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10 Whenyouhavecompletedyourstudyofthischapter youwillbeableto 1Explainwhynegativeexternalitiesleadtoinefficientoverproductionandhowpropertyrights pollutionchargesandtaxescanachieveamoreefficientoutcome 2Explainwhypositiveexternalitiesleadtoinefficientunderproductionandhowpublicprovisionandsubsidiescanachieveamoreefficientoutcome LEARNINGOBJECTIVES Externalities Anexternalityisacostorabenefitthatarisesfrom ProductionthatfallsonsomeoneotherthantheproducerConsumptionthatfallsonsomeoneotherthantheconsumerNegativeexternalityAproductionorconsumptionactivitythatcreatesanexternalcost PositiveexternalityAproductionorconsumptionactivitythatcreatesanexternalbenefit EXTERNALITIESINOURDAILYLIVES NegativeProductionExternalitiesPollutionisthemajorexampleofthistypeofexternality Othersarenoiseandcongestion PositiveProductionExternalitiesExample investmentinR D whichturnsoutsuccessfulandbenefitsthewholesociety Anotherexample HoneyproductionandOrchardsproducepositiveexternalityoneachother NegativeConsumptionExternalitiesSmokingtobaccoinaconfinedspace Noisyparties PositiveConsumptionExternalitiesEducationisamajorexampleofthistypeofexternality Othersareafluvaccinationandrestorationofanhistoricbuilding EXTERNALITIESINOURDAILYLIVES 10 1NEGATIVEEXTERNALITIES POLLUTION PrivateCostsandSocialCostsMarginalprivatecostisthecostofproducinganadditionalunitofagoodorservicethatisbornebytheproducerofthatgoodorservice Marginalexternalcostisthecostofproducinganadditionalunitofagoodorservicethatfallsonpeopleotherthantheproducer Marginalsocialcostisthemarginalcostincurredbytheentiresociety bytheproducerandbyeveryoneelseonwhomthecostfalls Marginalsocialcost MSC isthesumofmarginalprivatecost MC andmarginalexternalcost MSC MC Marginalexternalcost 10 1NEGATIVEEXTERNALITIES POLLUTION ProductionandPollution HowMuch Whenanindustryisunregulated theamountofpollutionitcreatesdependsonthemarketequilibriumpriceandthequantityofthegoodproduced Whenoutputlevelis4millionlitresofpaintamonth Marginalprivatecostis 1 00alitre Marginalexternalcostis 1 25alitre Marginalsocialcostis 2 25alitre 10 1NEGATIVEEXTERNALITIES POLLUTION Iftheindustrycreatesanexternalcost themarketequilibriumisinefficient Toomuchofthegoodisproduced Marginalsocialcostexceedsmarginalbenefit Theefficientquantityis2millionlitresofpaint wheremarginalsocialcostequalsmarginalbenefit Thegraytriangleshowsthedeadweightlosscreatedbythepollutionexternality 10 1NEGATIVEEXTERNALITIES POLLUTION FixingtheInefficientOverproductionThreewaysofdealingwithexternalitiestoavoidtheoverproductiontheybringareEstablishpropertyrightsMandatecleantechnologyTaxorpricepollution 10 1NEGATIVEEXTERNALITIES POLLUTION EstablishPropertyRightsExternalitiesarisewhenpropertyrightsaremissing Propertyrightsarelegallyestablishedtitlestotheownership use anddisposaloffactorsofproductionandgoodsandservicesthatareenforceableinthecourts Establishingpropertyrightsisonewayofdealingwithexternalities 10 1NEGATIVEEXTERNALITIES POLLUTION Toseehowpropertyrightscanwork supposethepaintproducersownthehomesandtheriver Therentalincometheycanearnonthehomesdependsontheamountofpollutiontheycreate Theeffectofpollutiononrentalincomegivesthepaintproducersanincentivetolimitpollution Theymightlimitpollutionby UsinganabatementtechnologyDecreasingproductionFirmswillchosetheleast costalternativemethod ThiscanbeexplainedusingCoaseTheorem 10 1NEGATIVEEXTERNALITIES POLLUTION TheCoaseTheoremCoasetheoremisthepropositionthatifpropertyrightsexist onlyasmallnumberofpartiesareinvolvedandtransactionscostsarelow thenprivatetransactionsareefficientandtheoutcomeisnotaffectedbywhoisassignedthepropertyright Transactionscostsaretheopportunitycostsofconductingatransaction 10 1NEGATIVEEXTERNALITIES POLLUTION ApplicationoftheCoaseTheoremIfpollutingpaintfactoriesownhomesandriver therentpeoplewillinglypaydecreasesastheamountofpollutionincreases Ifhomeownersowntheriver thefactoriesmustpayhomeownersforanypollution andthemorethefactoriespollute themoretheypay Regardlessofwhoownstheriver solongassomeoneownsit thefactoriesbearthecostofpollution andthequantityofproductionandpollutionareefficient 10 1NEGATIVEEXTERNALITIES POLLUTION MandateCleanTechnologyGovernmentsregulatewhatmaybedumpedinriversandlakesandemittedintotheatmosphere TheEnvironmentalProtectionandBiodiversityConservationActof1999givestheDepartmentoftheEnvironmenttheauthoritytoissueregulationsthatlimitemissionsandachievedefinedairqualitystandards Stateandterritorygovernmentshavesimilarlegislationandregulations 10 1NEGATIVEEXTERNALITIES POLLUTION TaxorPricePollutionGovernmentsusetwomethodstoconfrontpolluterswiththecostsoftheirdecisions TaxesCap andtradeToworkoutthepollutionchargeorpollutiontaxthatachievesefficiency theregulatorneedsalotofinformationabouttheindustry whichisgenerallynotavailable 10 1NEGATIVEEXTERNALITIES POLLUTION TaxesBysettingthetaxequaltothemarginalexternalcost ormarginalabatementcostifitislower firmscanbemadetobehaveinthesamewayastheywouldiftheyborethecostoftheexternalitydirectly Toseehowataxworks assumethatthegovernmenthasassessedthemarginalexternalcostofpollutionaccuratelyandimposesataxonthefactoriesthatexactlyequalsthiscost 10 1NEGATIVEEXTERNALITIES POLLUTION Cap and TradeCap and tradeplacesacaporceilingonemissionsandassignsorsellsemissionrightstoindividualproducerswhoarethenfreetotradepermits Itisatoolthatseekstocombinethepowerofgovernmenttolimittotalemissionswiththepowerofthemarkettominimisecostandmaximisebenefit Tousethismethod thegovernmentmustfirstestimatetheefficientquantityofpollution settheoverallemissionscaptoachievetheefficientoutcomeandallocatethecaptoproducers 10 1NEGATIVEEXTERNALITIES POLLUTION Themarketinpermitsdeterminestheequilibriumpriceofemissions Eachfirm confrontedwiththatprice maximisesprofitbysettingitsmarginalpollutioncostormarginalabatementcost whicheverislower equaltothemarketpriceofapermit Byconfrontingpolluterswithapriceofpollution tradeinpollutionpermitscanachievethesameefficientoutcomeasatax 10 2POSITIVEEXTERNALITIES EDUCATION PrivateBenefitsandSocialBenefitsMarginalprivatebenefitisthebenefitofanadditionalunitofagoodorservicethattheconsumerofthatgoodorservicereceives Marginalexternalbenefitisthebenefitofanadditionalunitofagoodorservicethatpeopleotherthantheconsumerofthegoodorserviceenjoy Marginalsocialbenefitisthemarginalbenefitenjoyedbysociety bytheconsumerofagoodorserviceandbyeveryoneelsewhobenefitsfromit Marginalsocialbenefit MSB isthesumofmarginalprivatebenefit MB andmarginalexternalbenefit MSB MB Marginalexternalbenefit 10 2POSITIVEEXTERNALITIES EDUCATION ProductionandEducation HowMuch Theamountofpositiveexternalitydependsonthemarketequilibriumpriceandthequantityofthegoodproduced When1 2millionstudentsattenduniversity Marginalprivatebenefitis 10 000perstudent Marginalexternalbenefitis 15 000perstudent Marginalsocialbenefitis 25 000perstudent 10 2POSITIVEEXTERNALITIES EDUCATION Iftheindustrycreatesanexternalbenefit themarketequilibriumisinefficient Toolessofthegoodisproduced MarginalsocialbenefitexceedsMarginalcost Theefficientnumberofstudentsis1 2million Thegreytriangleshowsthedeadweightlosscreatedbecausetoofewstudentsenrolinuniversity 10 2POSITIVEEXTERNALITIES EDUCATION GovernmentActionsIntheFaceofExternalBenefitsTwodevicesthatgover
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