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1、LECTURE 3EXTERNALITIESExternalities DefinedGovernment intervention is required because of market failures:Market failures refer to situations in which the market, absent of government intervention, leads to inefficiencies. An externality is a cost or benefit not expressed in a market and therefore n

2、ot internalized in buyers or sellers market decisions. Agent As welfare is directly affected by Agent Bs actions, yet Agent B neither bears the costs or receives the benefits of doing so.Externalities can be negative or positive.23Pollution, traffic congestion, smoking R&D, education No externalitie

3、sConsider a factory that produces steel and pollutes the environment. The quantity produced is such that: Demand = sum of the marginal benefits of buyers.i.e. 4S = DsupplydemandNo externalitiesSupply = private MC of the producerSuppose there is one producer. S shows the relationship between the MC a

4、nd the quantity produced. S shows how much the producer is willing to produce for a certain price.With several producers, the aggregate supply is the horizontal sum of the individual supply curves5No externalities6Note: In the absence of externalities the market solution Qc is efficient. Introducing

5、 externalitiesProduction incurs costs to the environment (due to pollution). “Social cost” of production.The true MC of production = MC of the producer, plus the social MC (associated with externalities). True MC = private MC + social MC The socially optimal quantity is such that:S= Di.e. where the

6、true MC is equal to MB7SIntroducing externalitiesThe socially optimal quantity entails less production than the market e. Deadweight loss: The area ABC, between QE and QC, S and DThe producer gains by producing more than QE, and people living close to the factory lose. Producing more than QE is inef

7、ficient because the gain for the producer is smaller than the loss of people living close to the factory. The producer does not take into account the negative externalities associated with production. production is above the socially optimal level8Positive externalitiesWith positive externalities, S

8、 is lower than S, thus the socially optimal quantity is greater than Qc the production is below the socially optimal levelFor instance, firms do not internalize the positive effects of R&D investment on the society. Insufficient investment in R&D9Personal interactions are not externalitiesTwo person

9、s have to share one drink. If one has more, the other one has less.Is this an externality?NOExternalities always involve inefficiencies.The total amount available to drink will not change if one person drinks more and one less. Only the distribution changes. 10Personal interactions are not externali

10、tiesAn ice-cream vendor faces unusually high demand, and increases the price.Buyers are affected negativelyIs it an externality? NO.The market has internalized the increased demand through prices. Although buyers are worse off, the seller is better off.11Economic problem: How to solve externalities?

11、 Private sector solutionsCan we rely on the private sector to correct externalities? What are the limitations of the private sector solutions?Public sector solutionsRegulation/quota approachTaxation approachWhen to use which approach?12Private ownership solutionsTragedy of the commonsTwo shepherds g

12、raze their sheep on a land without private owners, and the grass may run out due to overgrazing. “tragedy of the commons”. grazing = negative externality.Shepherds do not internalize the negative effect to the other shepherd, and eventually grass will run out. 13Ultimate tragedy of the commons: Gree

13、nhouse gases (CO2)Private ownership solutionsTragedy of the commonsSimilar to a prisoners dilemma:Solution: private ownership of land. If land belongs to the shepherds, using it requires payment to the other shepherd, to compensate for loss of grass. That way, both will restrict the number of sheep.

14、 14Person 2 restricts #sheepPerson 2 has large #sheepPerson 1 restricts #sheep 3,31,4Person 1 has large #sheep 4,12,2Private ownership solutionsTragedy of the commonsOther example: Traffic congestion.Each extra car slows down traffic.Drivers do not consider the effect to other drivers. Solution? A p

15、rivate owner of the highway would ask pay for use. Fewer people will drive and congestion is reduced. 15Private ownership solutionsPollutionFor pollution, externalities can be resolved if people have the legal right to have clean air.The polluter could be required to compensate the victims of pollut

16、ion, and would internalize the externality.Problems with this solution:How to assign the blame and identify the victims? Sharing the cost among polluters, and sharing the payment among victims may be not feasible.Negotiation on the price can be difficult when there are many agents having on both sid

17、es. 16Public policies and externalitiesPolicy options:Taxes/subsidiesRegulation and quotasTaxes used to combat externalities are called Pigovian taxes (Arthur Pigou)For negative externalities: A tax raises the MC of the producerIf the per-unit tax are at the right level, the quantity produced will b

18、e cut back to its optimal level.17Taxation18TaxationPer-unit tax t for the producer supply curve shifts upwards. The sellers optimal production solves:S + t =DTaxation increases the MC for the seller, which leads to a lower quantity. If the tax rate is just right, quantity falls to QE. 19MC after ta

19、xMBTaxationThe optimal tax is the social MC (i.e. level of externalities) at QE. On the figure: t =EHAt this level, producers will choose QE. The seller internalizes the externality.Tax revenue = AEHB.If we overestimate the externality, tax/subsidies will be too large, leading to an inefficient e.20

20、SubsidiesThe government can impose a Pigovian subsidy (i.e. negative tax) on producers of positive externalities, which increases the output.When the subsidy is at the right level, producers will fully internalize the externality and increase quantity. 21Example: Drunk driving Levitt and Porter 2001

21、Fines are typically in the $100 to $1000 range. Too low?They consider deadly car accidents in the US40,000 people die a year in car accidents. 2,910 traffic fatalities would be avoided if all drivers were sober.Value of life: assumed to be $3million, in line with other papers. Total externalities: $

22、3million x 2,910 = around $9bnSince there are 1.1 million arrest for drunk driving a year, the appropriate punishment should be:$9bn/1.1m=$8,00022RegulationAlternative solution: Direct government regulation.Smoking not allowed in public places.Compulsory education.Limitations on pollutants for diese

23、l.Direct regulatory measures are unlikely to replicate the efficient e, but are simple to implement compared to taxation.23QuotasThe government decides the total allowable quantity, and how it is distributed.CO2 emissionsCar registration platesThe government will issue total quotas of QE.The governm

24、ent can choose to supply quota rights in a competitive market. Quotas may or may not be tradable.Having to pay for quotas ensures they are used by those who have the greatest benefits from using them.24Quotas25Quotas: The EU emission trading systemThe worlds biggest scheme for trading CO2. Launched

25、in 2005, it covers some 11,000 power stations and industrial plants, whose CO2 emissions make up almost 50% of EUs total. Companies can trade their allowances, providing an incentive for them to reduce their emissions.In a basic sense the ETS has worked. It has set a cap on half of Europes carbon em

26、issions, and the companies covered by the scheme are no longer free to pollute. Carbon has a price and this influences the economics of burning fossil fuels.26Quotas: The EU emission trading systemWhen Phase I was introduced, the idea was to make pollution expensive. But then.The price collapse had

27、two causes. Far too many carbon credits were given out in the beginning of the program, resulting in a huge surplus of credits.Firms had reduced their emissions in the first two years of the phase, so that they didnt need as many allowances in 2007.27April 2006May 2006March 2007September 200730 euro

28、s10 euros1.2 euros0.1 eurosPhase II, starting in 2008, increased prices. Still, prices are declining again.Lesson: Restoring efficiency requires accurate allocation of quotas. Over-allocation leads to very low prices, which defeats the objective of having quotas.28Quotas: The EU emission trading sys

29、temQuotas vs. taxation approachIn which situations are quotas (i.e. quantity regulation) superior to taxation?Do governments choose the best approach to correct externalities?Let us consider the market for the REDUCTION of pollution.29QRPR0Social MBR*Private MC (for producer)Private MB (for seller)R

30、FullMore pollutionNo regulationOptimalreductionTaxQuotas vs. taxation approachThe private market e is zero pollution reduction, while the socially efficient level is higher.Taxation: To achieve R*, the tax rate should be SMBQuotas: just mandate pollution reduction of R*.Two cases in which the two ap

31、proaches are no equivalent:Uncertainty on costs and benefitsUnequal PMC across polluters31Suppose there are two firms, with different technologies for cutting pollution.Firm A is more efficient than Firm B at such reduction.With non-tradable quotas, the costs of Firm B are excessive.When different f

32、irms have different costs for pollution reduction, taxation is more efficient than regulation when quotas are non-tradable.32Quotas vs. taxation approachDifferent PMCQRPR0SMBR*PMCA + PMCBPMCBPMCARA,RBRARBtaxQuotas vs. taxation approachDifferent PMCAnother option is tradable quotas. Producers are all

33、owed to trade the permits to pollute.Firm B would buy some of Firm As permits, since PMCB (PMCA). Both sides are better off by Firm A selling a permit to Firm B.With tradable quotas, quantity regulation is equivalent to the taxation approach34Finally, the government may not always know with certaint

34、y how costly it is for a firm to reduce its pollution levels.The choice between taxation or licenses should be based on the size of the DWL.35Quotas vs. taxation approachUncertain costs and benefitsQRPR0SMBR1PMC1RFullPMC2R3TaxOptimal reductionQuotas vs. taxation approachWhen the SMB curve is flat compared to PMC, the DWL of taxation is smaller than the DWL of quantity regulation.Taxation is the best instrumentA small change in the level of PMC will affect greatly the optimal abatement level