• Can have trade-offs between a clean environment and a lower standard of living

Further Notes on Public Policy

• A clean environment is a normal good reflecting positive income elasticity
• Rich countries can afford a cleaner environment and more rigorous environmental protection
• Demand is ruled by law of demand regarding clean air and water
• The lower the environmental protection price, the more the public will want it

Private Solutions to Externalities

• These may include moral codes, social sanctions, and charities
• Self-interest with relevant parties
• Integrating different types of businesses and contracts between interested parties

The Coase Theorem

• If private parties can bargain without cost over resource allocation, they can solve the problem of externalities on their own
• Interested parties can reach a mutually beneficial and efficient bargain regardless of the initial distribution of rights

Why Private Solutions Don't ALways Work

• High transaction costs meaning parties must incur costs in the process of following through on a bargain
• Stubbornness can break down bargaining
• Coordination problems with a large number of interested parties

Summary of Chapter

• An externality occurs when a transaction affects a third party
• Negative externalities cause the socially optimal quantity to be less than the equilibrium
• Positive externalities cause the socially optimal quantity to be greater than the equilibrium
• Governments regulate or impose corrective taxes to address externalities' inefficiencies
• According to the Coase theorem, resources are allocated efficiently if people can bargain without cost
• Reaching an agreement is difficult among many interested parties; so the Coase theorem does not apply