Chapter 5 Externalities Problems and Solutions

Jonathan Gruber Public Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 Worth Publishers

Introduction
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. As we will see, this represents a market failure for which government action could be appropriate and improve welfare.

Introduction
Externalities can be negative or positive:

Acid rain, global warming, pollution, or a neighbors loud music are all negative externalities. Research and development or asking good questions in class are positive externalities.

Introduction
Consider global warming, a negative externality.

Many scientists believe this warming trend is caused by human activity, namely the use of fossil fuels. These fuels, such as coal, oil, natural gas, and gasoline produce carbon dioxide that in turn traps heat from the sun in the earths atmosphere. Figure 1 shows the trend in warming over the last century.

Figure 1

This table shows the global temperature during the 20th century.

Global Average Temperature Over Time

58.5

Global average temperature

58

57.5

There has been a distinct trend upward in temperature

57

56.5

56

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

Year

2000

Introduction
Although this warming trend has negative effects

overall on society, the distributional consequences vary.

In much of the United States, warmer temperatures will improve agricultural output and quality of life. In Bangladesh, which is near sea-level, much of the country will be flooded by rising sea levels.

If youre wondering why you should care about

Bangladesh, then you have identified the market failure that arises from externalities. From your private perspective, you shouldnt!

EXTERNALITY THEORY
Externalities can either be negative or positive, and they can

also arise on the supply side (production externalities) or the demand side (consumption externalities). A negative production externality is when a firms production reduces the well-being of others who are not compensated by the firm. A negative consumption externality is when an individuals consumption reduces the well-being of others who are not compensated by the individual. The basic concepts in positive externalities mirror those in negative externalities.

Economics of Negative Production Externalities

To understand the case of negative production

externalities, consider the following example:

A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river. The fishermen downstream are harmed by this activity, as the fish die and their profits fall.

This is a negative production externalities because: Fishermen downstream are adversely affected. And they are not compensated for this harm. Figure 2 illustrates each partys incentives in this situation.

Price of steel

SMC = PMC + MD

S=PMC

p2

p1

The yellow triangle is the The steel firm sets consumer and producerfirm overproduces PMB=PMC to find its The steel socially optimal level of privately optimal1profit surplus at Q . societys at Q , the from production is viewpoint. 2 This frameworkdamage Q1. of SMC and SMB. Themaximizingdoes not marginal output, intersection The red triangle is the curve (MD) represents the capture the harm done to The social marginal cost deadweight loss from the is fisherys harm per unit. the fishery, however. the sum of PMC and MD, and private production level. represents the cost to society. MD

D = PMB = SMB 0 Q2 Q1 QSTEEL

Figure 2

Negative Production Externalities

Economics of Negative Production Externalities

The steel firms privately optimal production solves:

PMB PMC
This yields a quantity of steel Q1 at a price of P1.

Economics of Negative Production Externalities

The steel firms emits pollution causing damage to

MD 0

the fishery. This is represented by the marginal damage curve. Ideally, the fishery prefers:

This would yield zero steel production, which is

obviously not in the steel firms best interests.

Economics of Negative Production Externalities

The social marginal cost accounts for both the

SMC PMC MD
price of P2, by solving:

direct costs to the steel firm and the indirect harm to the fishery:

We find the socially optimal quantity of steel Q2 at a

SMC SMB

Economics of Negative Production Externalities

The socially optimal quantity entails less production

of steel. By doing so, the steel firm would be worse off but the fishery would be better off.

Graphically, this triangle in between the PMB and PMC curves from Q2 to Q1. Graphically, this is the area under the MD curve from Q2 to Q1.

The damage to the fishery is reduced as well.

Economics of Negative Production Externalities

The deadweight loss from the original production

level Q1 is graphically illustrated as the triangle in between the SMC and SMB curves from Q2 to Q1. Note that the SMB equals the PMB curve in this case.

Negative Consumption Externalities

We now move on to negative consumption

externalities. Consider the following example:

A person at a restaurant smokes cigarettes. That smoking has a negative effect on your enjoyment of the restaurant meal.

In this case, the consumption of a good reduces the

well-being of someone else. Figure 3 illustrates each partys incentives in the presence of a negative consumption externality.

Price of cigarettes

S=PMC=SMC The The smoker sets the yellow triangle is surplus to the smokers PMB=PMC to find his privately optimal quantity (and producers) at Q1. The Theof cigarettes, Q1. ThisMD curve represents framework does not social marginal benefit is the nonsmokers harm per PMB capture the harm done to the difference between The red triangle is the non-smokers,and MD. pack of cigarettes. however. deadweight loss from the private production The socially optimal level of level. The smoker consumes too many cigarettes at Q2,societys MD smoking is from the intersection of SMC and SMB. viewpoint.

p1 p2

D=PMB SMB=PMB-MD 0 Q2 Q1 QCIGARETTES

Figure 3

Negative Consumption Externalities

Negative Consumption Externalities

The smokers privately optimal quantity solves:

PMB PMC
This yields a quantity of cigarettes Q1 at a price of

P1. The surplus is the same as before.

Negative Consumption Externalities

The smokers consumption causes damage to the

MD 0

other restaurant patrons. They would prefer:

This would yield zero cigarette smoking, which is

detrimental to the smoker.

Negative Consumption Externalities

The social marginal benefit accounts for both the

SMB PMB MD
at a price of P2, by solving:

direct benefit to the smoker and the indirect harm to the other patrons:

We find the socially optimal quantity of cigarettes Q2

SMC SMB

Negative Consumption Externalities

The socially optimal quantity entails less smoking.

By doing so, the cigarette smoker is worse off, but the other patrons are better off. The surplus to the smoker (and tobacco companies) falls.

Graphically, this is the triangle in between the PMB and PMC curves from Q2 to Q1.

The harm to other restaurant patrons is reduced as

well.

Graphically, this is the area under the MD curve from Q2 to Q1.

Negative Consumption Externalities

The deadweight loss from the original consumption

level Q1 is illustrated graphically as the triangle in between the SMC and SMB curves from Q2 to Q1. Note that the SMC equals the PMC curve in this case.

The Externality of SUVs

Consider a real-life example: the use of sport utility

vehicles (SUVs). They create three sorts of externalities:

Environmental externalities: They consume a lot of gasoline and create more pollution. Wear and tear on roads: SUV drivers do not bear the costs that result from their vehicles. Safety externalities: When SUVs are in accidents, the other drivers are often more severely injured.

Positive Externalities
Positive externalities can occur in production or

consumption. A positive production externality is when a firms production increases the well-being of others, but the firm is not compensated by those others.

Research and development is a production externality.

A positive consumption externality is when an individuals

consumption increases the well-being of others, but the individual is not compensated by those others.

Nice landscaping could be a consumption externality.

Positive Externalities
Lets consider positive production externalities.

Consider the following example:

A policeman buys donuts near your home. As a consequence, the neighbors are safer because of the policemans continued presence.

In this case, the production of donuts increases the

well-being of the neighbors. Figure 4 illustrates each partys incentives in the presence of a positive production externality.

Price of donuts

S = PMC

The donut shop setsis the The yellow triangle PMB =consumer and producer PMC to find its privately optimal profit at Q1. surplus maximizing This is theoutput, Q1 The external marginal The red triangleframework does .not benefit (EMB) capture the benefit to the deadweight loss from the represents The donut shop underproduces The socially optimal level of the neighbors benefit. neighbors, SMC = PMC private production level. however. donuts issocietys viewpoint. from at Q2, the intersection p1 of SMC andEMB SMB. EMB p2 The social marginal cost subtracts EMB fromD = PMB = PMC.

SMB
0 Q1 Q2 QDONUTS

Figure 4

Positive Production Externalities

Positive Externalities
The donut shops privately optimal production

PMB PMC
This yields a quantity of donuts Q1 at a price of P1.

solves:

Positive Externalities
The shop creates positive externalities to the

neighbors through the presence of police. This is represented by the external marginal benefit. Ideally, the neighbors prefer:

EMB 0
This would yield much more donut production,

which is obviously not in shops best interests.

Positive Externalities
The social marginal cost accounts for both the

SMC PMC EMB

We find the socially optimal quantity of donuts Q2

direct costs to the donut shop and the indirect benefit to the neighbors:

at a price of P2, by solving:

SMC SMB

Positive Externalities
The socially optimal quantity entails more

production of donuts. By doing so, the donut shop would be worse off but the neighbors would be better off. The consumer and producer surplus fall.

Graphically, this triangle is between the PMC and PMB curves from Q1 to Q2.

The benefit to the neighbors is increased as well. It

goes up.

Graphically, this is the area under the EMB curve from Q1 to Q2.

Positive Externalities
The deadweight loss from the original donut

production level Q1 is graphically illustrated by the triangle in between the SMB and SMC curves from Q1 to Q2. Note that the SMB equals the PMB curve in this case.

Positive Externalities
Finally, there can be positive consumption

externalities.
A neighbors improved landscape is a good example

of this. The graphical analysis is similar to negative consumption externalities, except that the SMB curve shifts outward, not inward.

Positive Externalities
The theory shows that when a negative externality is

present, the private market will produce too much of the good, creating deadweight loss. When a positive externality is present, the private market produces too little of the good, again creating deadweight loss.

The Solution (Coase Theorem)

The Coase Theorem: When there are well-defined

property rights and costless bargaining, then negotiations between the parties will bring about the socially efficient level. Thus, the role of government intervention may be very limitedthat of simply enforcing property rights.

The Solution (Coase Theorem)

Consider the Coase Theorem in the context of the

negative production externality example from before. Give the fishermen property rights over the amount of steel production. Figure 5 illustrates this scenario.

Price of steel

p2

SMC = PMC + MD This bargaining process will continue society is this this area, The to until the socially The gain gain to society is area, the efficient level. difference between (PMB the difference between (PMB PMC) and MD the first unit. PMC) and MD for for the second unit.

S = PMC

The reason ishad property If the fishery because any rights, it would initially impose steel production makes the p1 zero steelworse off. fishery production. MD Thus, it is is stillfor thesuffers While the fishery suffers bargain. But While the fishery to only there room for steel Thus, itThere possibleto bargain. the is possible room the steel a Thebribefirm the fishery in firm steel damage damage. The steel firm of a a of to amount gets in firmmodestbribe getsas lot bit the to same the fishery from less orderproduce first firstnext unit. surplus from unit. unit. the first ordersurplus fromthe thesecond unit. to to producethe unit. 0 1 2 Q2 Q1

D = PMB SMB QSTEEL

Figure 5

Negative Production Externalities and Bargaining

The Solution (Coase theorem)

Through a process of bargaining, the steel firm will

bribe the fishery to arrive at Q2, the socially optimal level. After that point, the MD exceeds (PMB - PMC), so the steel firm cannot come up with a large enough bribe to expand production further.

The Solution (Coase Theorem)

Another implication of the Coase Theorem is that

the efficient solution does not depend on which party is assigned the property rights, as long as someone is assigned them. The direction in which the bribes go does depend on the assignment, however. Now, lets give the property rights to the steel firm over the amount of steel production. Figure 6 illustrates this scenario.

Price of steel

SMC = PMC + MD

S = PMC

p2

This bargaining process will The The gain gain to society is this area, the continue until theto society is this area, socially If the steel firm production and (PMB This level of had property difference betweenbetween MD and the difference MD efficientthe steel suffers a While the steel firmfirm suffers While level. choose rights, PMC) byinitially another unit. maximizes the consumer and it would cutting (PMB-PMC) in loss in profits.1 unit. only a Q surplus. largermodest profits. back loss by cutting producer .
1

p1 MD The The is itgets getsfor lot of Thus, it fishery the same the Thus, possible a the fishery is possible for fishery to bribe the the from firm surplus as tofrom cuttingsteel fishery cutting back back surplus bribe steel firm D=PMB=SMB to cutthe firstcut back. unit. steel production by unit. back another one to unit.

Q2

Q1

QSTEEL

Figure 6

Negative Production Externalities and Bargaining

The Solution (Coase Theorem)

Figure 6 shows that even though the bargaining

process is somewhat different, the socially efficient quantity of Q2 is achieved.

Problems with Coasian Solutions

There are several problems with the Coase

Theorem, however.

The assignment problem The holdout problem The free rider problem Transaction costs and negotiating problems

Problems with Coasian Solutions

The assignment problem relates to two issues:

It can be difficult to truly assign blame. It is hard to value the marginal damage in reality.

Problems with Coasian Solutions

The holdout problem arises when the property

rights in question are held by more than one party.

The shared property rights give each party power over all others. This could lead to a breakdown in negotiations.

Problems with Coasian Solutions

The free rider problem is that when an investment

has a personal cost but a common benefit, individuals will underinvest.

For example, if the steel firm were assigned property rights and you are the last (of many) fishermen to pay, the bribe is larger than the marginal damage to you personally.

Problems with Coasian Solutions

Finally, it is hard to negotiate when there are large

numbers of individuals on one or both sides.

Problems with Coasian Solutions

In summary, the Coase Theorem is provocative, but

perhaps not terribly relevant to many of the most pressing environmental problems.

PUBLIC-SECTOR REMEDIES FOR EXTERNALITIES

Coasian solutions are insufficient to deal with large

scale externalities. Public policy makes use of three types of remedies to address negative externalities:

Corrective taxation Subsidies Regulation

Corrective Taxation
The government can impose a Pigouvian tax on

the steel firm, which lower its output and reduces deadweight loss. If the per-unit tax equals the marginal damage at the socially optimal quantity, the firm will cut back to that point. Figure 7 illustrates such a tax.

Price of steel

SMC=PMC+MD S=PMC+tax S=PMC The socially optimal level of production, Q2, then maximizes profits. The steel firm initially produces at QImposinga tax equal PMC MD Imposing a tax shifts to the 1, the intersection of the PMC and PMB. shifts the PMC curvereduces curve upward and such that steel production. it equals SMC.

p2

p1

D = PMB = SMB 0 Q2 Pigouvian Tax Q1 QSTEEL

Figure 7

Corrective Taxation
The Pigouvian tax essentially shifts the private

marginal cost. The firm cuts back output, which is a good thing when there is a negative externality.

Corrective Taxation
The steel firms privately optimal production solves:

PMB PMC tax

When the tax equals MD, this becomes:

PMB PMC MD SMC

determine the efficient level of production.

But this last equation is simply the one used to

Subsidies
The government can impose a Pigouvian subsidy

on producers of positive externalities, which increases its output. If the subsidy equals the external marginal benefit at the socially optimal quantity, the firm will increase production to that point. Figure 8 illustrates such a subsidy.

Price of donuts

S = PMC The donut shop initially shifts choosesProviding a subsidy equal Q1, maximizing the EMB shifts the PMC its toPMC curve downward. profits. curve downward to SMC. The socially optimal level of SMC=PMC-EMB donuts, Q2, is achieved by such a subsidy.

p1

p2 D = PMB = SMB 0 Figure 8 Q1 Pigouvian Subsidy Q2 QDONUTS

Subsidies
The subsidy also shifts the private marginal cost.

The firm cuts expand output, which is a good thing

when there is a positive externality.

Subsidies
The donut shops production solves:

PMB PMC subsidy

When the subsidy equals EMB, this becomes:

PMB PMC EMB SMC

determine the efficient level of production.

But this last equation is simply the one used to

Regulation
Finally, the government can impose quantity

regulation, rather than relying on the price mechanism. For example, return to the steel firm in Figure 9.

Price of steel

SMC = PMC + MD S = PMC

p2 The firm government could Yet the has an incentive to simply require it toQ1. produce produce no more than Q2.

p1

D = PMB = SMB

Q2

Q1

QSTEEL

Figure 9

Quantity Regulation

Regulation
In an ideal world, Pigouvian taxation and quantity

regulation give identical policy outcomes. In practice, there are complications that may make taxes a more effective means of addressing externalities.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

The key goal is, for any reduction in pollution, to

find the least-cost means of achieving that reduction. One approach could simply be to reduce output. Another approach would be to adopt pollutionreduction technology.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

The models we have relied on so far have examined

reductions in output. Thus, we will modify this. Our basic model now examines pollution reduction, rather than say, steel production. Figure 10 illustrates its features.

PR

Since it pays for increasing While it faces the pollution Pollutionmarginal the SMC isreducing reduction has a price same reduction, costs from the associated pollution level. its withPMC. as it.

S=PMC S=PMC=SMC

The optimal level of pollution While the benefit of pollution * reduction is thereforefirm, reduction is zero the R . society benefits by MD. MD = Thus, the x-axis of pollution SMB At The steel firms private some levelalso measures pollution The has achieved marginal benefit from reduction, the firmas we move pollution levelsgood that is being created On its an is zero. fulltoward the origin. Such own, the maximizes its reduction. pollution reduction action steel company is pollution reduction. would set Qprofits. QSteel=Q1. R=0 and D= PMB 0 PFull Figure 10 R* P* Model of Pollution Reduction RFull 0 More pollution QR

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

As Figure 10 shows, the private market outcome is

zero pollution reduction, while the socially efficient level is higher. In the figure, the optimal tax would simply be MD the firm would reduce pollution levels to R*, because its MC is less than the tax up until that point, but no further. Quantity regulation is even simplerjust mandate pollution reduction of R*.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

Assume now there are two firms, with different

technologies for reducing pollution. Assume firm A is more efficient than firm B at such reduction. Figure 11 illustrates the situation.

PR

PMCB

Firm Firm As PMCB ToWhile B has relatively get any given is more For the total output PMCefficient. A inefficient pollution marginal cost, we B>PMCA. S = PMCA + PMCB = level, PMC sum reduction technology. horizontally. SMC EfficientIf, instead, we got more regulation is Quantity regulation in this where the way is from The SMB curve is the marginal of reduction cost Firm A, we The efficient level of clearly inefficient, before. pollution reductionB is total social could is since lower the worse as Firm for same at pollution reduction each firm equals SMB. reducing pollution. cost. the same as before. MD=SMB

PMCA Quantity regulation could Imposing involve equal reductions in a Pigouvian tax pollution by bothequal to MD induces these firms, levels of output. such that R1 + R2 = R*.

RB RA,RA RB

R*

QR

Figure 11

Two Firms Emit Pollution

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

Figure 11 shows that price regulation through taxes

is more efficient than is quantity regulation. A final option is quantity regulation with tradable permits. Idea is to:

Issue permits that allow firms to pollute And allow firms to trade the permits

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

As in the previous figure, initially the permits might

be assigned as quantity regulation was assigned.

This means that initially RA = RB.

But now Firm B has an interest in buying some of

Firm As permits, since reducing its emissions costs PMCB (>PMCA). Both sides could be made better off by Firm A selling a permit to Firm B, and then Firm A simply reducing its pollution level.

This trading process continue until PMCB=PMCA.

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

Finally, the government may not always know with

certainty how costly it is for a firm to reduce its pollution levels. Figure 12 shows the case when the social marginal benefit is locally flat.

PR

In addition, imagine that But it is possible for the firms costs to be PMC2.2 the governments PMC best Then there is large Suppose the true deadweight loss.guess of costs is PMC1. costs are PMC . PMC1 This results in a 2 much smaller DWL, If, instead, theFirst,could be the and much less This assume government leviedcase for global a pollution reduction. SMB is downward tax, it would equalwarming, for sloping, but fairly MD at QR = R1. example. flat. MD = SMB

Regulation mandates R1.

0 R3 PFull Figure 12

R1 More pollution

RFull 0

QR

Model with Uncertainty and Locally Flat Benefits

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

Figure 13 shows the case when the social marginal

benefit is locally steep.

In addition, imagine that But it is possible for the firms costs to be PMC2.2 the governments PMC best Then therethe small Suppose is true deadweight loss.guess of costs is PMC1. costs are PMC2. PMC1 This results in a larger DWL, and If, instead, the much less pollution government levied a reduction. tax, it would equal MD at QR = R1. PR First,could be the This assume SMB is downward case for nuclear sloping, andfor leakage, fairly example. steep.

Regulation mandates R1.

MD = SMB 0 R3 PFull Figure 13 R1 More pollution Model with Uncertainty and Locally Steep Benefits RFull 0 QR

DISTINCTIONS BETWEEN THE PRICE AND QUANTITY APPROACHES TO ADDRESSING EXTERNALITIES

These figures show the implications for choice of

quantity regulation versus corrective taxes.

The key issue is whether the government wants to get the amount of pollution reduction correct, or to minimize firm costs.

Quantity regulation assures the desired level of

pollution reduction. When it is important to get the right level (such as with nuclear leakage), this instrument works well. However, corrective taxation protects firms against large cost overruns.

Recap of Externalities: Problems and Solutions

Externality theory

Private-sector solutions
Public-sector solutions Distinctions between price and quantity approaches

to addressing externalities