The Concept of
Externalities & Policy
Intervention
by
Nasruddin Djoko Surjono
0906621621
Faculty of Economics
University of Indonesia
Market Failure
•
•
•
•
•
no markets
market power
public goods
externalities
no or weak defined property rights (also Open Access
conditions; right to use)
• incomplete information and uncertainty
• instability to determine preferences of future generations
Market Failures: Externalities
• When a market outcome affects parties other than the
buyers and sellers in the market, side-effects are
created called externalities.
• an externality is said to occur when the production or
consumption decisions of one agent have an impact on
the utility or profit of another in an unintended way, and
when no compensation payment is made;
• Externalities cause markets to be inefficient, and thus
fail to maximize total surplus.
• Externalities lead to inefficient results SMC ≠ SMB; a
solution to externalities is to internalise these such that
SMC = SMB
Market Failures: Externalities
• When the impact on the bystander is adverse, the
externality is called a negative externality.
• When the impact on the bystander is beneficial, the
externality is called a positive externality.
• Externalities may be related to production activities,
consumption activities, or both.
-Production externalities: production activities of one
individual imposes costs/benefits on other individuals
that
are not transmitted accurately through a
market.
-Consumption externalities: consumption of an
individual
imposes costs or benefits on other
individuals that are not accurately
transmitted
through a market.
Examples of Negative Externalities
•
•
•
•
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment
building
SMC = PMC +
MD
Price
of
steel
S=PMC
The
The
steel
yellow
firmtriangle
sets PMB=PMC
is the
toconsumer
find its privately
and producer
optimal
The
The
steel
firm
optimal level from
of
profit maximizing
surplus at output,
Q1. socially
Q1. overproduces
production
society’s
is at Qviewpoint.
2, the intersection
The
This
marginal
framework
damage
doescurve
not of SMC and SMB.
capture
(MD) represents
the harmthe
done
fishery’s
to the
The red triangle is the
The
social
marginal
cost
is
the
fishery,
harm per
however.
unit.
deadweight loss from the private
sum of PMC and MD, and
production level.
represents the cost to society.
p2
p1
MD
D = PMB =
SMB
0
Figure
Q2
Q1
QSTEEL
Presence of Externalities May lead to Inefficiency
Negative Production Externalities
Examples of Positive Externalities
•
•
•
•
•
Immunizations
Restored historic buildings
Research into new technologies
A flood control dam
More educated people become better workers and better
citizens who benefit those around them
Positive Externalities in Production...
Price
of Robot
Value of
technology
spillover
Supply (private cost)
Social cost
Equilibrium
Optimum
Demand
(private value)
0
QMARKETQOPTIMUM
Quantity
of Robots
Internalizing Production Externalities
• Taxes are the primary tools used to
internalize negative externalities.
• Subsidies are the primary tools
used to internalize positive
externalities.
Market Failure and Policy Intervention
• The possibility of an inefficient resource allocation means
that an increase in efficiency & distribution fairness could
be attained through policy intervention.
• Policy Intervention:
Efficiency is not the only important criteria.
– Social Optima (Allocation/Fairness)
– Sustainability
– Indices about living standards
Criteria for GOOD Instruments
• Cost-efficiency (cost-effectiveness): least cost in attaining
any given target.
• Certainty/reliability
• Efficiency consequences under conditions of
uncertainty/poor information
• Acceptable effects on distributions of income and wealth
• Should contribute to sustainability
• Low administration cost
• Transparency/acceptability to general public
Private Solutions to Externalities
Government action is not always
needed to solve the problem of
externalities.
The Coase Theorem
The Coase Theorem states that if private
parties can bargain without cost over the
allocation of resources, then the private
market will always solve the problem of
externalities on its own and allocate
resources efficiently.
The Coase Theorem...(Cont’d)
The root cause of externality problems is the absence of property rights.
The Coase Theorem states that as long as property rights are assigned
and assumptions
(i) The costs of bargaining to the parties are low &
(ii) Owners of resources can identify & legally prevent the source of
damages to their property
hold then the efficient solution will be obtained independently of who is
assigned the property rights.
Bargaining: The Coasian Solution for
Externalities
MBM
EMCM
Total Benefit = a+b+d
Total Cost = b+d+c
c
a
b
0
Coase (1960): the introduction as
well as an independent
distribution of property rights
leads to an efficient outcome =>
incentive for agents to bargain
for a contract.
d
M*
M0
Pollution Emissions M
Implications
• Bargaining may bring about efficient solutions to externality
problems.
• Government should provide an institutional framework that
encourages bargaining.
• Many international environmental problems are dealt with (at least
initially) through bargaining (e.g., Kyoto and greenhouse gas).
Limitations:
– Transaction cost
a) large number of generators and/or sufferers
b) linkage identification
– the effect is public
a) non-excludable
b) non-rival
Why Private Solutions
Do Not Always Work
Sometimes the private solution
approach fails because transaction
costs can be so high that private
agreement is not possible.
Public Policy Toward Externalities
When externalities are significant and
private solutions are not found,
government may attempt to solve the
problem through . . .
command-and-control policies.
market-based policies.
Efficient Level of Output
(of a polluting good)
Price
EMC = external marginal cost of production or damage cost
PMC = private marginal cost of production
SMC = social marginal cost of production
PMB = private marginal benefits
PMNB = private marginal net benefit
Price
PMNB
SMC = PMC + EMC
PMC
P**
P*
EMC
P*
EMC
PMB
Q** Q*
Quantity/Period
Q** Q* Quantity/Period
SMC=PMC+MD
S=PMC
+tax
S=PMC
Price
of
steel
The socially optimal level of
production, Q2, then
maximizes profits.
The steel firm initially
produces at
Qtax
the to the
1, equal
Imposing
aatax
Imposing
shifts the
intersection
of
PMC
and
PMB.such
MD shifts the PMC curve
p2
p1
PMC curve upward and
that steel
it equals
SMC.
reduces
production.
D = PMB =
SMB
0
Figure
Q2
Q1
Pigouvian Tax
QSTEEL
Taxes versus Subsidies
There is a problem with emissions taxation (and subsidies) – if the
firms’ PMNB functions are not known, it is not possible to
calculate the tax rate that will bring about the desired overall
reduction in pollution. Whatever reduction is achieved will be
brought about at least cost, but it could be too big or too small.
Tradeable permits avoid this problem. Since the quantity of permits
issued is equal to the desired level of total emissions, assuming
compliance, the achieved reduction is the intended one.
Tradeable permits are dependable, as well as least cost. They
have the least cost property because with a single market price
per permit, all firms move to where their PMNB = permit price,
and the situation is as in the previous slide.
If the permits are initially issued free, there is no revenue arising, as
there is with taxation.
Policy Tax (a)
• Consumption Tax:
Sales tax on polluting goods.
Demand curve for firms in the market shifts downward to
represent the net price of each unit sold. The net price, or
Net Marginal Benefit (NMB), is the Marginal Benefit of
consumers less the level of the sales tax (NMB = D - t*).
Q*=Social Optimum output
Pc*=Optimal Consumer price
Ps*=Pc*-t=net producer price
t=consumption tax
Policy Tax (b)
• Production tax: If the government knows
how much pollution is produced per unit of
production output, then it can set a tax on
production output that achieves the same
results as an externality tax. However, the
relationship between pollution and
production output is often very difficult to
estimate with any degree of precision.
Public Responses to Externalities - Taxes
MSC = MPC + MD
(MPC + cd)
$
Pigouvian
tax revenues
i
j
MPC
d
c
MD
MB
0
Q*
Q1
Q per year
GOVERNMENT INTERVENTION:TAXES AND WELFARE
How does the Pigouvian tax affect welfare?
SMC
P,
$
S=PMC
A
P
*
Pm
Pp K
H
EG
J F
B
C
The Pigouvian tax increases welfare by H
D
D= PMB=SMB
I
Q*
Qm
Q (electricity)
Market Equilibrium
Before Taxes
Market
Equilibrium
After Taxes
Consumer Sur.
A+B+E+G
A
Producer Sur.
C+K+D+J+F
K+D
“Victim”
-(D+J+E+F+G+H)
-(D+J+E)
Govt. Revenue
---------
B+E+C+J
Total Welfare
A+B+C+K-H
A+B+C+K
A uniform taxation across discharge
sources, the overall reduction is
achieved at least cost
PMNB1
PMNB2
a
M1 t M1 *
b
M1
M2 t
t
M2 *
M2
PMNB is Private Marginal Net Benefit = PMB - PMC
No Tax (t) - Profits are max, where PMNB = 0
With Tax (t) - Profits are max, where PMNB = t
Total Cost of Pollution Reduction = Areas: a M1 M1t + b M2 M2t
There is no re-allocation of pollution reduction as between the two firms that
can reduce the total cost.
Subsidy Policy
• Consumer surplus = ABP*.
• Producer surplus = OFBP* + BGHF,where
BGHF = (P* - PP)·(Qc - Q*)].
• Government expenditure = BGHF.
$
MSC
A
MPC
E
B
P*
PC
PP
F
G
C
H
MEC
D
Q*
QC
Public Responses to Externalities - Subsidies
MSC = MPC + MD
(MPC + cd)
$
MPC
Pigouvian
subsidy
i
j
d
c
k
f
g
h
MD
MB
0
e
Q*
Q1
Q per year
Policy Quota (Standards on
Pollution/Output)
• Command-and-control approach
through production quotas to restrict
output to Q*.
Do command-and-control policies lead to cost
effective emissions reductions? Do emissions fees?
• Cap-and-trade policies again involve capping
emissions at a fixed level, in the following sense:
Permits for emissions are distributed to producers.
The number of permits equals the total imposed
pollution cap.
But this time we permit polluters to trade pollution
permits.
In this example, suppose that Factory A and Factory B
are initially polluting 90 units’ worth. The government
gives 100 pollution permits to Factory A.
Welfare implications of quotas
• Consumer surplus= ABP*
• Producer surplus= OFBP* (larger than it is for
Externality Tax)
• Government revenue= zero (smaller than it is for
MSC
Externality Tax) $ A
E
MPC
B
P*
PC
PP
F
G
C
H
MEC
D
Q*
QC
Emissions Fees
MCW
Factory A’s Tax
Payment
Factory B’s Tax
Payment
MCF
f=
$50
f=
$50
50
75
90
Factoty A’s
pollution
reduction
25
50
75
90
Factory B’s
pollution
reduction
Elasticity Effects on the Magnitude of
Externalities
MSC
Q
MPC
D Inelastic
PC, QC=Competitive price & quantity
PI, QI=Socially optimal price &
quantity, when D is inelastic
PE, QE=Socially optimal price &
quantity, when D is elastic
Pl
PE
PC
D elastic
QE
Ql
QC
P
Elasticity and regulation
• When demand is inelastic, the socially optimal
level of production, Qi, is not too far from the
competitive level of production, Qc. Therefore, the
inefficiency associated with a production
externality may be small, and it may not be worth
regulating the externality.
• When demand is elastic, the socially optimal level
of production, Qe, is farther away from the
competitive level, Qc. In this case, the
inefficiency associated with the production
externality may be relatively large, and regulation
may be desirable.
Thank You