Econ 309 Externalities
Summary of last time
There are market failures
For civilization to exist, governments must act to some degree to fix these problems
To fix market failures, governments must spend, and so must tax.
If governments do this poorly, governments and even societies fail.
Running a government system of taxing and spending lead to social literacy, numeracy, and even the field of economics itself.
When governments try to make things work better, the question is raised, "Better for whom?" The ruler? Everyone in the area? The citizens? The people who work in government?
There is a risk that a government will try to do too much. Ours clearly does, in some areas.
Danger: Government action can make things worse, particularly due to the harm from taxation. (Someone please tell Nancy Pelosi!)
Externalities and Public Goods: The two clearest areas for government action are:
Externalities – Effects on other parties other than through the price mechanism
Public Goods - Anything for which the investment by one member of a group benefits everyone in the group in a way that is non-rival and non-excludable (non-excludability is the big problem preventing efficient market provision of these)
A note on Marshallian and Hicksian Demand Curves
In a simple world, we get nice equilibria. Supply and demand curves meet where the marginal cost of production equals the marginal utility of consumption for each good. However, there’s a slight technical problem with this analysis. Normal supply and demand curves are from Alfred Marshall and are known as “Marshallian”, and with those curves price changes have both substitution and income effects, and these income effects mess up the nice MC=MU result. For most of the analysis in this class, we’ll be thinking about the approach of Sir John Hicks, or “Hicksian” demand curves are considered to be “income compensated.’’
With Marshallian demand curves (the standard ones from Intro Micro), if the price of gasoline when up by $1 per gallon, you would buy less gasoline because you were effectively poorer (an income effect) and because you would be substituting to other relatively cheaper things (a substitution effect). With a Hicksian demand curve, the thought experiment is if the price of gasoline when up by $1, how much extra income would you need to keep the same utility level as before the price when up? Of course, even with the compensated income, you would likely buy less gasoline, but then it would be purely due to a substitution effect. (For a given “straight line” Marshallian demand curve, the associated Hickisian demand curve would be curved with a negative second derivative.)
In general for this class, the differences are not significant, and we will try to be clear when it matters.
Failure of a simple market system to reach an equilibrium were social marginal benefits and social marginal costs are equal implies that for the quantity chosen, on the margin, social benefits and costs will not be equal and so dead weight loss will result. If we are making “too much” of something, then the social cost on the margin will be greater than the social benefit; we will be taking valuable resources and turning them into something of less value, we will be destroying value. If we are making “too little” of something, then the marginal social benefit is greater than the marginal social cost; we are failing to make all the possible social gain, we are failing to convert low value inputs into some output that society values much more.
Externalities
Externalities occur where one party can make another better or worse off but the first party feels no cost or benefit from doing so.
This results in a quantity such that marginal social benefit does not equal marginal social cost, thus creating Dead Weight Loss (DWL).
Dead Weight Loss is about waste, wasted opportunities
Externalities are the effect of spillovers, side effects, neighborhood effects
The direct effect of an agent in the economy on another agent (changing a person’s utility or altering the production possibilities of a firm), where "direct effect" here means not through the price mechanism, not through trade.
Versus "pecuniary externalities" that work through the price mechanism.
For example I might big up the cost of parking near NU so that you choose to ride your bike. No DWL!
Beneficial versus Negative - Honey production and fruit trees, and outdoor restaurants
Negative externality examples: Pollution, noise, ugliness, emotional distress
Beneficial externality examples: Beauty, safety
From producers or consumers
Two-sided (The insight of Ron Coase)
To seek efficient market outcomes, attempt to "internalize" the externality so that all parties feels social costs or benefits.
Economists who paid central roles in developing this topic: Sidgwick 1887, Alfred Marshall 1890, A.C. Pigou 1920 (Supply & Demand graphs with marginal damage curves), Ronald Coase 1960 (control via property rights), Kenneth Arrow 1972 (markets for pollution)
Economic Theory: Externalities and Dead Weight Loss
Private agents will produce and buy up to the point were Private Marginal Benefit = Private Marginal Cost. (At this point there is zero dead weight loss.)
Social Marginal Cost = Private Marginal Cost + Marginal Damage (SMC = PMC + MD)
Social Marginal Benefit = Private Marginal Benefit + External Benefit (SMB = PMB + EB)
If we leave things to private markets, we get PMC = PMB
This gives DWL if MD or EB aren’t zero.
Gruber’s Rule of Thumb: DWL is an “arrow” that points from the private equilibrium to the socially optimal one
Economic Theory: Fixing DWL from Externalities
Command & Control (C&C) - Limit who and make or buy something, limit how something is produced, ration quantities, outright ban some things, etc.
Usually an expensive way of approaching the problem!
Sometimes it might be the best way to go: Banning lead in gas
Pigouvian Pollution Taxes, or Subsidies: Set taxes as pseudo-prices for the un-priced environmental resources being sued, Tax = the MD at the optimal social quantity
Cap & Trade of Pollution Permits - Limit pollution to some optimal level and then let people buy and sell the right to emit that pollution.
Coase Theorem - Two-sided aspect of externalities can be worked out with Property Rights (which is sort of the grandfather of Cap & Trade)
Internalize the externality by merging the effected units together, so that all feel some of the benefits or suffer some of the harm.
Which system should we choose?
Efficiency goal: Get to efficient quantities (ie. reduce negative externalities) as cheaply as possible (ie. low cost reductions before high cost reductions).
Pigouvian taxs and Cap & Trade are very similar. When potential costs of correcting externalities are uncertain, the slope of the marginal damage curve matters for whether regulation or corrective taxes are more likely to produce an efficient outcome. Interesting result, but something to be left for Econ 370: Environmental Economics.
Controlling Externalities
a. Ideally, quantities are chosen, including externality effects so that:
i. Marginal Social Cost = Marginal Social Benefit
1. where Marginal Social Cost = Marginal Private Cost + Marginal Damage
ii. Of course externalities can be positive as well:
1. Marginal Social Benefit = Marginal Private Benefit + Extra Social Benefit)
iii. Note: We can find the socially optimal quantity by either adding MD to private MC, or subtracting MD from MB. Either gives the same result for the optimal social quantity produced and sold.
II. Gruber’s Rule of Thumb: DWL is an “arrow” that points from the private equilibrium to the socially optimal one
III. How do we control externalities to minimize DWL? Six methods
a. Command and control, Regulation
i. Set pollution to zero or some other low level by regulating how much firms in an industry can produce, or how they produce it.
ii. If regulators can only observe output, how would they mandate cutbacks in production to reduce pollution? Optimally, firms that can reduce pollution cheaply in terms of lost output (dirty plants) should do so, and firms where the loss in output would be high for a given pollution reduction (clean plants) should reduce less.
iii. Clearly in such a case it would be sub-optimal for both firms to cut back by the same amount or percentage.
iv. What difficulties might arise in running such a system?
1. Would getting firms in concentrated industries to jointly reduce production lead to more oligopoly profits?
2. Would each firm that tried to enter the market have to go to the regulators to find out how much it would be allowed to produce?
3. If entry would reduce prices and profits for firms in the industry, incumbents in the business might even press for more stringent standards to keep firms out of the business. This has actually happened. (And is happening now with the push by major toy makers to have a major certification program for toy safety.)
b. Pigouvian taxes
i. Unit tax on firm output equal to the marginal damage created by the firm's output.
ii. This will increase marginal private costs to the point where they are equal to marginal social costs.
iii. Pigouvian taxes were worked out by A.C. Pigou. Arthur Cecil Pigou, who you just know got beat up in gym class every day. At Cambridge, he was a rival of John Maynard Keynes.
iv. Such a tax would increase the price of the "under-priced" social resource, and simulate a market where the market fails to exist due to a lack of property rights.
v. In effect, the tax attempts to serve as a price for the un-priced input (such as clean air), as judged by the quantity of output.
vi. It would probably be better to tax the pollution created directly but that can be very hard (expensive) to do.
vii. As such, since we can’t tax the externality directly, this is a “second best” solution.
viii. It is always difficult to calculate marginal damage, particularly when the marginal damage may not be a linear function of output as it is in this example.
ix. The optimal Pigouvian tax would be equal to the marginal damage that would be created if the firm were producing at its optimal level of output.
x. One very nice feature of Pigouvian taxes is that they bring in tax revenue (although these taxes may be expensive to enforce).
xi. These taxes can even be used to encourage beneficial externalities as well. Evanston could put a tax on people who do not plant flowers in their yards.
c. Pigouvian subsidies
i. Pay unit subsidy to firm for each unit it reduces its output.
ii. The subsidy would be equal to the marginal damage created by firm output to encourage firm to reduce its production of the pollution causing good.
iii. This would increase the opportunity cost of producing goods. A firm would know that for every unit it produces, it would lose (say) $5 in subsidy.
iv. This is a pretty stupid idea really. It is expensive to come up with the revenue for these subsidies and this increases taxation DWL in other markets. It may cause firms to enter market just to get the subsidy. This effect could be reduced in the short run by "grand-fathering" in and limiting the subsidy to the original outputs of incumbent firms in the market. Certainly, firms in the industry prefer Pigouvian subsidies to Pigouvian taxes.
v. There are government sponsored "buy-back" programs for guns that are examples of a Pigouvian subsidy.
vi. In the unimaginably distant past, Michael Jackson’s sister LaToya Jackson held some concerts where a person could be admitted by turning in a gun. I wonder if any of them were unsatisfied with the concert and demanded their guns back. My guess is that the real criminals probably held on to their weapons anyway. Oh well, at least there are fewer stray guns around for kids to use as playthings. Illinois considered a buy-back program to get high-polluting old cars off the streets. However, they realized that any price they would set would bring lots of currently dead cars out of junk yards just to get the subsidy. The supply of cheap junk cars is highly elastic. It is not even clear that this is a good policy. It pollutes to make a car and many of the old junkers are driven very little. So if people turned in their old cars and bought new ones, and drove these new cars more pollution might even go up. Still, old cars do tend to pollute a lot.
vii. Two current Pigouvian subsidies are tax deductions for buying hybrid automobiles and for producing ethanol. There are surely better uses for this lost government revenue.
d. Auction Pollution Permits - Calculate how much pollution is acceptable and sell rights to produce this pollution.
i. The Clean Air Act of 1990 created a market in pollution rights. Some people see buying a right to pollute as being akin to buying a right to murder someone. However, it has its advantages.
ii. It is a flexible system where quantities are easily altered.
iii. Market based approaches are nice in this way, environmental groups could just buy up these permits and give us zero pollution.
iv. As compared to strict regulation, this program can shelter jobs from changes in environmental regulations and allow time for adjustments to be made.
v. However, it is very hard to monitor compliance and so far works only on the pollution from firms.
vi. To date, this approach does nothing about the biggest polluters of all, automobiles.
vii. If policing can be worked out, this system may make for a practical method of organizing international coordination on pollution. Rather than having the rich countries tell the poor ones not to pollute, the rich countries could pay them not to.
viii. It is very tough to set regulations and taxes between nations but buying and selling is quite common, if we can believe or monitor those who claim to be cutting back on polluting in exchange for payments. This may be a big problem.
ix. If set to the optimal amount and adequately policed, this system will drive the price of this "under-priced" good to its "true" value, which should be equal to the Pigouvian tax. Making the firms pay for the pollution they have to "buy" would shift their supply curves upward. If the shift is too little, DWL will remain. If the shift is too far, DWL will be created.
x. One potential problem with this sort of policy is that it is very sensitive to local concentrations. Reducing some pollution in fairly clean Kansas with a tradeoff of increased pollution in dangerously polluted LA is a bad outcome.
xi. Examples
1. In 1992 Mobil Oil paid $3 million for the right to emit a certain amount of pollutants in Torrance, California. General Motors sold the rights to Mobil after it closed down its plant in the town. GM's saleable rights were less than the pollution it previously emitted and the profit from the sale was an incentive to close the old, polluting plant.
2. Commodities exchanges like Chicago's Board of Trade have begun selling rights and futures for these markets.
3. Starting in 1995, the Clean Air Act set rules that all new power plants in the US had to pay for the right to emit sulfur dioxide. The credits are denominated in pounds of pollution per day and typically sell for $1,000 to $4,000 per pound. This has become a major expense of opening a new plant.
4. In 1992, the Tennessee Valley Authority paid nearly $3,000,000 to a Wisconsin utility for the right to emit 10,000 tons of sulfur dioxide. This is the cheapest way for the two utilities to cut the cost of their pollution. This system also makes pollution reducing devices like stack scrubbers financially attractive to firms.
e. Internalized the Externality
i. Economically connect the producers of the externality with those who feel its effect.
ii. For instance, get the up-stream polluting paper mill to merge with the down stream fishery. Then losses to the fishery will hurt the company and so it will have incentives to try to reduce the pollution from its paper mill.
f. Property rights, Coase Theorem
i. If transactions costs don't overwhelm gains, saleable property rights will bring social resources to their socially efficient uses, even when there are externalities. Social welfare will be maximized.
ii. This is a simple variant on the pollution permit auction.
II. Externalities and Coase, one of the most influential articles in the field of law
a. Coase: Pigou is wrong about his “polluter pays” idea of controlling externalities. Who is actually producing the externality turns out to be a subjective matter.
b. Don’t we have a right to live our lives without putting up with negative externalities from others? But don’t we also have a right to do reasonable things without having others whine about negative externalities?
c. Aren’t such disputes a matter for the courts?
d. Coase says sure, but unless “transactions costs” are too high to allow us to get to the efficient outcome, then we end up at the efficient outcome (duh!) and all the courts effectively do is settle if one party pays the other party anything. As such, the laws here have no real effect on what is done in the economy, just over side payments. (Transaction costs and Netflix)
e. Coase theorem: “If property rights are clearly specified and there are no transactions costs, bargaining will lead to an efficient outcome no matter how the rights are allocated.”
f. Examples: Physician and candy maker, train and farmers. Goal: get efficient outcome at minimum cost.
g. Some problems with Coase approach beyond very local setting, clearly transactions costs become huge when the number of parties involved becomes large.
III. Problems with Coase approach
a. With many parties, dangers of “free riders” not being willing to pay for “public good” non-excludable benefits
b. Holdout Effect – some party may strategically demand payment that would result in economic rents, attempt to expropriate all economic rents
c. Equity issues: Poor communities may end up paying rich ones to avoid pollution? Income distribution and varying environmental standards
d. Rent seeking, Gary, Indiana
e. Note legal issue of “coming to the nuisance” – Even if property rights favor you, don’t expect payments if you undertook some effort to fall downwind of some externality. We try not to have the law incentivize rent seeking behavior such as making choices that would result in costs.
IV. Coase Example
a. On the land along the railroad tracks, the farmers of Coaseland grow crops each year that produce a profit of $4000.
b. The train that runs along those tracks earns $2500 in profits per season.
c. The smokestack of this train throws off sparks that each season burn $2000 worth of crops that grow near the tracks.
d. (Status quo social surplus: $4000 + $2500 – $2000 = $4500 in value produced)
e. It costs $400 to negotiate a solution.
f. The loss of crops could be avoided by
i. stopping the train (Surplus $4000)
ii. not growing crops (Surplus $2500)
iii. eliminate the sparks by having trains put on taller smokestacks on the train (at a cost of $1800 per season) (Surplus $4700)
iv. save crops by having farmers put up high fences in front of the crops (at a cost of $2150 per season). (Surplus $4350)
g. What is the socially optimal outcome?
h. What will be the outcome if all the property rights favor the farmers?
i. What if the rights favor the train?
j. General Coasian result: With low enough transactions costs, we get efficient social outcome regardless of how the law defines property rights, as long as they are defined!