Topic 5 Econ 103 page 1
Principles in Microeconomics
Topic 5: Externalities
(In the Real World, Not All Government Policies Result In DWL)
Text Reference: Chapter 19
Overview:
- Market surplus vs. social surplus
- Externalities
- Policies to address market failure
Topic 5 Econ 103 page 2
Principles in Microeconomics
Market Surplus Versus Social Surplus
► Recall the definition of external costs and benefits from
Topic 4.
- External costs (EC): activities in a market impose
costs on those outside the market.
- External benefits (EB): activities in a market yield
benefits to those outside the market.
The presence of external cost/benefits means market
surplus does not equal social surplus.
Topic 5 Econ 103 page 3
Principles in Microeconomics
Market surplus (MS) = private benefit (PB)-private costs (PC).
MS = PB - PC
Social surplus (SS) = social benefits (SB) – social costs (SC).
SS = SB - SC
► SB = PB + EB
► SC = PC + EC
Topic 5 Econ 103 page 4
Principles in Microeconomics
We can also think about externalities on the margin.
Marginal external costs (MEC) =external costs imposed
by an additional unit of
output.
- similar definition for MEB.
Marginal social costs (MSC) = all costs imposed by an
additional unit of output.
-
MSC = MPC + MEC
similar definition for MSB.
Topic 5 Econ 103 page 5
Principles in Microeconomics
We know markets are excellent at maximizing market
surplus.
But, when market surplus does not equal social surplus,
we have a problem.
The market ignores external costs/ external benefits, even
though these are real costs and benefits.
Topic 5 Econ 103 page 6
Principles in Microeconomics
Topic 5 Econ 103 page 7
Principles in Microeconomics
Recall:
- Competitive market equilibrium is where MPC-MPB
(QS=QD).
- Social surplus is maximized where MSC = MSB.
The output that maximizes market surplus will not typically
be the same output that maximizes social surplus, if there are
external costs and/or external benefits.
Means, government intervention in markets can result in
and increase in social surplus!
Topic 5 Econ 103 page 8
Principles in Microeconomics
Negative Externalities
Assume EC > 0 & EB = 0.
- A negative externality: MSC=MPC + MEC
- Example: gasoline consumption →GHG emission
- Note: MPB=MSB, since EB = 0.
$
MSC= MPC+MEC
Competitive
equilibrium yields QE.
MEC
MPC (S)
We know QE
maximizes market
surplus.
MSB (D)
Q*
QE
Quantity
Want to prove social
surplus will be greater
at Q* that it is at QE.
Topic 5 Econ 103 page 9
Principles in Microeconomics
Note two things:
- At Q*, MSC = MCB
- At QE, MSC > MCB
This is enough to tell us that QE does
NOT maximize social surplus.
Units between Q* and QE result in and increase in social cost that
is greater than the increase in social benefit. Hence, social
surplus falls.
$
MSC= MPC+MEC
As output (Q) increases
from Q* to QE:
MPC (S)
- SB ↑ by A + B.
C
- SC↑ by A+B+C.
B
- SS↓ by C.
A
Q*
MSB (D)
Q
E
Quantity
Topic 5 Econ 103 page 10
Principles in Microeconomics
Another way to look at it:
At QE, market surplus = B+F+G
But, market surplus does not equal social surplus.
Social surplus = market surplus – external costs.
$
MSC= MPC+MEC
MPC (S)
F
Total external cost (EC) given
QE = G+B+C.
C
B
G
A
Q*
MSB (D)
Q
E
So, SS = market surplus – EC
= (B+F+G)- (G+B+C)
= F-C.
Quantity
Topic 5 Econ 103 page 11
Principles in Microeconomics
If instead of QE, there were Q* units produced and consumed:
- Market surplus = F+G and SS = F
SS is higher at Q* and private surplus is lower at Q*.
So gains to external agents (EC↓) must > losses to agents in
the market.
E
$
As Q ↓ for Q to Q*:
EC ↓ by B+C
Market surplus ↓ by
B.
Thus, SS ↑ by C.
MSC= MPC+MEC
MPC (S)
C
B
A
Q*
MSB (D)
Q
E
Quantity
Topic 5 Econ 103 page 12
Principles in Microeconomics
The Social surplus at competitive equilibrium is ‘C’ less than it
would be at Q* rather than QE.
Tells us the ‘C’ is the DWL due to the unaddressed externality.
- The market has failed to maximizes SS.
- This is what economists mean when then say market failure.
- Market outcomes are not always the best outcomes.
If we could decrease quantity from QE to Q*, better outcome for
society.
- Luckily, we already know lots of ways that policy can
decrease output.
- Note: not everyone will be better off at Q* than at QE.
- This won’t be a win-win.
- But, in aggregate, society is better off as measured by SS.
Note again: the source of the DWL is due to MSC>MSB.
Topic 5 Econ 103 page 13
Principles in Microeconomics
Policies To Address Market Failure
We know we need to decrease output from QE to Q*.
- There are lots of policies that can get us there (Topic 4)
- We will look in detail at an output tax.
$
MSC= MPC+MEC
MEC = t
MPC (S)
If we levy t=MEC, then
MPC + t =MSC
Obviously changes
equilibrium output.
MSB (D)
Q*
Q
E
Quantity
Topic 5 Econ 103 page 14
Principles in Microeconomics
Losers and Winners:
- Losers are consumers and producers.
- Winners include the government, but now there is also
an extra social gain in terms of decreased external cost.
- I.e. lower pollution costs.
$
MSC= MPC+MEC
Change in CS=b+c+g <0
MEC =t
MPC (S)
b
c
g
h
n
Change in PS = h+n<0
Total market losses are the
same as Topic 4.
MSB (D)
Q*
Q
E
Quantity
Topic 5 Econ 103 page 15
Principles in Microeconomics
Government gains revenue= b + c + h.
The difference is in terms of decreased EC.
- Before tax, EC = m + h + c + n + g + k
- After tax, EC= m + h + c.
$
MSC= MPC+MEC
Change in EC = n+g+k.
MEC = t
PC
MPC (S)
b
k
c
g
h
n
PF
PP
EC <0.
Leads to a gain.
m
MSB (D)
Q*
Q
E
Quantity
Topic 5 Econ 103 page 16
Principles in Microeconomics
Losses in market surplus: b + c + h + n + g
Total gains: b + c + h + n + g + k
Gain > losses by k, the DWL due to the uncorrected
externality.
Just as in Topic 4, policy creates winners and losers.
$
MSC= MPC+MEC
P
MEC = t
C
MPC (S)
b
P
k
E
P
P
c
g
h
n
Not everyone in society is better
off, but society is better off as
measured by SS.
m
MSB (D)
Q*
But for the first time in this
course, the gains outweigh the
losses.
Q
E
Taxes lead to increased SS!
Quantity
Topic 5 Econ 103 page 17
Principles in Microeconomics
Internalizing the Externality
Recall that the source of the original DWL was the EC.
- Agents in the market ignored EC, even though they
exist and are just as real as any other cost.
- It was like they were getting a factor of production for
free.
Market activities used a scarce resource – environmental
quality – without paying for it.
How to Fix? Make agents in the market “internalize” those
costs.
- That is what the tax does.
Topic 5 Econ 103 page 18
Principles in Microeconomics
- The tax doesn’t make market agents directly pay those
who bear the pollution costs.
- Instead it makes them pay an amount to the government
that is equal to those costs.
Policy such as this, are often described as having the effect of
“internalizing the externality”.
- What was once an external cost is now internal.
- Taxes in this context are often referred to as
“Pigovian” taxes.
- Also sometime hear the language of “user pays” in this
context.
Topic 5 Econ 103 page 19
Principles in Microeconomics
Couple more things to note:
- The Pigovian tax does not eliminate pollution.
- There are still EC > 0 at taxed equilibrium.
- It instead makes sure that pollution is at its optimal
level.
- There are benefits to pollution as well as costs.
- Pigovian tax ensures market weighs those costs and
benefits properly.
Topic 5 Econ 103 page 20
Principles in Microeconomics
What to Tax?
Pigovian tax we have considered here is an output tax.
-Example: we know burning gas → pollution, so we tax
gas.
This gets the “right” outcome, but only given a certain
MEC.
In particular, Pigovian output tax creates no incentive to
come up with new production techniques that result in
lower EC.
Creates no incentive to make output cleaner on the
margin.
Topic 5 Econ 103 page 21
Principles in Microeconomics
Not a problem if we think there is little scope to decrease
MEC.
Example: one litre of gas always has 2.7 hg of CO2 due to
physics and stuff.
Nothing producers of gas can really do about it.
Much bigger problem if there is possibly a lot of
scope to decrease MEC.
Example: electricity can be produced with a lot or a little
carbon.
If we set a tax rate for electricity that reflects current MEC,
there is no incentive for producers to decrease MEC.
Taxing electricity without reference to CO2 is not smart policy.
Topic 5 Econ 103 page 22
Principles in Microeconomics
Alternative: tax pollution directly, rather than indirectly
via output.
Set tax rate ‘t’ not on unit of output, but on units of
pollution.
Obviously will have effect in output markets.
In world where MEC just cannot be reduced, will exactly
replicate Pigovian output tax.
Benefit is in cases where MEC can change: now there is
an incentive to make output cleaner on the margin.
Topic 5 Econ 103 page 23
Principles in Microeconomics
To look at policies that target pollution levels directly,
rather than indirectly, we need to think more about
production.
Why do firms pollute? Presumably, because there are
benefits.
Equivalently, producing output in “dirty” ways is cheaper
for firms that producing output in clean ways.
We can think about firms’ polluting decisions using the
same framework as we use for all decision making:
- polluting firms weigh marginal benefit of pollution
against marginal cost of pollution.
- But firms only weigh the MC and MB to them, not to
society.
Topic 5 Econ 103 page 24
Principles in Microeconomics
We will denote pollution as P, but in some context you
will see it denoted as E (E for emissions of pollution).
Benefits: might seem odd to talk about the benefits of
pollution, but reducing pollution entails a resource cost.
Terminology: we call reducing pollution “pollution
abatement”.
So, the benefits of pollution are avoided abatement costs.
Means the MB of pollution is just the avoided MC of
abatement.
Denote the MC of abatement MCA.
Topic 5 Econ 103 page 25
Principles in Microeconomics
There are good reasons to believe that at high levels of
pollution, abatement is relatively cheap.
If firms are not making any effort to reduce pollution,
there is typically quick and cheap ways to clean up.
But, as firms clean up their pollution, abatement becomes
more costly on the margin.
Topic 5 Econ 103 page 26
Principles in Microeconomics
Abatement Policies
MCA likely to be low at high pollution levels and high at low
pollution levels.
Tells us that MB of pollution is low at high pollution and high
at low pollution levels.
Remember: that MB of pollution is avoided MCA.
$
MCA is a component of social
costs.
We will and should account for
them when thinking about policy.
MBP=MCA
Pollution (P)
Resources used to make
production cleaner are resources
that cannot be used for something
else.
Topic 5 Econ 103 page 27
Principles in Microeconomics
Abatement Policies
Recall, that the area under any marginal curve gives us total.
So, the area under the MCA will measure costs of falling pollution.
Suppose firms pollution from PMAX to P1 (i.e. abates A1).
At PMAX it is making an effort to reduce
P, so abatement ‘A’ costs are zero.
$
At P1 it has incurred costs = area under
MCA.
MBP=MCA
Blue triangle tells us the resource costs
associated with cleaning up production
process.
P1
P
A1=PMAX – P1
MAX
Pollution (P)
Topic 5 Econ 103 page 28
Principles in Microeconomics
So, benefits of pollution (P) to a firm = avoided abatement (A)
costs.
What about costs of pollution to a firm?
Is there a downside to polluting, to the firm’s bottom
line?
We are going to assume that absent regulation, there is no
downside to polluting for firm.
Means that private benefits to the firm from abatement
are zero.
MPC of pollution = MPB of abatement
Topic 5 Econ 103 page 29
Principles in Microeconomics
By our assumption, MPC of P = MPB of A = 0.
Of course there are social costs of P, but if the firms are
free to choose the level of P and MPC of P = 0, they will
pollute until MB=0.
Topic 5 Econ 103 page 30
Principles in Microeconomics
Graphically, the firm will choose P= PMAX if MB of A = 0.
$
Obviously there are social costs
associated with pollution (SB of A).
MBP=MCA
Policy design is about trying to get
polluting firms to account for those
costs.
P
MAX
Pollution (P)
We want to think about what the social costs of pollution
are, and in particular what the MSCP curve looks like.
There are good reasons to believe that:
- at low P, MSCP is relatively low
- at high P, MSCP is relatively high.
Topic 5 Econ 103 page 31
Principles in Microeconomics
Graphically, the firm will choose P=PMAX.
$
MBP=MCA
MSCP
Means that the MSCP curve is
upward sloping.
SS max is P=P*.
P*
P
MAX
Pollution (P)
We want to think about what the social costs of pollution
are, and in particular what the MSCP curve looks like.
There are good reasons to believe that:
- at low P, MSCP is relatively low
- at high P, MSCP is relatively high.
Topic 5 Econ 103 page 32
Principles in Microeconomics
Policy Problem is clear in this context:
- If we can know or measure MSCP, we can identify P*.
- Just need to implement policies to get firms to set
P=P*.
Reality problem: we know P is costly, but it is extremely
hard to get anyone to agree on exactly how costly.
Measuring environmental costs are hard.
Means that we can’t really expect to be able to identify P*.
Instead, the real world of environmental policy ends up being
about settling on some target level of abatement, that we think
seems about right.
Topic 5 Econ 103 page 33
Principles in Microeconomics
Typically, pollution control targets are set via a political
process, not by a bunch of economists estimating the MSCP.
But, economics can tell us a lot about various ways to achieve
politically determined pollution control targets.
Factors that matter for choosing environmental policies:
- Costs: all else equal, if there are low cost ways of
improving the environment, these preferable to high
costs way.
- Simplicity of implementation, especially information
of limits
- Distribution: environmental policy is going to involve
costs. Who is going to pay those costs?
Topic 5 Econ 103 page 34
Principles in Microeconomics
We want to look at three policies with the above in mind:
-
Pollution taxes
Tradable pollution permits (a.k.a. “cap and trade”).
Pollution standards.
Topic 5 Econ 103 page 35
Principles in Microeconomics
Pollution Taxes:
Recall that the source of the problem is that the MPB of
abatement (MPBA) to firms of reducing P is zero.
Pollution taxes offer a simple fix. If firms must pay a per unit
tax t for every unit of P, MPBA = t.
By reducing pollution (abating) by one unit, firm avoids
paying t.
► When firm chooses level of P it weighs MCA against
MPBA = t.
- If MCA > t, better to pay the tax and pollute.
- If MCA < t, better to avoid the tax and abate.
Topic 5 Econ 103 page 36
Principles in Microeconomics
Tells us that firm will now choose P such that MCA= t.
Instead of polluting PMAX, firm will abate at least some P.
The amount of abatement depends on the tax:
Higher t → more A →less P.
Topic 5 Econ 103 page 37
Principles in Microeconomics
Firm optimally chooses P such that MCA = t:
$
MPBA < MCA
A
At PMAX, MPBA > MCA.
MC
MPBA
T
MPBA < MCA
P
■
►
►
L
P
E
P
MAX
Better for the firm to abate
and avoid t.
So, at a high P, firm will
want to ↓ P.
Pollution (P)
At low P, MPBA < MCA → better for the firm to pollute
and pay the tax.
So at low P, firm will want to ↑ P.
At P=PE, firm is doing the best it can, given t.
Topic 5 Econ 103 page 38
Principles in Microeconomics
If every polluting firm faces the same tax t, then each will
optimally choose P such that MCA = t.
Each firm will have the same MCA, at the level of P they
emit.
This is important:
- Recall from Topic 2 that we want production to reflect
MCs.
- To get a given level of output at least cost, we want to
exploit low MC production opportunities.
- If one firm has high MC and another has low MC, we
can get the same output at lower cost by reorganizing.
- The same is true here; in this context the good we are
producing is environmental improvement.
Topic 5 Econ 103 page 39
Principles in Microeconomics
If some firms can decrease pollution at relatively low
MCA, then we want these firms to decrease pollution by
more than firms who have relatively high MCA.
Climate policy is costly; if we can get a given
environmental improvement at low rather than high cost,
this is a good thing.
So emissions taxes ensure that the level of abatement we
achieve is achieved at least cost.
One potential downside of emissions taxes arises if there
is uncertainty about exactly what abatement costs are.
Topic 5 Econ 103 page 40
Principles in Microeconomics
We know each firm will choose P such that MCA =t.
But if we don’t know what firms’ MCA are, we can’t
know in advance the level of reduced P that will be
achieved.
In practice, we adjust the tax over time as we observe the
behavioural response of emitters:
o If the initial t doesn’t get the environmental
improvement we are looking for, we increase the t
over time.
Topic 5 Econ 103 page 41
Principles in Microeconomics
Downside to this is that economic agents do not typically like
tax uncertainty: businesses like regulatory certainty.
Ideally we would like a policy that achieves a target level of
abatement with certainty, and does so at least cost.
This is what tradable emissions permit schemes are all about.
Such policies also referred to as “cap and trade.”
Topic 5 Econ 103 page 42
Principles in Microeconomics
Cap and Trade:
How do cap and trade programs work?
Government sets a target for abatement/pollution.
Prints “permits” equal in number to the target pollution
level.
Distributes permits to polluting firms.
Various ways to do this, and it turns out to make no
difference in terms of overall policy effectiveness.
Topic 5 Econ 103 page 43
Principles in Microeconomics
Each firm must own permits that are equal in number to
the level of pollution it emits.
If firms have more permits than they need, they can sell
permits.
If firms have fewer permits than they need, must buy
permits.
Recall: source of the problem of externalities is that firms
have access to a scarce resource (the environment) at zero
cost.
Cap and trade literally creates a market for this scarce
resource:
- Means that firms now must pay for use, just like they
must for all other inputs to production.
Topic 5 Econ 103 page 44
Principles in Microeconomics
We want to think about why would a firm want to buy
or sell permits; then use this to look at equilibrium in the
permit market.
For each permit a firm holds, it faces a choice:
- Use the permit to pollute, thus so avoiding having to
incur abatement costs.
- Sell the permit in the market, thus having to incur
abatement costs.
What a firm will do depends on the relationship between
the price of permits p and the firm’s MCA.
Topic 5 Econ 103 page 45
Principles in Microeconomics
If MCA < p, then the firm can make money by selling
the permit and reducing its own pollution.
If MCA > p, then the firm is better off buying permits
in the market and polluting.
Tells us that, in the market for permit:
- firms for who MCA < p will be sellers.
- Firms for whom MCA> p will be buyers.
As sellers of permits abate more, MCA will increase.
As buyers of permits pollute more, MCA will fall.
We will see that, in equilibrium all firms’ MCAs will be
equal.
Topic 5 Econ 103 page 46
Principles in Microeconomics
Cap and Trade Example:
Suppose we have two polluting firms. In the absence of
regulation, each firm would produce 800 tonnes of CO2 /yr.
That is, we have P1MAX = P2MAX =800 and aggregate PT=
1600.
Government decides it wants to reduce aggregate emissions
to 700.
That is, we want PT = 700.
So, the government prints 700 permits in total, where each
permit allows the firm to emit one tonne of CO2.
Topic 5 Econ 103 page 47
Principles in Microeconomics
Assume the government gives each firm one half of permits.
- Initial allocation gives each firm the right to pollute 350
tonnes.
- Denote the level of P at the initial allocation of permits
as P^.
- So we have P1^ =P2^ = 350.
Prior to regulation we have:
- P1 = P1MAX =800
- P2 = P2MAX =800
At the initial allocation of permits we have:
- P1 = P1^=350
- P2 = P2^ =350
Topic 5 Econ 103 page 48
Principles in Microeconomics
So if no firm buys or sells permits, each must abate 450 units.
A
A
MC
≠
MC
Well see that if
1
2 at P= 350, there will be trade:
- Low MCA firm sells and abates more than 350 units
and
- High MCA firm buys and abates less than 350.
MC1A = MCA2 ,
In equilibrium, we will have permit price p =
meaning that we reach aggregate target at least cost.
Topic 5 Econ 103 page 49
Principles in Microeconomics
Suppose our two firms MCAs are as drawn below. Recall each
firm’s baseline P= 800, but each only gets 350 permits.
Note: at initial allocation,
MCA1 > MCA2.
Means that at any p such that
MCA1 > p > MCA2:
- Firm 1 will buy permits
- Firm 2 will sell permits.
Topic 5 Econ 103 page 50
Principles in Microeconomics
Firm 1: pays p, saves MCA1 → net gain = (MCA1- p) per
permit.
Firm 2: gets p, incurs MCA2 → net gain = (p – MCA2) per
permit.
Firm 1: P1↑→MCA1↓
Firm 2: P2↓ → MCA2 ↑
Trade reallocates abatement:
- Away from high MCA firm
- Towards low MCA firm
Same environmental benefits at
lower cost than before trade.
P
Topic 5 Econ 103 page 51
Principles in Microeconomics
Note: the incentive for trade exists as long as MCA1 > MCA2.
So trade continues until P1 = 500 and P2 = 200.
At P1 = 500 and P2 = 200,
MCA1 =MCA2.
No further incentive for
trade.
Environmental target
achieved at least cost.
Topic 5 Econ 103 page 52
Principles in Microeconomics
Given P1 = 500 and P2 = 200, equilibrium number of permits
traded = 150.
What about equilibrium price of permits?
If permit market is perfectly
competitive, equilibrium
price is pE = $15.
Only at pE = $15 is QD = DS
in permit market.
Note: pE = MCA1 =MCA2.
Price is the mechanism that
ensures least cost abatement.
Topic 5 Econ 103 page 53
Principles in Microeconomics
Equilibrium in permit market:
-
p (permit price) adjusts so QS = QD; each firm chooses
P (level of emissions) subject (permit price) p = MCA.
- Abatement target is met at least cost.
- Each firm incurs compliance costs:
►Total abatement cost + cost of permits for buyers
►Total abatement costs – permit revenue for sellers.
Topic 5 Econ 103 page 54
Principles in Microeconomics
Another important point to note: equilibrium levels and pE are
independent of the initial distribution of permits.
Extremely important in the context of global climate policy.
Too see this, rework previous example, but give all 700
permits to firm 2.
Now regulation makes firm 2 better off at the expense of firm
1.
Think about the relevance for distributional effects of climate
policy.
Why do we care about distribution of permits and compliance
costs if it doesn’t matter for achieving efficient abatement?
Topic 5 Econ 103 page 55
Principles in Microeconomics
Because, distribution matters in political processes.
The realities of global climate change problem:
Poorer/less developed countries are low MCA.
Richer countries are higher MCA.
Efficient abatement dictates abatement activity takes place in
poorer countries if we make them pay for it too.
Permit policy can allow abatement to take place in poorer
countries, but paid for by richer countries.
We just need to allocate poorer countries enough permits,
which they will then sell to richer countries.
Topic 5 Econ 103 page 56
Principles in Microeconomics
Concluding Remarks:
External costs matter and unregulated markets do not
ensure the best outcome for society where there are
external costs.
External benefits matter too.
There are many ways to regulate:
- Pigovian taxes
- Abatement policies
- Emission taxes
- Cap and Trade
- Emission standards
Topic 5 Econ 103 page 57
Principles in Microeconomics
Whatever the approach, there will be costs.
Costs will end up being passed on to the consumers in
output markets.
Distribution matters for political and equity reasons.
Can lessen hardship on low income households through
rebates.
Remember: point of policy is to change people’s
behaviour.