Transcript Relational Data Base Fundamentals

Chapter 5: Externalities
Problems and Solutions
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Outline
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Externality theory
Private solutions
Public solutions
Focus on prices or focus on quantities?
A couple problems
Introduction
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Externalities arise whenever the actions of one
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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.
Externalities can be negative or positive:
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Acid rain, bad. Asking good questions in class, good.
Introduction
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Global warming is likely the result of a negative
externality. Most scientists who study the issue
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 earth’s atmosphere.
Figure 1 shows the trend in warming over the last
century.
This table shows the global
temperature during the 20th century.
Figure 1
Global Average Temperature Over Time
58
There has been a distinct trend
upward in temperature
57.5
57
56.5
Year
2000
1990
1980
1970
1960
1950
1940
1930
1920
1910
1900
1890
56
1880
Global average temperature
58.5
Introduction
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Although this warming trend has negative effects
overall on society, the distributional consequences
vary.
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In much of the United States, warmer temperatures may
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 you’re wondering why you should care about
Bangladesh, then you have identified the market
failure that arises from externalities.
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From your private perspective, you shouldn’t! But this is
the essence of an externality – your actions have
consequences for others that you do not consider.
EXTERNALITY THEORY
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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
firm’s production reduces the well-being of others
who are not compensated by the firm.
A negative consumption externality is when an
individual’s consumption reduces the well-being of
others who are not compensated by the individual.
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Positive externalities are similar to negative externalities,
except the actions have beneficial effects for others.
Economics of Negative Production
Externalities
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To understand the case of negative production
externalities, consider the following example:
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This is a negative production externalities because:
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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.
Fishermen downstream are adversely affected.
And they are not compensated for this harm.
Figure 2 illustrates each party’s incentives in this
situation.
SMC = PMC +
MD
Price
of steel
S=PMC
TheThe
yellow
steeltriangle
firm sets
is the
consumer
PMB=PMC
andto
producer
find
its firmoptimal
The
steel
socially
overproduces
level of
privately
surplus
optimal
at Q
. society’s
1profit
from
production
is at
viewpoint.
Q2, the
maximizing
output,
This
Theframework
marginal damage
does
notQ1. of SMC and SMB.
intersection
The red triangle is the
curve
capture
(MD)
therepresents
harm donethe
to
The social marginal cost deadweight
is
loss from the
fishery’s
the fishery,
harm
however.
per unit.
the sum of PMC and MD, and
private production level.
represents the cost to society.
MD
p2
p1
D = PMB =
SMB
0
Figure 2
Q2
Q1
Negative Production Externalities
QSTEEL
Negative Consumption Externalities
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We now move on to negative consumption
externalities. Consider the following example:
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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 party’s incentives in the
presence of a negative consumption externality.
Price of
cigarettes
S=PMC=SMC
The The
yellow
smoker
triangle
sets
is the
surplus
PMB=PMC
to thetosmokers
find his
privately
(and producers)
optimal quantity
at Q1.
of
cigarettes,
The
ThisThe
MD
framework
curve
represents
does Q
not
1.benefit is
social
marginal
the
capture
nonsmoker’s
harmharm
done
per
to PMB
the the
difference
between
The red triangle is the
non-smokers,
pack of cigarettes.
however.
and MD.
deadweight loss from the
private
production
The
The socially
smoker
optimal
consumes
leveltoo
of level.
MD
manysmoking
cigarettes
is at
from
Q2,society’s
the
intersection
viewpoint.
of SMC and SMB.
p1
p2
D=PMB
SMB=PMB-MD
0
Figure 3
Q2
Q1
Negative Consumption Externalities
QCIGARETTES
Externalities Result in
Underproduction or Overproduction
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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.
Graphing Externalities
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Determine whether the externality is associated with
production (steel, donuts) or consumption
(smoking, landscaping).
Is the externality positive (donuts, landscaping) or
negative (steel, smoking).
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Negative production externality, SMC is above PMC
Positive production externality, SMC is below PMC
Negative consumption externality, SMB is below PMB
Positive consumption externality, SMB is above PMB
The Solution (Coase Theorem)
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The Coase Theorem: When there are welldefined 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 limited—that of simply
enforcing property rights.
SMC = PMC +
This bargaining processMD
will
until
theissocially
The gain
to society
is area,
this area,
Thecontinue
gain
to society
this
level.
the efficient
difference
between
the difference
between
(PMB(PMB
PMC)
PMC)
andand
MDMD
for for
thethe
firstsecond
unit. unit.
Price
of steel
p2
S = PMC
The
If the
reason
fisheryishad
because
property
any
rights,
steel itproduction
would initially
makes
impose
the
p1
zero
fishery
steelworse
production.
off.
MD
Thus,
While
But
While
there
itthe
is possible
is
fishery
the
still
room
fishery
room
suffers
to
forbargain.
suffers
to
the
bargain.
only
steel
the
Thus,
itThere
is
possible
for
the
steel
a The
modest
firm
same
steel
to steel
“bribe”
amount
damage
firm
firm
gets
the
of
gets
fishery
as
damage.
a lot
from
ainbit
ofinthe
less
firm
toThe
“bribe”
the
fishery
order
surplus
surplus
to produce
from
from
first
the
the
the
unit.
first
second
next
unit.
unit.
unit.
order
to
produce
the
first
unit.
0
Figure 5
1
2
Q2
Q1
D = PMB
SMB
QSTEEL
Negative Production Externalities and Bargaining:
Giving the Fish People Property Rights
SMC = PMC +
MD
Price
of steel
S = PMC
This bargaining process will
The gain gain
to society
is this
the
society
is area,
this area,
continueThe
until thetosocially
If the
This
steel
levelfirm
of
production
had property
difference
between
MD and MD
(PMB
the
difference
between
and
efficient
level.
While
While
the
steel
the
steel
firm
firm
suffers
suffers
a
rights,
maximizes
it would
the
consumer
choose
and unit.
PMC)
byinitially
cutting
another
(PMB-PMC)
byloss
cutting
back 1 unit.
only
larger
a
modest
loss
in
profits.
in profits.
producer
Q surplus.
.
p2
1
p1
MD
The
Thus,
The
Thus,
fishery
it is
fishery
itpossible
gets
is possible
gets
the for
same
a lot
the
forofthe
fishery
surplus
fishery
surplus
toas“bribe”
to
cutting
from
“bribe”
the
cutting
back
the
steel
from
steel
back
firmfirm
D=PMB=SMB
to
steel
cutthe
production
back
first
toanother
cut
unit.
back.
by unit.
one unit.
0
Figure 6
Q2
Q1
QSTEEL
Negative Production Externalities and Bargaining:
Steel Producers Have Property Rights
Problems with Coasian Solutions
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There are several problems with the Coase Theorem,
however.
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The assignment problem
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The holdout problem
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Each party has power, so it can be hard to negotiate settlements
The free rider problem
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Hard to assign blame, hard to value marginal damages
If investment is costly, but benefits are common, individuals will
underinvest.
Transaction costs and negotiating problems
PUBLIC-SECTOR REMEDIES
FOR EXTERNALITIES
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Coasian solutions are insufficient to deal with
large scale externalities. Public policy makes
use of three types of remedies to address
negative externalities:
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Corrective taxation
Subsidies
Regulation
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 QImposing
of PMC
Imposing
aatax
taxequal
shifts
to
thethe
PMC
MD
1, the intersection
and
PMB.curve
shifts
curve
the
upward
PMC
and reduces
such that
steel
it equals
production.
SMC.
p2
p1
D = PMB =
SMB
0
Figure 7
Q2
Pigouvian Tax
Q1
QSTEEL
Subsidies
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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
a subsidy equal
shifts
choosesProviding
Q1, maximizing
the
to
PMC
EMB curve
shifts downward.
the PMC
its
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
Regulation
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Finally, the government can impose quantity
regulation, rather than relying on the price
mechanism.
For example, return to the steel firm in
Figure 9.
SMC = PMC + MD
S = PMC
Price
of steel
p2
The
Yet firm
the government
has an incentive
couldto
simply require
produce
it toQproduce
no
1.
more than Q2.
p1
D = PMB =
SMB
0
Figure 9
Q2
Q1
Quantity Regulation
QSTEEL
DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
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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
pollution-reduction technology.
Since
While
it pays
it faces
for increasing
the pollution
Pollution
reduction
has
a
price
reduction,
marginal the
costs
SMC
from
isreducing
the same
associated
with
it. level.
its pollution
as PMC.
PR
S=PMC=SMC
S=PMC
The
optimal
level of
While
the benefit
of pollution
pollution
reduction
is
therefore
R*.
reduction is zero the firm,
society benefits by MD.
MD =
Thus,
At some
the x-axis
levelalso
of pollution
measuresSMB
The steel firm’s private
pollutionthe
levels
firm
as
has
wethat
achieved
move
marginal benefit from reduction,
pollution
The
good
is being created
On
Such
its an
own,
action
the steel
maximizes
company
itsthe
full
toward
pollution
origin.
reduction
is zero.
isreduction.
“pollution
reduction.”
would set Qprofits.
=0
and
Q
=Q
.
R
Steel
1
D=
PMB
0
PFull
R*
P*
RFull
0
More pollution
Figure 10
Model of Pollution Reduction
QR
DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES
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

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.
Firmthe
B
Firm
has
A’s
relatively
is more
PMCB ToWhile
get
total
For
any
given
output
PMCefficient.
A
inefficient
marginal
cost,
we Bpollution
sum
level,
PMC
>PMCA. S = PMCA + PMCB =
reduction
technology.
horizontally.
SMC
Efficient
is got more
Quantity
If,regulation
instead,
regulation
we
in this
curve is the
where thereduction
marginal
costThe
of SMB
way
from
inefficient,
Firm
A, we
The efficient level
ofis clearly
same
as
before.
pollution
reduction
for
could
since
lower
Firm
B
the
is
total
“worse”
social
at
pollution reduction is
each firm equals
SMB.
reducing
cost.
pollution.
the same as before.
PR
PMCB
PMCA
Quantity regulation could
Imposing
involve equal reductions
in a Pigouvian tax
pollution by bothequal
firms,to MD induces these
such that R1 + R2 = R*.levels of output.
0
Figure 11
RB RA,RA
RB
R*
Two Firms Emit Pollution
MD=SMB
QR
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.
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
This means that initially RA = RB.
But now Firm B has an interest in buying some of Firm
A’s 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
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
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
But
addition,
it is possible
imagine
for that
the
PMC
firm’s
the
government’s
costs
to
be
PMC
best2.2
Then
Suppose
therethe
is large
true
guess of costs is PMC1.
deadweight
costs are PMC
loss.
PMC1
2.
This results in a
much smaller DWL,
If, instead, theFirst,
and much less
This could
assume
be the
government
levied
a
pollution reduction.
SMB
caseisfor
downward
global
tax, it would equal
sloping,
warming,
but for
fairly
MD at QR = R1. example.
flat.
Regulation
mandates R1.
0 R3
PFull
R1
MD =
SMB
RFull
0
More pollution
Figure 12
Model with Uncertainty and Locally Flat Benefits
QR
DISTINCTIONS BETWEEN THE PRICE AND
QUANTITY APPROACHES TO ADDRESSING
EXTERNALITIES

Figure 13 shows the case when the social
marginal benefit is “locally steep.”
In
But
addition,
it is possible
imagine
for that
the
PMC
firm’s
the
government’s
costs
to
be
PMC
best2.2
Then
Suppose
therethe
is small
true
guess of costs is PMC1.
deadweight
costs are PMC
loss.
PMC1
2.
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
Regulation
mandates R1.
First,
This could
assume
be the
SMB
caseisfor
downward
nuclear
sloping,
leakage,
andfor
fairly
example.
steep.
MD =
SMB
0 R3
PFull
R1
RFull
0
More pollution
Figure 13
Model with Uncertainty and Locally Steep Benefits
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.