Module 75: Externalities & Public policy
Duffka School of Economics
Key Economic Concepts
• Pollution is a form of negative externality. It can be lessened with environmental standards, emissions taxes, and/or tradable emissions permits. The taxes and permits tend to reduce pollution more efficiently as they equate, for all producers, the marginal cost of the next ton of pollution emitted.
• When consumption of a good generates external benefits to third parties, it is said to provide a positive externality.
• The market will under-produce a good with a positive externality because the marginal social benefit is greater than the marginal private benefit. This outcome creates deadweight loss that could be eliminated with a Pigouvian subsidy equal to the marginal external benefit.
• The market will over-produce a good with a negative externality because the marginal social cost is greater than the marginal private cost. This outcome creates deadweight loss that could be eliminated with a Pigouvian tax equal to the marginal external cost.
Module Layout
I. Policies Toward Pollution
A. Environmental Standards
B. Emissions Taxes
C. Tradable Emissions Permits
II. Production, Consumption, and Externalities
A. Private versus Social Benefits
B. Private versus Social Costs
C. Network Externalities
I. Policies Toward Pollution
Major pieces of environmental legislation in the U.S. have only been around since the early 1970s.
Recent laws have incorporated more market-based incentives to reduce pollution and gain economic efficiency.
LINKS
I. Policies Toward Pollution
A. Environmental Standards
Early legislation was written with a heavy dose of “thou shalt not” pollute more than _____ amount of gunk in the air, water, and/or soil. This was a vast improvement on the unregulated, and heavily polluted, situations that led to the environmental movement, but was seen by economists as an inefficient way to tackle the problems. These environmental standards are also known as “command and control” measures for reducing pollution.
Example: Many cities require autos to pass emissions inspections before the license plate can be renewed.
Sewage must be treated before it can be released back into the environment.
I. Policies Toward Pollution
B. Emissions Taxes
The socially optimal quantity of pollution QOPT is where MSB=MSC and suppose this corresponds to $200 per ton.
The unregulated marketplace would produce QMKT tons of pollution and the government would like to reduce pollution back to QOPT.
I. Policies Toward Pollution
B. Emissions Taxes
The government is about to impose a tax on every ton of pollution emitted. This gives the firm a simple choice: spend money on pollution abatement for that ton, or pay the tax on that ton.
If the tax is set at $200, firms will spend money on abatement measures from QMKT all the way back to QOPT. So if the tax is set at the point where MSB=MSC, pollution will be reduced to the socially optimal amount.
By putting a price (the tax) on each ton polluted, the government gives the firms a financial incentive to
reduce pollution.
TAX
I. Policies Toward Pollution
B. Emissions Taxes
Environmental standards versus emissions taxes
This comparison shows that both reduce pollution by 600 tons but the tax places the burden on the firm and not the taxpayers.
I. Policies Toward Pollution
C. Tradable Emissions Permits
DETAILS:
• The government would issue (or auction) 600 permits, each allowing the holder to emit one ton of pollution. This removes 600 tons of pollution from the environment, because 1200 would have been emitted without the permit system.
• If a firm found that they needed to pollute more, they would buy permits from a firm that found they could pollute less.
• The firm buying permits knows that it’s cheaper to buy a permit than it is to install costly abatement equipment, so it profits from this transaction.
• The firm selling permits knows that it’s cheaper to install abatement equipment, so it sells excess permits and profits from the transaction.
• When there are no more mutually beneficial transactions to be made, an equilibrium price is set for permits.
LINK
II. Production, Consumption, and Externalities
A. Private versus Social Benefits
When the production and consumption of a good provides benefits to third parties, that good is said to provide positive externalities to society.
Example
• I consume a slice of pizza. This provides me with private benefit, but my friends, neighbors or fellow citizens of the world receive no benefit from my actions.
• But if I consume a flu shot or chickenpox vaccine, my friends, neighbors and fellow citizens of the world are going to receive some of the benefit because these two viruses just became less likely to be carried by me.
• If Sue spends lots of money improving the value of her home, she receives private benefit. But the improvement of her home has a spillover benefit to her neighbors by raising the value of their homes.
II. Production, Consumption, and Externalities
A. Private versus Social Benefits
Total Social Benefit = Total Private Benefit + Total External Benefit.
In the graph below we show that the marginal private benefit (MPB) declines. This represents the private benefits that people like Sue receive with more consumption of home improvements and the private market demand curve for the good. But Sue’s neighbors also benefit so when we add the positive amount of MEB to MPB, the MSB curve lies above the MPB curve.
Socially optimal outcome- MSB=MSC.
II. Production, Consumption, and Externalities
A. Private vs. Social Benefits
We could provide a subsidy (called a Pigouvian subsidy) on each unit of home improvement goods demanded by people. If the subsidy was equal to MEB, it would shift the MPB upward so that it was located on the MSB curve. This would increase output to QOPT and increase the price suppliers receive to POPT, but the price PCONS consumers pay would be (POPT – Subsidy), which is actually lower than the original price PMKT. We can see this in a simplified version of the graph above.
Subsidy
II. Production, Consumption, and Externalities
B. Private versus Social Costs
Market outcome:
Equilibrium occurs where the demand curve intersects MPC (private supply) and QMKT is produced at price of PMKT But the MPC only reflects the costs incurred by the actual producers of electricity; it does not reflect all of the costs like those borne by the surrounding environment. When we include the external costs, the price society would be willing to pay for QMKT is higher at PMSC.
II. Production, Consumption, and Externalities
B. Private versus Social Costs
Socially optimal outcome:
If the external costs are considered, the socially optimal outcome is where the demand curve intersects the MSB curve and QOPT is produced at a price of POPT. At this point the marginal benefit of consuming electricity (from the demand curve) is equal to the marginal costs society incurs from producing it.
Socially optimal outcome is where MSB=MSC.
II. Production, Consumption, and Externalities
B. Private versus Social Costs
The area of the deadweight triangle is above the demand curve, with base of (QMKT – QOPT), and height of (PMSC – PMKT),
II. Production, Consumption, and Externalities
B. Private versus Social Costs
We could provide a tax (a Pigouvian tax) on each unit of electricity supplied by the power plants.
If the tax was equal to MEC, it would shift the MPC upward so that it was located on the MSC curve.
This would decrease output to QOPT and increase the price consumers pay to POPT, but the price PFIRM firms receive would be (POPT –Tax), which is actually lower than the original price PMKT.
II. Production, Consumption, and Externalities
C. Network Externalities
A network externality exists when the value to an individual of a good or service depends on how many other people use the same good or service.
When more people use Facebook or Twitter, it becomes more valuable to you. When more people have cell phones with Verizon service, it means your Verizon phone can call more people at lower prices.
APE U5 L2 A56
56.1
MSB MSC 1(a) 1st unit of sludge
350 160 MSB $350
300 210 MSC $160
250 260 MSB > MSC
200 310 WOULD be efficient
150 360
1(b) 5th unit
MSB $150
MSC $360
MSB < MSC
WOULD NOT efficient
APE U5 L2 A56
56.2
MSB MSC
350 160
300 160
250 160
200 160
150 160
2 (a) 4th Unit 2(b) 5th unit
MSB $200 MSB $150
MSC $160 MSC $160
MSB>MSC MSB<MSC
Efficient Inefficient
APE U5 L2 A56
3. Pollution-control ordinance:
Proposal A: WOULD NOT maximize efficiency
Because economic efficiency considers MSC and MSB.
MSB<MSC after firm 1 reduces two units
MSB<MSC after firm 2 reduces four units
For five units MSC>MSB for both firms
Therefore, it would not be economically efficient to make either firm reduce 5 units b/c the MSB would be less than the MSC
APE U5 L2 A56
3. Pollution-control ordinance:
Proposal B: WOULD NOT maximize efficiency
Because it is marginal (not total) benefits and marginal (not total) costs that count in finding the optimum point of econ. Efficiency. If Firm 2 reduces 5 units and firm 1 reduces 0 units, net gain is $1250-$800=$450 from firm 2. However if Firm 2 reduces only 4 units and firm 1 reduces two units, the total net gain is $740:
Firm 1 $650-$370 = 280
Firm 2 $1,100-$640 = 460
$740
APE U5 L2 A56
3. Pollution-control ordinance:
Proposal C: WOULD NOT maximize efficiency
Because making firm 1 reduce a 3rd unit would result in MSB<MSC.
Stopping firm 2 at 3 units would leave MSB>MSC. Efficiency would increase if firm 1 cut back to reducing 2 units, and firm 2 continued reducing to a 4th unit.
With each reducing three units , the total net gain is $690:
Firm 1: $900-$630 = $270
Firm 2: $900-$480 = $420
With firm 1 reducing two units and firm 2 reducing 4 units the total gain is $740
Firm 1 $650-$370 = $280
Firm 2 $1,100-$640=$460
APE U5 L2 A56
4. Using the data above, what do you think is the optimum level of emissions reduction? Explain why you chose these numbers.
Firm 1: ____ Units
Firm 2: ____ Units
2
4
The optimal level of emissions is the output where MSB=MSC.
For Firm 1, MSB>MSC up to a reduction of two units; beyond this point MSB<MSC.
For Firm 2, MSB>MSC up to a reduction of four units; beyond this point MSB<MSC. No other combination yields a net gain greater than $740
Practice Question-FRQ 2011
What is the question asking?
Do I have to draw, identify, and/or explain?
How many components am I expected to answer?
What details do I need to know that I don’t have to draw?
Practice Question-FRQ 2011
Hints & Tips
Negative Externality=too much(q).
Draw:
MPC & MSC—Stated
D=MSB—Implied
Show TOO much consumption Qm>Qs
DWL-TOO much privately vs. social optimal
Explain-Lump sum taxes do not change output(per unit taxes change output).
Practice Question #2—FRQ 2010
Practice Question #2—FRQ 2010
S=MSC
Practice Question #2—FRQ 2010
Externalities-Animated
Practice Question-MC
1. Which of the following policy tools is inefficient even when correctly administered?�
a. environmental standards�
b. emissions taxes�
c. tradable emissions permits�
d. Pigouvian taxes�
e. cap and trade programs
Practice Question-MC
2. An efficient Pigouvian subsidy for a good is set equal to the good’s�
a. external cost.�
b. marginal social benefit.�
c. marginal external cost.�
d. marginal external benefit.�
e. price at which MSC = MSB.
Practice Question-MC
3. Which of the following is true in the case of a positive externality?�
a. MSC > MSB�
b. MPB > MSC�
c. MSB > MPB�
d. MPB > MSB�
e. MSC > MPC
Practice Question-MC
4. One example of a source of external benefits is�
a. technology spillover.�
b. traffic congestion.�
c. pollution.�
d. subsidies for polluters.�
e. taxes on environmental conservation.
Practice Question-MC
5. Marginal social benefit equals marginal private benefit plus�
a. marginal external benefit.�
b. marginal private cost.�
c. total external benefit.�
d. total external cost.�
e. marginal social cost.