5.

2

Private-Sector Solutions to Negative Externalities
Chapter 5 Externalities: Problems and Solutions

The Solution
Coase Theorem (Part I) When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity.

Coase Theorem (Part II) The efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e

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0 Net Cost to the Laundromat associated with the firm’s marginal production = $1. Jonathan Gruber. Case (ii): Laundromat has the property right © 2007 Worth Publishers Public Finance and Public Policy.20 *Efficient outcome? Case (i): Factory has the property right. 2e 2 of 33 .2 Example I Chapter 5 Externalities: Problems and Solutions Net Benefit to the factory associated with marginal production = $1.5.

0 *Efficient outcome? Case (i): Factory has the property right Case (ii): Laundromat has the property right © 2007 Worth Publishers Public Finance and Public Policy.20 Net Cost to the Laundromat associated with the firm’s marginal production = $1.5. Jonathan Gruber. 2e 3 of 33 .2 Example II Chapter 5 Externalities: Problems and Solutions Net Benefit to the factory associated with marginal production = $1.

2e 4 of 33 .14 4 3 21 4 2 0 -2 -4 -8 -9 -10 4012 4014 4014 4012 4008 4000 3991 3981 * 5 6 7 ** 8 9 10 © 2007 Worth Publishers Public Finance and Public Policy.2 The problem of the Common Chapter 5 Externalities: Problems and Solutions Example: 1000 identical persons who can do nothing but fish. Each can catch 4 fish on shore. Jonathan Gruber.8 6 5.5. No of Men 0 1 2 Total Catch on Board 0 6 16 MP (on board) 0 +6 +10 AP (on board) 0 6 8 Net Social MP (on board) 0 2 6 Social Total 4000+0=4000 3396+6=4002 3392+16=4008 3 4 24 30 34 36 36 32 27 21 +8 +6 +4 +2 0 -4 -5 -6 8 7.5 6.

2e 5 of 33 .4 Chapter 5 Externalities: Problems and Solutions Distinctions Between Price and Quantity Approaches to Addressing Externalities Basic Model © 2007 Worth Publishers Public Finance and Public Policy. Jonathan Gruber.5.

Chapter 5 Externalities: Problems and Solutions Abatement: Algebraic Illustration Ē = firm’s pollution without abatement X = abatement E = Ē-X = pollution C(X) = abatement cost D(E) = D(Ē–X) = pollution damage C’(X) = marginal abatement cost D’(E) = marginal damage of pollution © 2007 Worth Publishers Public Finance and Public Policy. Jonathan Gruber. 2e 6 of 33 .

© 2007 Worth Publishers Public Finance and Public Policy. Optimal abatement: Choose X to Minimize C(X) + D(E) = C(X) + D(Ē-X) • • => C’(X) .D’(Ē-X)=0. Or.Chapter 5 Externalities: Problems and Solutions 1. C’(X) = D’(E). Jonathan Gruber. 2e 7 of 33 .

Chapter 5 Externalities: Problems and Solutions 2. set t= D’(E). Jonathan Gruber. © 2007 Worth Publishers Public Finance and Public Policy. 2e 8 of 33 . Optimal solution for a firm in the presence of a tax: Minimize C(X) + t E = C(X) + t Ē – t X (x) • => t= C’(x) • To attain social optimum then.

4 Chapter 5 Externalities: Problems and Solutions Distinctions Between Price and Quantity Approaches to Addressing Externalities Multiple Plants with Different Reduction Costs © 2007 Worth Publishers Public Finance and Public Policy. Jonathan Gruber.5. 2e 9 of 33 .

X2 Pollution damage = D(E1+E2) =D(Ē1 + Ē2 . 2e 10 of 33 .Chapter 5 Externalities: Problems and Solutions Example with Multiple Firms Ē1.X1 . X2. E1 = Ē1 . Ē2.X1. E2 = Ē2 . X1.X2) © 2007 Worth Publishers Public Finance and Public Policy. Jonathan Gruber.

=> Set: t = D’(E) © 2007 Worth Publishers Public Finance and Public Policy. Jonathan Gruber. * Firm’s solution: Minimizes Ci(Xi) + t (Ēi .X1 .X2)  C1’ (X1) = C2’(X2) = D’(E).Xi) => Ci’(Xi) = t.Chapter 5 Externalities: Problems and Solutions * Optimal abatement: Minimize C1(X1) + C2(X2) + D(Ē1 + Ē2 . 2e 11 of 33 .

X2=150 © 2007 Worth Publishers Public Finance and Public Policy. 2e 12 of 33 . Jonathan Gruber.Chapter 5 Externalities: Problems and Solutions Example Assume: D(E) =10 E C1(X1)=F + 1/10 (X1)2 C2(X2)=F + 1/30 (X2)2 => => => D’(E) =10 C1’(X1) =1/5 (X1) C2’(X2) =1/15 (X2) Setting C1’(X1) = C2’(X2) = D’(E) => X1=50.

• Costs: C1 = F + 1/10 (100)2 C2 = F + 1/30 (100)2 © 2007 Worth Publishers Public Finance and Public Policy.Chapter 5 Externalities: Problems and Solutions Equal pollution Reduction: Ask each firm to reduce pollution by 100. 2e 13 of 33 . Jonathan Gruber. • Same benefit of damage reduction as with the Pigouvian solution.

Jonathan Gruber.Chapter 5 Externalities: Problems and Solutions Total cost of abatement= C1 + C2 = 2F + (100)2 [1/10 + 1/30] = 2F + 4000/3 Versus the total cost for the Pigouvian solution: C1 = F + 1/10 (50)2 C2 = F + 1/30 (150)2 => C1 +C2 = 2F + 1000. © 2007 Worth Publishers Public Finance and Public Policy. 2e 14 of 33 .

it will be the number of permits sold. Jonathan Gruber. Want 200 reduction Issue 300 permits (150 each) Firm i’s pollution level is Ei = Ēi .Xi = 150 + ni ni denotes the number of extra permits purchased. • • © 2007 Worth Publishers Public Finance and Public Policy. 2e 15 of 33 . If ni is negative.Chapter 5 Externalities: Problems and Solutions Market for Permits • • • • Suppose Ē1 + Ē2 = 500.

Jonathan Gruber.Chapter 5 Externalities: Problems and Solutions • • • • Price of a permit= p Cost of polluting Ei = Ci (Xi) + ni p Or Ci (Xi) + (Ē . • © 2007 Worth Publishers Public Finance and Public Policy. C1’(X1)= C2’(X2) If p=t. 2e 16 of 33 .Xi – 150) p Minimizing costs yields Ci’(Xi)=p. we will have the Pigouvian solution.

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