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th Publishers

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5.1 Externality Theory

5.2 Private-Sector Solutions to Negative Externalities

Externalities: Problems and Solutions

5.3 Public-Sector Remedies for Externalities

5.4 Distinctions between Price and Quantity Approaches to Addressing Externalities

5.5 Conclusion

PREPARED BY

FERNANDO QUIJANO AND SHELLY TEFFT

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CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

In December 1997, representatives from over 170 nations met in Kyoto, Japan, to attempt one of the most ambitious international negotiations ever: an international pact to limit the emissions of carbon dioxide worldwide because of global warming. The nations faced a daunting task. The cost of reducing the use of fossil fuels, particularly in the major industrialized nations, is enormous. Replacing these fossil fuels with alternatives would significantly raise the costs of living in developed countries.

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CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

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CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

externality 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.

market failure A problem that causes the market economy to deliver an outcome that does not maximize efficiency.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Economics of Negative Production Externalities

negative production externality When a firms production reduces the well-being of others who are not compensated by the firm.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Economics of Negative Production Externalities
FIGURE 5-2

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Economics of Negative Production Externalities

private marginal cost (PMC) The direct cost to producers of producing an additional unit of a good.

social marginal cost (SMC) The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Economics of Negative Production Externalities

private marginal benefit (PMB) The direct benefit to consumers of consuming an additional unit of a good by the consumer.

social marginal benefit (SMB) The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Negative Consumption Externalities

negative consumption externality When an individuals consumption reduces the well-being of others who are not compensated by the individual.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Negative Consumption Externalities
FIGURE 5-3

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory

APPLICATION

The Externality of SUVs

The typical driver in 2008 was in a car that weighed about 4,117 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,742 pounds. The consumption of large cars such as SUVs produces three types of negative externalities:
Environmental Externalities: The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions. Wear and Tear on Roads: Each year, federal, state, and local governments spend $33.1 billion repairing our roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight. Safety Externalities: One major appeal of SUVs is that they provide a feeling of security because they are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Positive Externalities

positive production externality When a firms production increases the wellbeing of others but the firm is not compensated by those others.

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Positive Externalities

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5.1

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Externality Theory
Positive Externalities

positive consumption externality When an individuals consumption increases the wellbeing of others but the individual is not compensated by those others.

One aspect of the graphical analysis of externalities is knowing which curve to shift, and in which direction. There are four possibilities: Negative production externality: SMC curve lies above PMC curve Positive production externality: SMC curve lies below PMC curve Negative consumption externality: SMB curve lies below PMB curve Positive consumption externality: SMB curve lies above PMB curve The key is to assess which category a particular example fits into. First, you must assess whether the externality is associated with producing a good or with consuming a good. Then, you must assess whether the externality is positive or negative.
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5.2

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Private-Sector Solutions to Negative Externalities

The Solution

internalizing the externality When either private negotiations or government action lead the price to the party to fully reflect the external costs or benefits of that partys actions.

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5.2

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Private-Sector Solutions to Negative Externalities

The Solution
FIGURE 5-5

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5.2

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Private-Sector Solutions to Negative Externalities

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.

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5.2

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Private-Sector Solutions to Negative Externalities

The Problems with Coasian Solutions
In practice, the Coase theorem is unlikely to solve many of the types of externalities that cause market failures. The Assignment Problem Because of assignment problems, Coasian solutions are likely to be more effective for small, localized externalities than for larger, more global externalities. The Holdout Problem holdout problem Shared ownership of property rights gives each owner power over all the others.

As with the assignment problem, the holdout problem would be amplified with a huge externality.

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5.2

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Private-Sector Solutions to Negative Externalities

The Problems with Coasian Solutions
The Free Rider Problem free rider problem When an investment has a personal cost but a common benefit, individuals will underinvest. Transaction Costs and Negotiating Problems The Coasian approach ignores the fundamental problem that it is hard to negotiate when there are large numbers of individuals on one or both sides of the negotiation. This problem is amplified for an externality such as global warming, where the potentially divergent interests of billions of parties on one side must be somehow aggregated for a negotiation.
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5.2

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Private-Sector Solutions to Negative Externalities

The Problems with Coasian Solutions
Bottom Line Ronald Coases insight that externalities can sometimes be internalized was a brilliant one. It provides the competitive market model with a defense against the onslaught of market failures. It is also an excellent reason to suspect that the market may be able to internalize some small-scale, localized externalities.

It wont help with large-scale, global externalities.

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5.3

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Public-Sector Remedies for Externalities

The Environmental Protection Agency (EPA) was formed in 1970 to provide public-sector solutions to the problems of externalities in the environment. Public policy makers employ three types of remedies to resolve the problems associated with negative externalities.

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5.3

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Public-Sector Remedies for Externalities

Corrective Taxation
FIGURE 5-6

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5.3

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Public-Sector Remedies for Externalities

Subsidies
subsidy Government payment to an individual or firm that lowers the cost of consumption or production, respectively.

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5.3

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Public-Sector Remedies for Externalities

Subsidies

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5.3

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Public-Sector Remedies for Externalities

Regulation
In an ideal world, Pigouvian taxation and regulation would be identical. Because regulation appears much more straightforward, however, it has been the traditional choice for addressing environmental externalities in the United States and around the world. In practice, there are complications that may make taxes a more effective means of addressing externalities.

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Basic Model
FIGURE 5-8

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Price Regulation (Taxes) vs. Quantity Regulation in This Model
FIGURE 5-8
The optimal tax, as before, is equal to the marginal damage done by pollution. Plants will walk up their marginal cost curves, reducing pollution up to a reduction of R* at point B. The government simply mandates that the plant reduce pollution by an amount R*, to get to the optimal pollution level P*. For the more general case of a falling MD, the government needs to know the shapes of both MC and MD curves in order to set either the optimal tax or the optimal regulation.

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Multiple Plants with Different Reduction Costs
FIGURE 5-9

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Multiple Plants with Different Reduction Costs
Policy Option 1: Quantity Regulation The efficient solution is one where, for each plant, the marginal cost of reducing pollution is set equal to the social marginal benefit of that reduction; that is, where each plants marginal cost curve intersects with the marginal benefit curve. Policy Option 2: Price Regulation through a Corrective Tax

Pigouvian taxes cause efficient production by raising the cost of the input by the size of its external damage, thereby raising private marginal costs to social marginal costs.
Policy Option 3: Quantity Regulation with Tradable Permits Trading allows the market to incorporate differences in the cost of pollution reduction across firms.

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Uncertainty about Costs of Reduction
FIGURE 5-10a

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Uncertainty about Costs of Reduction
FIGURE 5-10b

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5.4

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Distinctions between Price and Quantity Approaches to Addressing Externalities

Uncertainty about Costs of Reduction
Implications for Effect of Price and Quantity Interventions The uncertainty over costs has important implications for the type of intervention that reduces pollution most efficiently. Implications for Instrument Choice The central intuition here is that the instrument choice depends on whether the government wants to get the amount of pollution reduction right or whether it wants to minimize costs.

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5.5

CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS

Conclusion
Externalities are the classic answer to the when question of public finance: when one partys actions affect another party, and the first party doesnt fully compensate (or get compensated by) the other for this effect, then the market has failed and government intervention is potentially justified. This naturally leads to the how question of public finance. There are two classes of tools in the governments arsenal for dealing with externalities: price-based measures (taxes and subsidies) and quantity-based measures (regulation). Which of these methods will lead to the most efficient regulatory outcome depends on factors such as the heterogeneity of the firms being regulated, the flexibility embedded in quantity regulation, and the uncertainty over the costs of externality reduction.

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