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Externalities, Market Failures and Policy

Interventions


By

Mahendra Reddy
Externalities, Market Failures, and Policy
Interventions
Evaluate positive and negative externalities
in the context of an otherwise well-
functioning competitive market.

Identify inefficiencies caused by externalities
& possible policy interventions.
Positive Externalities
Illustrative example: Open space, viewshed,
wildlife habitat, watershed benefits of
pastureland
Suppose that pastureland is bought and sold in
otherwise well-functioning competitive markets
for land
What happens if market demand only reflects
the benefits to the private landowner?
Positive Externalities
What is a positive externality?
An unpaid-for benefit to other members of society
generated as a side effect or consequence of an
economic exchange, such as between a buyer and a
seller
Positive Externalities
How might there be unpaid-for benefits to society
in the previous agricultural land example?
Nearby residents and visitors enjoy the open space,
views, wildlife, and watershed benefits but do not
have to pay for them
Why is this a problem?
Positive Externalities
Unpaid for benefits are wonderful things.
That isnt the problem
The problem is that the market will not allocate
enough resources to produce the socially optimal
quantity of the thing (pastureland) if only the
farmers benefits are reflected in willingness-to-
pay
Positive Externalities
Market Supply and Demand
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Quantity
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Demand, Private
Benefits
Demand, Social
Benefits
Q too small
MEB
Note:
MEB is
marginal
external
benefit,
the
external
benefit
per acre
of land in
this case
Positive Externalities
Thus too much ag. land gets allocated to housing
and commercial development rather than kept as
pastureland under market allocation because
external benefits are not internalized into the
market demand curve
What are some possible interventions that could
help secure the socially optimal quantity of
pastureland in a market process?
Positive Externalities
One common government intervention is to
provide subsidies to those who provide society
with positive externalities
Williamson Act tax credits for preserving ag. land, public
funding to acquire conservation easements
Subsidized vaccinations
Other examples?
Note that altruistic non-government groups like land trusts or
public health organizations can fulfill some of this intervention
function
Property Rights and Externalities
Society can also decide that neighboring
residents have a property right to some of the
external benefits described previously, and thus
that landowners do not have an unlimited right
to develop their land
How does this tie in with the 5
th
Constitutional
Amendment concerning takings?
Property Rights and Externalities
One can see that the way that property
rights are allocated has a huge impact on
the way that externalities are addressed
by social policy
What are the five key categories of property right
and the four ownership regimes?
Property Rights and Externalities
Access: Non-extractive right to enjoy benefits of
property. Authorized entrants have access
rights, such as permission to bike on timber
company roads.
Withdrawal: Right to extract or remove some or
all of the product of the property. Authorized
users have access and withdrawal rights, such as
those with valid CA fishing licenses.
Property Rights and Externalities
Management: Right to regulate use (access,
withdrawal) and improvements. Claimants such
as farmers who participate in the management
of government-owned irrigation systems hold
these rights.
Exclusion: Right to exclude others from access,
withdrawal, and management. Proprietors who
collectively govern common-property (ex: condo
swimming pool) hold exclusion rights.
Property Rights and Externalities
Alienation: Right to sell (alienate) property to
someone else. Owners of cars have the right to
sell their cars to someone else.
Frequently, we hold limited property rights to
many different things. Usufructuary rights, for
example, are open-ended withdrawal rights that
may run with the land (riparian law) or may
cover treaty rights (ex: Indian fishing rights).
State may be owner in public trust capacity.
Property Rights and Externalities
Ownership Regimes:
Private property
Common property
Government (state) property
Open access (no propertyres nullius [nullis?]
Property Rights and Externalities
The issue of who holds what property right
determines how law and public policy
addresses externalities
What is the common law, and what is it
designed to protect and enforce?
The term common law refers to the body of legal
principles which evolve through the interpretation of law by
judges, as distinct from the body of law created through
legislation. The term originally referred to the common law
of England -- general rules applicable to the whole country,
as distinct from local customs.
Property Rights and Externalities
The common law evolved to protect life,
property, contractual rights and
responsibilities, etc.
Property Rights and Externalities
Thus we might ask, did common law
adequately address + or externalities?
Key problem: If harms are done to an open-
access resource, who has legal standing to sue
under common-law, which protects property?
Moreover, even if it is clear that you were harmed
by pollution to an open-access resource, it may
not be possible to assign liability to a particular
source of emissions if there are many sources.
Property Rights and Externalities
In a few rare cases, 19
th
century judges recognized
that water pollution impacted downstream
usufructuary rights holders. Until the Mineral King
decision, users of open access natural resources were
not widely recognized as having the necessary legal
standing to sue. Thus common law was largely
ineffectual in protecting the environment.
Property Rights and Externalities
Note: Environmental regulations essentially
make the government a proprietor of air, water,
fisheries, wildlife, and other former open-access
resources in a public trust capacity.
Alternatively, land and other non-fugitive
resources can become private property and be
protected under the common law
Alternatively, many resources can become common
property and be protected under common law
Negative Externalities
What is a negative externality?
An uncompensated cost borne by members of
society (or the aspects of the natural world they
care about) that comes about as a byproduct of
economic exchange, such as through market
transactions.
Examples?
Negative Externalities
Assertion: When production of a good or
service generates significant negative
externalities, profit-maximizing firms in
a competitive market will supply too
much of that good or service. Consumers
will pay a subsidized price and so will
consume too much.
Negative Externalities
In a well-functioning competitive market
the firms marginal cost curve is its
supply curve.
So, why should we care about all of this cost curve
analysis?
Because in an unregulated competitive market
external costs are not accounted for in the firms
marginal cost, which means that the firms supply
decision ignores external costs.
Negative Externalities
Marginal social cost =
Marginal private cost (borne by the firm)
Marginal external cost (borne by the environment
and society)
+
Negative Externalities
Thus there are two supply curves
The supply curve based on marginal private cost.
This is the supply curve that firms supply along in
the absence of environmental regulation or
reputational enforcement.
The supply curve based on marginal social cost.
This is the supply curve that reflects the full social
cost of production.
Marginal Private, External, and Social Costs
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Quantity
$
Marginal External
Cost = $30
Marginal
social cost
Marginal
private cost
Market Supply and Demand
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Cost
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MEC
Supply, Social
Cost
Market Supply and Demand
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Supply, Private
Cost
Supply, Social
Cost
A
B
C
D
E
F
Area ABC:
Gross gains
from trade to
buyers and
sellers
Area BCDE:
Total external
cost
Area ABC
Area BCDE:
True net gains
from trade to
all who are
affected
Area AFD:
Max. avail.
gains from
trade w/
Pigouvian tax
Negative Externalities
Theory of Efficiency-Enhancing Policy
Interventions
Pigouvian (aka Pigovian) tax (named after English
economist A.C. Pigou): Tax per unit of output (e.g.,
electricity) equal to marginal external cost, with tax
revenues being used to compensate those harmed
and/or fix environmental harms.
Theory of Efficiency-Enhancing Policy Interventions

What happens if the Pigouvian tax is less than the
cost per unit of reducing emissions? Relate to
benefit/cost analysis.
What happens if the Pigouvian tax is greater than
the cost per unit of reducing emissions? Relate to
benefit/cost analysis.
How does a Pigouvian tax (or environmental tax in
general) affect the market viability of less polluting
alternatives, and research and development to find
clean alternatives?
Theory of Efficiency-Enhancing Policy Interventions

For a Pigouvian tax to fully resolve the inefficiency
due to negative externalities, the following must
hold:
Ability to accurately measure marginal external
cost
Ability of the political system to produce an
efficient environmental policy
Ability to monitor emissions, charge appropriate
tax, and enforce this system
Theory of Efficiency-Enhancing Policy Interventions

In Chapter 8 we will investigate political economy,
an area of study that uses economic methods to
analyze political (legislative, administrative)
outcomes.
In Chapter 9 we will look at economic issues
associated with promoting compliance with
environmental and NR law.
Practice Problem, Negative Externalities
Demand: P = 1500 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q
1. Solve for equilibrium P, Q, and total gross gains from trade
assuming no regulation (use private-cost supply)
2. Solve for total external cost under #1 above
3. Solve for the true or net gains from trade under #1 above (total
gross gains from trade total external cost)
4. Solve for equilibrium P, Q, and total gains from trade assuming a
Pigouvian tax (use the social-cost supply). Compare with #3 above.
By how much does the Pigouvian tax enhance efficiency (net gains
from trade)?
Practice Problem, Negative Externalities
Demand: P = 1500 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q
1. Solve for equilibrium P, Q, and total gross gains from trade
assuming no regulation (use private-cost supply)
1500 0.1Q = 100 + 0.1Q Q = 7000, P = $800
CS = $(1500-800)*7000/2 = $2,450,000
PS = $(800-100)*7000/2 = $2,450,000
Total gross gains from trade = CS+PS = $4,900,000
Practice Problem, Negative Externalities
Demand: P = 1500 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q

2. Solve for total external cost under #1 above
Since marginal external cost is a constant $200,
Total external cost = $200*Q = $200*7000 = $1,400,000
Practice Problem, Negative Externalities
Demand: P = 1500 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q
3. Solve for the true or net gains from trade under #1 above (total gross
gains from trade total external cost)
Total gross gains from trade = CS+PS = $4,900,000
Total external cost = $200*Q = $200*7,000 = $ 1,400,000
Total net gains from trade = $3,500,000

Practice Problem, Negative Externalities
Demand: P = 1500 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q
4. Solve for equilibrium P, Q, and total gains from trade assuming a
Pigouvian tax (use the social-cost supply). Compare with #3 above. By
how much does the Pigouvian tax enhance efficiency (net gains from
trade)?
1500 0.1Q = 300 + 0.1Q Q = 6,000, P = $900
CS = $(1500-900)*6,000/2 = $1,800,000
PS = $(900-300)*6000/2 = $1,800,000
Total gains from trade = $3,600,000, which is $100,000 larger than
in the free market without the Pigouvian tax.
Practice Problem, Negative Externalities
Demand: P = 1500 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q
4. Solve for equilibrium P, Q, and total gains from trade assuming a
Pigouvian tax (use the social-cost supply). Compare with #3 above. By
how much does the Pigouvian tax enhance efficiency (net gains from
trade)?
Also note that in the free market without the Pigouvian tax,
consumers are pay a subsidized price of $800, which is $100 below
the price that is based on the full marginal social cost of production.
Practice Problem, Positive Externalities
Second problem:
Suppose that supply is given by the equation p = 100 + 2q
Private-benefit demand is given by the equation p = 1000 q
Social-benefit demand is given by the equation p = 2000 q
1. Derive the free market equilibrium values for p and q, and
calculate gross gains from trade.
2. Calculate total external benefits under the free market equilibrium
above.
3. Calculate true net gains from trade and deadweight loss.
4. Derive the socially optimal equilibrium values for p and q,
under the assumption that all externalities are internalized, and
calculate total gains from trade.
5. How much would society have to subsidize each unit of this good
in order to fully internalize the positive externality?
Practice Problem, Negative Externalities
Third problem:
Suppose that private-cost supply is given by the equation p =
100 + 2q
Social-cost supply is given by the equation p = 500 + 2q
Suppose that the supply curve based on the use of clean, non-
polluting technology is given by the equation p = 400 + 2q
Suppose that demand is given by the equation p = 2000 q.
1. What is the dollar value for marginal external cost?
2. If regulators charge firms that pollute a Pigouvian tax, which
of the supply curves above will prevail in the market? What
will be the equilibrium p and q?
3. How would this change if the supply curve based on the use
of clean, non-polluting technology was given by the equation p
= 600 + 2q?