CHAPTER EXTERNALITIES: PROBLEMS AND SOLUTIONS Introduction   Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so As we will see, this represents a market failure for which government action could be appropriate and improve welfare EXTERNALITY EXTERNALITY THEORY 1 EXTERNALITY THEORY     Externalities can either be negative or positive, and they can also arise on the supply side (production externalities) or the demand side (consumption externalities) A negative production externality is when a firm’s production reduces the well-being of others who are not compensated by the firm A negative consumption externality is when an individual’s consumption reduces the well-being of others who are not compensated by the individual The basic concepts in positive externalities mirror those in negative externalities a, Economics of Negative Production Externalities  To understand the case of negative production externalities, consider the following example:    This is a negative production externalities because:    A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river The fishermen downstream are harmed by this activity, as the fish die and their profits fall Fishermen downstream are adversely affected And they are not compensated for this harm Figure illustrates each party’s incentives in this situation SMC = PMC + MD Price of steel S=PMC p2 p1 MD D = PMB = SMB Q2 Q1 QSTEEL Negative Production Externalities Figure b, Negative Consumption Externalities We now move on to negative consumption externalities Consider the following example:      A person at a restaurant smokes cigarettes That smoking has a negative effect on your enjoyment of the restaurant meal In this case, the consumption of a good reduces the well-being of someone else Figure illustrates each party’s incentives in the presence of a negative consumption externality Price of cigarettes S=PMC=SMC p1 MD p2 D=PMB SMB=PMB-MD Figure Q2 Q1 QCIGARETTES Negative Consumption Externalities c, Positive Externalities Positive externalities can occur in production or consumption A positive production externality is when a firm’s production increases the well-being of others, but the firm is not compensated by those others    Research and development is a production externality A positive consumption externality is when an individual’s consumption increases the well-being of others, but the individual is not compensated by those others   Nice landscaping could be a consumption externality c, Positive Externalities Let’s consider positive production externalities Consider the following example:      A policeman buys donuts near your home As a consequence, the neighbors are safer because of the policeman’s continued presence In this case, the production of donuts increases the well-being of the neighbors Figure illustrates each party’s incentives in the presence of a positive production externality Price of donuts S = PMC SMC = PMC EMB p1 EMB p2 D = PMB = SMB Figure Q1 Q2 QDONUTS Positive Production Externalities Positive Externalities    Finally, there can be positive consumption externalities A neighbor’s improved landscape is a good example of this The graphical analysis is similar to negative consumption externalities, except that the SMB curve shifts outward, not inward Positive Externalities   The theory shows that when a negative externality is present, the private market will produce too much of the good, creating deadweight loss When a positive externality is present, the private market produces too little of the good, again creating deadweight loss EXTERNALITY THE COASE THEOREM The Solution for Private sector The Solution for Private Sector The Coase Theorem: When there are well-defined property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level Thus, the role of government intervention may be very limited—that of simply enforcing property rights   The Solution (Coase Theorem)    Consider the Coase Theorem in the context of the negative production externality example from before Give the fishermen property rights over the amount of steel production Figure illustrates this scenario SMC = PMC + MD Price of steel S = PMC p2 p1 MD D = PMB SMB Figure Q2 Q1 QSTEEL Negative Production Externalities and Bargaining The Solution (Coase theorem) Through a process of bargaining, the steel firm will bribe the fishery to arrive at Q2, the socially optimal level After that point, the MD exceeds (PMB - PMC), so the steel firm cannot come up with a large enough bribe to expand production further   The Solution (Coase Theorem)     Another implication of the Coase Theorem is that the efficient solution does not depend on which party is assigned the property rights, as long as someone is assigned them The direction in which the bribes go does depend on the assignment, however Now, let’s give the property rights to the steel firm over the amount of steel production Figure illustrates this scenario SMC = PMC + MD Price of steel S = PMC p2 p1 MD D=PMB=SMB Figure Q2 Q1 QSTEEL Negative Production Externalities and Bargaining The Solution (Coase Theorem)  Figure shows that even though the bargaining process is somewhat different, the socially efficient quantity of Q2 is achieved Problems with Coasian Solutions  There are several problems with the Coase Theorem, however     The assignment problem The holdout problem The free rider problem Transaction costs and negotiating problems Problems with Coasian Solutions  The “assignment problem” relates to two issues:   It can be difficult to truly assign blame It is hard to value the marginal damage in reality Problems with Coasian Solutions  The “holdout problem” arises when the property rights in question are held by more than one party   The shared property rights give each party power over all others This could lead to a breakdown in negotiations Problems with Coasian Solutions  The “free rider” problem is that when an investment has a personal cost but a common benefit, individuals will underinvest  For example, if the steel firm were assigned property rights and you are the last (of many) fishermen to pay, the bribe is larger than the marginal damage to you personally Problems with Coasian Solutions  Finally, it is hard to negotiate when there are large numbers of individuals on one or both sides Problems with Coasian Solutions  In summary, the Coase Theorem is provocative, but perhaps not terribly relevant to many of the most pressing environmental problems EXTERNALITY SOLUTIONS OF THE PUBLIC SECTOR PUBLIC-SECTOR SOLUTIONS FOR EXTERNALITIES  Coasian solutions are insufficient to deal with large scale externalities Public policy makes use of three types of remedies to address negative externalities:    Corrective taxation Subsidies Regulation 10 a, Corrective Taxation    The government can impose a “Pigouvian” tax on the steel firm, which lower its output and reduces deadweight loss If the per-unit tax equals the marginal damage at the socially optimal quantity, the firm will cut back to that point Figure illustrates such a tax SMC=PMC+MD S=PMC+tax S=PMC Price of steel p2 p1 D = PMB = SMB Figure Q2 Q1 QSTEEL Pigouvian Tax Corrective Taxation   The Pigouvian tax essentially shifts the private marginal cost The firm cuts back output, which is a good thing when there is a negative externality 11 Corrective Taxation The steel firm’s privately optimal production solves:  PMB  PMC  tax  When the tax equals MD, this becomes:  But this last equation is simply the one used to determine the efficient level of production PMB  PMC  MD  SMC b, Subsidies    The government can impose a “Pigouvian” subsidy on producers of positive externalities, which increases its output If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point Figure illustrates such a subsidy Price of donuts S = PMC SMC=PMC-EMB p1 p2 D = PMB = SMB Figure Q1 Q2 QDONUTS Pigouvian Subsidy 12 Subsidies   The subsidy also shifts the private marginal cost The firm cuts expand output, which is a good thing when there is a positive externality Subsidies  The donut shop’s production solves: PMB  PMC  subsidy  When the subsidy equals EMB, this becomes: PMB  PMC  EMB  SMC  But this last equation is simply the one used to determine the efficient level of production c, Regulation   Finally, the government can impose quantity regulation, rather than relying on the price mechanism For example, return to the steel firm in Figure 9 13 SMC = PMC + MD S = PMC Price of steel p2 p1 D = PMB = SMB Figure Q2 Q1 QSTEEL Quantity Regulation Regulation   In an ideal world, Pigouvian taxation and quantity regulation give identical policy outcomes In practice, there are complications that may make taxes a more effective means of addressing externalities Recap of Externalities: Problems and Solutions    Externality theory Private-sector solutions Public-sector solutions 14 NEXT CHAPTER…  PUBLIC GOODS 15 ... externalities) A negative production externality is when a firm’s production reduces the well-being of others who are not compensated by the firm A negative consumption externality is when an individual’s... production externality is when a firm’s production increases the well-being of others, but the firm is not compensated by those others    Research and development is a production externality. .. consumption externality is when an individual’s consumption increases the well-being of others, but the individual is not compensated by those others   Nice landscaping could be a consumption externality