CHAPTER 5 Externalities Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

CHAPTER 5

Externalities

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

5-2

Externalities

• Externality – An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism

• Not an Externality – suburban-urban migration example

5-3

The Nature of Externalities

• Privately-owned versus commonly-owned resources

• Externalities can be produced by consumers as well as firms

• Externalities are reciprocal in nature

• Externalities can be positive

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

5-4

The Nature of Externalities-Graphical Analysis

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Actual outputSocially efficient output

ab

c

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5-5

What Pollutants Do Harm?

• Empirical Evidence: What is the Effect of Pollution on Health?

• What Activities Produce Pollutants?

• What is the Value of the Damage Done?

• Empirical Evidence: The Effect of Air Pollution on Housing Values

5-6

Bargaining and the Coase Theorem

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5-7

The Coase Theorem

• Coase Theorem – Provided that transaction casts 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 necessary for Coase Theorem to work– The costs to the parties of bargaining are low

– The owners of resources can identify the source of damages to their property and legally prevent damages

5-8

Other Private Solutions

• Mergers

• Social conventions

5-9

Public Responses to Externalities - Taxes

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MSC = MPC + MD

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(MPC + cd)

Pigouviantax revenues

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5-10

Public Responses to Externalities - Subsidies

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MPC

MSC = MPC + MD

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(MPC + cd)

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jgk

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Pigouviansubsidy

5-11

Public Responses to Externalities- Emissions Fee

0Pollution reduction

MSB

MC

e*

f*

$

5-12

Emissions Fees Continued-Uniform Pollution Reductions

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

Bart’s TaxPayment Homer’s Tax

Payment

5-13

Public Responses to Externalities- Cap-and-Trade

Bart’spollutionreduction

Homer’spollutionreduction

50 75 90 50 75 90

MCB

MCH

25

f = $50

f = $50

10

a

b

5-14

Cap-and-Trade vs. Emissions Fee

0Pollution reduction

MSB

MC*

e*

f*

$

MC’

ef e’

Too much pollution reductionToo little pollution reduction

5-15

Cap-and-Trade v Emissions Fee

0Pollution reduction

MC*

e*

f*

$

MC’

ef e’

MSB

Too much pollution reductionToo little pollution reduction

5-16

Emissions Fee v Cap-and-Trade

• Responsiveness to Inflation

• Responsiveness to Cost Changes

• Responsiveness to Uncertainty

• Distributional Effects– Emissions fee– Cap-and-Trade

• Policy Perspective: Addressing Climate Change

5-17

Command-and-Control Regulation

• Incentive-based regulations

• Command-and-control regulations– Technology standard– Performance standard

• Is command-and-control ever better?– Hot spots

5-18

The U.S. Response

• Clean Air Act– 1970 amendments– Command-and-control in the 70s– How well did it work?

5-19

Progress with Incentive-Based Approaches

• Policy Perspective: Cap-and-Trade for Sulfur Dioxide

5-20

Implications for Income Distribution

• Who Benefits?

• Who Bears the Cost?

5-21

Positive Externalities

Researchper year

$

MPB

MC

MEB

MSB = MPB + MEB

R*R1

5-22

A Cautionary Note

• Requests for subsidies– Resource extracted from taxpayers– Market does not always fail

• Policy Perspective: Owner-Occupied Housing