Externalities
Chapter 5
LOGO
Contents
www.themegallery.com
1
The nature of externalities
2
Graphical analysis
3
Private responses
4
Public responses to externalities
5
Implications for income distribution
6
Positive externalities
Company Logo
Externalities
 An externality is present when the
activity of one entity (person or firm)
directly affects the welfare of another
entity in a way that is outside the
market mechanism.
 Negative externality: These activities impose
damages on others.
 Positive externality: These activities benefits on
others.
www.themegallery.com
Company Logo
More details
1,They can be produced by consumers as well
as firms.(factory,cigar)
2,Externalities are reciprocal in nature .(Bart
polluter,Lisa polluter as well—increasing the
social cost of Bart’s)
3,Externalities can be positive.(vaccination)
4,public goods can be views as special kind of
externality.(when an individual creates a positive
externality with full effects felt by every person in
the economy,the externalities is a pure public
good.(83)
www.themegallery.com
Company Logo
Graphical Analysis
 For simplicity, assume that a steel firm
dumps pollution into a river that harms a
fishery downstream.
 Competitive markets, firms maximize
profits
 Note that steel firm only cares about its own profits, not the
fishery’s profits.
 Fishery only cares about its profits, not the steel firm’s
profits.
www.themegallery.com
Company Logo
MB = marginal benefit to steel firm
MPC = marginal private cost to steel
firm
MD = marginal damage to fishery
MSC = MPC+MD = marginal social
cost
www.themegallery.com
Company Logo
Figure 5.1
From Figure 5.1, as usual, the steel
firm maximizes profits at MB=MPC.
This quantity is denoted as Q1 in the
figure.
Social welfare is maximized at
MB=MSC, which is denoted as Q* in
the figure.
www.themegallery.com
Company Logo
Graphical Analysis, Implications
 Result 1: Q1>Q*
 Steel firm privately produces “too much” steel, because it does
not account for(负责) the damages to the fishery.
 Result 2: Fishery’s preferred amount is 0.
 Fishery’s damages are minimized at MD=0.
 Result 3: Q* is not the preferred quantity for either
party, but is the best compromise between fishery
and steel firm.
 Result 4: Socially efficient level entails some
pollution.
 Zero pollution is not socially desirable.
www.themegallery.com
Company Logo
Figure 5.2
 In Figure 5.2, loss to steel firm of moving to
Q* is shaded triangle dcg.
 This is the area between the MB and MPC curve going
from Q1 to Q*.
 Fishery gains by an amount abfe.
 This is the area under the MD curve going from Q1 to Q*.
By construction, this equals area cdhg.
 Difference between fishery’s gain and steel
firm’s loss is the efficiency loss from
producing Q1 instead of Q*.
www.themegallery.com
Company Logo
The private responses
Part I
Part II
Part III
The Coase
Theorem
(科斯定理）
Mergers
(合并)
Social
Conventions
（伦理道德）
www.themegallery.com
Company Logo
The private responses
Insight: root of the inefficiencies from
externalities is the absence of property
rights（所有权）.
 The Coase Theorem states that once
property rights are established and
transaction costs are small, then one of the
parties will bribe（贿赂） the other to attain
the socially efficient quantity.
 The socially efficient quantity is attained
regardless of to whom the property rights
were initially assigned.(88)
www.themegallery.com
Company Logo
When Is the Coase Theorem Relevant?
 Low transaction costs
 Few parties involved
 : Several firms with pollution
 Source of externality well defined
 Example
 Not relevant with high transaction costs or
ill-defined externality
 Example: Air pollution
www.themegallery.com
Company Logo
Mergers
1,another way to deal with an externality is to
internalize it by combining the involved
parties.(one company)
2,Once the two firms merge ,the externality is
internalized.The external effects would not
exist,and the market would not be inefficient.(If
Bart purchased the fishery,he would willingly
produce less output than before, because at the
margin doing so would increase the profits of his
fishery subsidiary more than it decreased the
profits from his factory subsidiary.)
www.themegallery.com
Company Logo
Social Conventions
1,Do unto others as you would have others do
unto you.
2,Before you undertake some activity,take into
account its external marginal benefits and costs.
3,Some moral precepts correct for the absence
of missing market.(littering)
www.themegallery.com
Company Logo
Public responses to externalities
Subsidies
B
taxes
A
C
Emissions fees
Public
responses
to externalities
Command-andcontrol regulation
www.themegallery.com
E
D
Cap-and-trade
Company Logo
Public responses to externalities
 Again, return to the steel firm/fishery
example.
 Steel firm produces inefficiently because the
prices for inputs incorrectly signal social
costs. Input prices are too low. Natural
solution is to levy a tax on a polluter.
 A Pigouvian tax is a tax levied on each unit
of a polluter’s output in an amount just
equal to the marginal damage it inflicts at
the efficient level of output.
www.themegallery.com
Company Logo
Figure 5.4
Subsidies
2.subsidy
the efficient level of production can be obtained
by paying the polluter not to pollute.
it works much like the tax scheme.This is
because a subsidy for not polluting is simple
another method of raising the polluter’s effective
production cost. (Figure 5.5)
pitfalls:more firms may be induced to locate
along the river;
 may be ethically undesirable;
administratively difficult.
www.themegallery.com
Company Logo
Emissions fee
Emission fee: A tax levied on each unit of pollution.
The market for pollution reduction (figure 5.6-5.7)
Efficiency requires that bart reduce pollution if the marginal social
benefit (MSB)is greater than the marginal cost (MC)of doing so.thus
E* is the efficient amount of pollution reduction.
An emissions fee is cost effective (figure 5.9 )
An emissions fee induces each polluter to reduce pollution up to the
point where the marginal cost of reducing equals the level of the
fee.This results in equal marginal costs across poluters,which is
cost effective.(a policy that achieves a given outcome at the lowest
cost possible)
Uniform pollution reductions across polluters are not cost
effective (figure 5.8 )
www.themegallery.com
Company Logo
Cap-and-trade
Cap-and-trade
 A policy of granting permits to pollute, which the
number of permits set at the desired pollution
level , and allowing polluters to trade the permits.
 A Cap-and-trade system is cost effective
 (figure 5.10 )
www.themegallery.com
Company Logo
Making a comparison between emissions fee and cap-andtrade)
 1.responsiveness to inflation
 emission fee---fix
 Cap-and-trade---chang
 2.responsiveness to cost changes
 Emission fee: fee-fix quantity-change
 Cap-and-trade: fee-change quantity-fix
 3.responsiveness to uncertainty
 Figure 5.11 and figure 5.12
 4.distributional effects
www.themegallery.com
Company Logo
Command-and-control regulation
1.incentive-based regulations
Policies that provide polluters with financial incentives to
reduce pollution.(emission fees and cap-and-trade)
2. Command-and-control regulation
policies that require a given amount of pollution
reduction with limited or no flexibility with respect to how
it may be achieved.(technology standard and
performance standard)
Technology stardard: A type of command-and-control
regulation that requires firms to use a particular
technology to reduce their pollution.
Performance stardard: A type of command-and-control
regulation that sets an emission that sets an emissions
goal for each individual polluter and allows some
flexibility in meeting the goal.
www.themegallery.com
Company Logo
Evaluation
1,The presence of externalities often
requires some kinds of intervention to
achieve efficiency.Implementing any
environmental policy entails a host of
difficult technical issues.
2,No policy is to do a perfect
job.However,most economists prefer
market-oriented solutions.They are more
likely to achieve efficient outcomes than
direct regulation.
www.themegallery.com
Company Logo
Externalities
Externalities
Implications
for income
distribution
www.themegallery.com
Positive
externalities
Company Logo
Implications for Income Distribution
1,Who benefits?(99)
2,who bears the costs?(100)
www.themegallery.com
Company Logo
Positive externalities
www.themegallery.com
Company Logo
Recap of Externalities
Externalities definition
Negative externalities – graphical and
numerical examples
Private responses
Public responses
Positive externalities
www.themegallery.com
Company Logo
LOGO