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 1 of 33
 5.2
Example I
Chapter 5 Externalities: Problems and Solutions

Net Benefit to the factory associated with marginal production = $1.0

Net Cost to the Laundromat associated with the firm’s marginal
production = $1.20

*Efficient outcome?

Case (i): Factory has the property right.

Case (ii): Laundromat has the property right

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 2 of 33
 5.2
Example II
Chapter 5 Externalities: Problems and Solutions

Net Benefit to the factory associated with marginal production = $1.20

Net Cost to the Laundromat associated with the firm’s marginal
production = $1.0

*Efficient outcome?

Case (i): Factory has the property right

Case (ii): Laundromat has the property right

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 3 of 33
 5.2
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.

No of Total Catch MP AP Net Social Social Total

Men on Board (on board) (on board) MP (on board)
0 0 0 0 0 4000+0=4000
1 6 +6 6 2 3396+6=4002
2 16 +10 8 6 3392+16=4008
3 24 +8 8 4 4012
4 30 +6 7.5 2 4014
* 5 34 +4 6.8 0 4014
6 36 +2 6 -2 4012
7 36 0 5.14 -4 4008
** 8 32 -4 4 -8 4000
9 27 -5 3 -9 3991
10 21 -6 21 -10 3981

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 4 of 33
 5.4
Distinctions Between Price and Quantity
Approaches to Addressing Externalities
Chapter 5 Externalities: Problems and Solutions

Basic Model

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 5 of 33
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
Chapter 5 Externalities: Problems and Solutions

1. Optimal abatement: Choose X to

Minimize C(X) + D(E) = C(X) + D(Ē-X)

• => C’(X) - D’(Ē-X)=0.

• Or, C’(X) = D’(E).

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 7 of 33
Chapter 5 Externalities: Problems and Solutions

2. 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, set t= D’(E).

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 8 of 33
 5.4
Distinctions Between Price and Quantity
Approaches to Addressing Externalities
Chapter 5 Externalities: Problems and Solutions

Multiple Plants with Different Reduction Costs

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 9 of 33
Chapter 5 Externalities: Problems and Solutions

Example with Multiple Firms

Ē1, Ē2;
X1, X2;
E1 = Ē1 - X1;
E2 = Ē2 - X2
Pollution damage = D(E1+E2) =D(Ē1 + Ē2 - X1 - X2)

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 10 of 33
Chapter 5 Externalities: Problems and Solutions

* Optimal abatement:

Minimize C1(X1) + C2(X2) + D(Ē1 + Ē2 - X1 - X2)

 C1’ (X1) = C2’(X2) = D’(E).

* Firm’s solution: Minimizes Ci(Xi) + t (Ēi - Xi)

=> Ci’(Xi) = t.

=> Set: t = D’(E)

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 11 of 33
Chapter 5 Externalities: Problems and Solutions

Example
Assume:

D(E) =10 E => D’(E) =10

C1(X1)=F + 1/10 (X1)2 => C1’(X1) =1/5 (X1)

C2(X2)=F + 1/30 (X2)2 => C2’(X2) =1/15 (X2)

Setting C1’(X1) = C2’(X2) = D’(E)

=> X1=50; X2=150

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 12 of 33
Chapter 5 Externalities: Problems and Solutions

Equal pollution Reduction: Ask each firm to reduce

pollution by 100.

• Same benefit of damage reduction as with the

Pigouvian solution.
• Costs:
C1 = F + 1/10 (100)2
C2 = F + 1/30 (100)2

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 13 of 33
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, Jonathan Gruber, 2e 14 of 33
Chapter 5 Externalities: Problems and Solutions

Market for Permits

• Suppose Ē1 + Ē2 = 500.
• 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.
• If ni is negative, it will be the number of permits sold.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 15 of 33
Chapter 5 Externalities: Problems and Solutions

• Price of a permit= p
• Cost of polluting Ei = Ci (Xi) + ni p
• Or Ci (Xi) + (Ē - Xi – 150) p
• Minimizing costs yields

Ci’(Xi)=p.

C1’(X1)= C2’(X2)
• If p=t, we will have the Pigouvian solution.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 16 of 33