PF03 Externalities

Public Finance
- Externalities -
Sun Go
Chung-Ang University
Overview Definition Problem Private response Public response Income distribution Positive externality Summary
Review
Public goods
I What are public goods?
I Efficiency provision of public goods
I Free riders problem
I Preference revelation mechanism
I The Lindahl model
Sun Go Externalities 2/91

Overview
Externalities
I Definition and nature
I Problems
I Private responses: the Coase theorem, mergers, norms
I Public responses: tax and subsidy, emissions fees,
cap-and-trade programs, command-and-control regulation
I Implications for income distribution
I Positive externalities
Textbook
I Ch. 5


Definition

Definition
Externality
I A cost or benefit that occurs when the activity of one entity
directly affects the welfare of another in a way that is outside
the market mechanism
I External = outside the market
I Externalities reduce economic efficiency
I The effects are not transmitted via prices

Examples
I Pollution by a factory and people living around there
I An apple orchard and an apiarist (beekeeper producing honey)
I An annoying person next to an irritable person

The nature of externalities
I Externalities can be produced by consumers as well as firms
I Externalities are reciprocal in nature
I Externalities can be positive
I Public goods can be viewed as a special kind of externality


Problem

Example: air pollution

Example: air pollution
I The production of a good pollutes the air, incurring damage to

the nearby residents
I But the air pollution does not affect the production decision of
the firm

Notation
I Q: total output by the producer

I MB: the marginal benefit to the producer of each level of
output (we assumes the diminishing marginal benefit from
output)
I MPC: marginal private cost to the producer
I Assume that there is a fixed amount of pollution per unit of
output (The amount of pollution it creates increases as the
factory’s output increases)
I MD: marginal damage to the local resident (Assume that
additional pollution makes the resident worse off at an
increasing rate)
I MSC = MPC + MD: marginal social cost

An externality problem
A producer’s decision: Private market equilibrium

I MB=MPC, for the producer to max profit
Socially desirable outcome

I Efficient if MSC=MB

An externality problem
kenapa sih Q1 is not efficient?

Implications
I When externalities exist, private markets do not produce the

socially efficient output level
I Efficiency improvement from Q1 to Q ∗
I Note: Zero pollution is not socially desirable
I But how would we find Q ∗ in practice?
what if zero pollution? can we?
gov can mandate the corporate to stop production, and the Q is zero. so it is not
efficient also.
what if gov tax the corporate profit?

local resident will be happy, and they will accept the marginal damage.
thus, zero pollution is not desirable bcs it is not efficient

Responses Text
1. Private response
I The Coase theorem
I Mergers and norms
2. Public response
I Taxes and subsidies
I Emission fees and cap-and-trade programs
I Command-and-control regulation


Private response 1: The Coase

theorem

Bargaining and the Coase Theorem

there is no definition regarding property rights.
no one knows whose pollution it is? who is the ownership of the air?
so who is responsible to pollution?
Problem with externalities

I The absence of property rights
Two assumptions
I Property rights are assigned to someone (either producers or
residents)
I No cost for bargaining each other

Scenario 1
The property right is given to the producer

I The producer would be willing to produce less as long as he
receives a payment that exceeds his net incremental gain from
producing that unit (=MB - MPC)
I The residents would be willing to pay the producer not to
produce a given unit as long as the payment is less than the
marginal damage to him
MB to the resident from
Market solution exists decreasing the Q
MC for the producer
I At Q ∗ , MD(=dc) = (MB-MPC) to decrease the Q
I Total payment would be between triangle cdg & area cdhg
I The exact amount depends on their relative bargaining
strengths

Bargaining and the Coase Theorem MD>MB-MPC is how much the producers
should be paid to reduce the Q by 1 unit
How much the resident are willing to pay

to reduce Q by 1 unit

Scenario 2 Firm’s max possible payment = a+b

Resident min required revenue = b
The property right is given to the resident
I The producer’s MC becomes MPC + MD
I The producer Would be willing to pay the resident to produce
more as long as the payment < (MB - MPC)
I The resident Would be willing to accept some pollution as
long as the producer’s payment > MD
Market solution still exists

I At Q ∗ , MD(=dc) = (MB-MPC)
I Total payment would be between the producer’s total profit
and the residents’ total damage at Q ∗
I The exact amount depends on their relative bargaining
strengths

The Coase theorem
“Provided that transaction costs are negligible, an efficient solution

to an externality problem is achieved as long as someone is assigned
property rights, independent of who is assigned those rights.”
Assumptions
I The costs to the parties of bargaining are low
I The owners of resources can identify the source of damages to
their property and legally prevent damages

Issues
In the real world

I Typically the transaction cost is too high
I Difficult to find the source of damages
I But sometimes it works well (ex. elephant conservation policy)
I Kenya: banned all hunting in 1977 but not successful
I Zimbabwe: granted landowners property rights over wildlife.
Successful.
I It is more profitable to stop growing food and let the land
revert to its natural state, then charge tourists to view the
animals.
Redistribution
I The assignment of property rights is relevant of income
distribution


Private response 2: Mergers and

norms

Mergers
Internalize the externality

I A resident buys the factory, or the Factory owner buys and
lives in the neighborhood town
I Then the externality would be internalized
I And the outcome is no more inefficient

Norms
Social conventions
I “Do unto others as you would have others do unto you”
I A social convention can be an attempt to force people to take
into account the externalities they generate and internalize it
I What you learned from kindergarten
I Ex. farting, littering


Public response 1: Taxes and subsities

Public response 1-1: A Pigouvian tax

A Pigouvian tax
I A tax levied on each unit of an externality-generator’s output

in an amount equal to the marginal damage at the efficient
level of output
I The Pigouvian tax = cd = MD = (MSC - MPC)
I The producer’s new MPC after tax = MPC + cd
I New after-tax equilibrium at Q* (MPC+cd = MB)
I The pigouvian tax revenue = rectangle cdij
I But don’t compensate the resident with this revenue. It will
increase the number of resident, thus increasing inefficiency.

A Pigouvian tax

A Pigouvian tax
Practical problems
I Finding the correct tax rate is very difficult
I Ex: automobile emission
I Mileage tax is difficult to levy. A compromise is gasoline tax.


Public response 1-2: A Pigouvian

subsidy

Subsidy
A Pigouvian subsidy
I Pay a subsidy for not polluting the air
I A subsidy to the producer by cd (= MD at Q ∗ )
I Same result as the Pigouvian tax
I Total subsidy = cdfh < the pigouvian tax revenue

A Pigouvian subsidy

A Pigouvian subsidy
Practical problems
I The subsidy will attract more polluters in the long run, thus
increasing pollution
I Subsidizing polluters is not ethically undesirable
I Polluters might game the system by undertaking inefficient
actions that increase their assigned baselines, thus raising the
amount of subsidy

Problems with taxes and subsidies
It might not give the polluter the proper incentives to search for
ways to reduce pollution other than reducing output
I No incentive to invest in eco-friendly innovation


Public
Private response 2: Emissions fees
and cap-and-trade programs

Emissions fees and cap-and-trade programs
MSB: marginal social benefit

I The fall in the resident’s costs for each unit reduction in the
producer’s pollution
I Slopes downward
I Assumption: worse off at an increasing rate for each additional
unit of pollution
MC: the marginal cost to the producer to reduce each unit of

pollution
I Slopes upward
I The cost of reducing pollution increases at an increasing rate

MSB and MC

A problem
The producer has no incentive to reduce pollution

I It is inefficient
I How can we make the producer choose the efficient outcome
e∗
Government policies to achieve e ∗

I Emissions fee
I Cap-and-trade
I Command-and-control regulation


Private response 2-1: Emissions fees

Emissions Fee
I A (Pigouvian) tax levied on each unit of pollution

I The government levies an emissions fee that charges f ∗ for
each unit of pollution
I f ∗ =MSB at e ∗
I The producer’s emission fee payment goes down by f ∗ for each
unit of pollution the producer cuts
I The producer reduces pollution if f ∗ >MC, and stops at
f ∗ =MC, that is e ∗

Emissions Fee

Emissions fees vs. uniform pollution reduction
Setting
I Consider two polluters: Bart and Homer
I It is more costly for Homer to reduce pollution than it is for
Bart
I MCHomer is steeper than MCBart
I Suppose each emits 90 units of pollution per day (total 180)
I Government finds that the efficient amount of pollution is 80
units per day
I Homer and Bart need to reduce total 100 units per day

Scenario 1
Uniform pollution reduction

I Each reduces pollution by 50 units
I But MCHomer > MCBart
I Not cost effective
I Efficiency gain if Bart reduces pollution more and Homer
reduces it less
I Cost effective if MCHomer = MCBart

Emissions Fees

Scenario 2
Emissions Fees
I f ∗ = MCHomer = MCBart
I Efficient and cost effective
I Homer, who pollutes more, pays more tax
I An incentive for eco-friendly innovation

Emissions Fees

Emissions Fees
Examples of cost-effective policy

I Congestion pricing
I A tax levied on driving equal to the marginal congestion costs
imposed on other drivers
I Someone will reduce driving more than others


Public
Private response 2-2: Cap-and-trade
programs

Cap-and-trade programs
A system of tradable pollution permits

I A policy of granting permits to pollute, with the number of
permits set at the desired pollution level, and allowing
polluters to trade the permits
Example: government issues 80 permits each year

I To reduce daily pollution from 180 to 80
The initial allocation of permits among the polluters does not

matter at all
I Remind the Coase theorem
I “Permits” play a role like the property rights
I But the allocation has distributional consequences

Example: Bart and Homer

Pollution
B - 90
H - 90
Suppose Bart takes all the 80 permits
I Now Bart has to reduce 10 units of pollution with 80 permits
(a)
I At the same time, Homer has to reduce all the 90 units of
pollution as he has no permit (b)
I Not cost effective: MCHomer > MCBart
I Bart would like to sell a permit to Homer at the price between
MCHomer & MCBart
I Equilibrium when MCHomer = MCBart

I Bart sells 65 permits to Homer

Note
Emission fees set at f’ achieves the same pollution reduction as a

cap-and-trade program does
I Then, what are the differences between the emission fees and
the cap-and-trade programs?
I Responsiveness to inflation
I Responsiveness to cost changes
I Responsiveness to uncertainty


Public
Private response 2-3: Emissions fees
vs. cap-and-trade programs

Emissions fee vs. cap-and-trade
Responsiveness to inflation
I The emissions fee needs to be adjusted for the inflation
I Inflation lowers the real emissions fee
I The cap-and-trade system leads to the same amount of
pollution regardless of inflation


Responsiveness to cost changes
I An emissions fee
I Limits the cost of reducing pollution
I But leads to changes in emissions as the cost changes
I A cap-and-trade system
I Limits the amount of emissions
I But leads to changes in the cost of reducing pollution as the
cost changes
I Neither system automatically leads to an efficient outcome
when the costs of pollution reductions change
I The Safety valve price
I Within a cap-and-trade system, a price set by government at
which polluters can purchase additional permits beyond the cap
I The price can be set rather high so it will only be used if the
cost of reducing pollution is much higher than expected
I A hybrid system

Responsiveness to uncertainty
I Inelastic MSB
I Elastic MSB

Inelastic MSB
Suppose government expects MC ∗ , but real MC = MC’
I Based on MC ∗ , issues permits to achieve a reduction of e ∗
I If the true MC is MC’, too much pollution reduction
I e ∗ > e’
Emissions fees
I Set the fee at f ∗ based on MC ∗
I If the true MC is MC’, too little pollution reduction
I ef > e’

Inelastic MSB

Inelastic MSB
When MSB is inelastic, cap-and-trade programs are better

I e ∗ is closer to e’ than ef
I A change in cost has little effect on the optimal amount of
pollution reduction

Elastic MSB
Suppose government expects MC ∗ , but real MC = MC’
I Based on MC ∗ , issues permits to achieve a reduction of e ∗
I If the true MC is MC’, too much pollution reduction
I e ∗ > e’
Emissions fees
I Set the fee at f ∗ based on MC ∗
I If the true MC is MC’, too little pollution reduction
I ef > e’

Elastic MSB

Elastic MSB
When MSB is inelastic, emission fees are better

I ef is closer to e’ than e ∗
I A change in cost has a sizable effect on the optimal amount of
pollution reduction

Distributional effects
Emission fees
I Polluters pay taxes for each unit of pollution
I The revenue goes to the government
I If the permits are allocated directly to the polluters for free,
government receives no revenue
I Someone who takes the permit first will gain
I If the government sells the permits, it can raise some revenue


Public response 3:
Command-and-control regulation

Incentive-based regulations
I Policies that provide polluters with financial incentives to
reduce pollution
I Emission fees, cap-and-trade programs
Command-and-control regulations
I Policies that require a given amount of pollution reduction with
limited or no flexibility with respect to how it may be achieved
I Ex1: a technology standard

Examples
I A technology standard
I A type of command-and-control regulation that requires firms
to use a particular technology to reduce their pollution
I Not cost-effective as there’s no incentive to invest in
cost-saving technology
I A performance standard
I A command-and-control regulation that sets an emissions goal
for each individual polluter and allows some flexibility in
meeting the goal
I Not cost-effective as everyone has the same goal and cannot
shift a burden from one to the other

Command-and-control regulations can be preferable

I If the monitoring cost of the emissions is too high
I If incentive-based system can lead to high concentrations of
pollution in certain local areas


Income distribution

Benefit
Who benefits from pollution reduction?

I Some evidence suggests that poor neighborhoods tend to have
more exposure to air pollution than high-income
neighborhoods
I Lowering the level of air pollution might make the distribution
of real income more unequal
I Improvement in recreational areas
I Benefits mainly high-income families, who tend to be their
main users

Cost
Who bears the cost?

I Do the environmental regulations reduce the number of jobs
for the poor?
I Labor-intensive sweatshops may close and dismiss low-skill
labor
I Environmentalists insist that there is no evidence on such “job
blackmail”
I Environmental regulations may raise the price of the
commodity
I If the buyers are the rich, more equal income distribution
I Otherwise, unequal
Mostly “empirical questions”


Positive externality

In case of positive externalities, a good may be produced less than

the socailly desirable amount
I MEB: Marginal external benefit
I MSB: marginal social benefit
I R ∗ (efficient) > R1 (the market outcome)


Caution
A subsidy is not free

I Every subsidy embodies a redistribution of income
I The fact that an activity is beneficial per se does not mean
that a subsidy is required for efficiency
I Ex: subsidy for farmers’ gas purchases, subsidy for using credit
cards
I Many “tax expenditure” programs


Summary

Summary
Re-cap: Externalities
I Definition and nature
I Problems
I Private responses: the Coase theorem, mergers, norms
I Public responses: tax and subsidy, emissions fees,
cap-and-trade programs, command-and-control regulation
I Implications for income distribution
I Positive externalities
Next class:
I Tax incidence (Ch. 14)

PF03 Externalities

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PF03 Externalities

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Public Finance

Sun Go Externalities 2/91

Sun Go Externalities 3/91

Sun Go Externalities 4/91

Sun Go Externalities 5/91

Sun Go Externalities 6/91

I Pollution by a factory and people living around there

I An apple orchard and an apiarist (beekeeper producing honey)

I An annoying person next to an irritable person

Sun Go Externalities 7/91

The nature of externalities

I Externalities can be produced by consumers as well as firms

I Externalities are reciprocal in nature

I Externalities can be positive

I Public goods can be viewed as a special kind of externality

Sun Go Externalities 8/91

Sun Go Externalities 9/91

Sun Go Externalities 10/91

Example: air pollution

Sun Go Externalities 11/91

Example: air pollution

I The production of a good pollutes the air, incurring damage to

Sun Go Externalities 12/91

I Q: total output by the producer

Sun Go Externalities 13/91

A producer’s decision: Private market equilibrium

Socially desirable outcome

Sun Go Externalities 14/91

Sun Go Externalities 15/91

I When externalities exist, private markets do not produce the

what if gov tax the corporate profit?

thus, zero pollution is not desirable bcs it is not efficient

Sun Go Externalities 16/91

Sun Go Externalities 17/91

Sun Go Externalities 18/91

Private response 1: The Coase

Sun Go Externalities 19/91

Bargaining and the Coase Theorem

Problem with externalities

Sun Go Externalities 20/91

The property right is given to the producer

Sun Go Externalities 21/91

How much the resident are willing to pay

Sun Go Externalities 22/91

Scenario 2 Firm’s max possible payment = a+b

Market solution still exists

Sun Go Externalities 23/91

The Coase theorem

“Provided that transaction costs are negligible, an efficient solution

Sun Go Externalities 24/91

In the real world

Sun Go Externalities 25/91

Sun Go Externalities 26/91

Private response 2: Mergers and

Sun Go Externalities 27/91

Internalize the externality

Sun Go Externalities 28/91

Sun Go Externalities 29/91

Sun Go Externalities 30/91

Public response 1: Taxes and subsities

Sun Go Externalities 31/91

Public response 1-1: A Pigouvian tax