Transcript Externalities

Externalities
• A cost or benefit to a third party who is not
involved in the transaction between
producer and consumer
• External cost is also known as “negative
externality”
• External benefit is also known as “positive
externality”
Examples of External Costs & Benefits
External Costs
External Benefits
-dumping toxic waste
destroys habitats
-overfishing depletes fish
stocks
-burning coal adds to
global warming
-location of firm in high
unemp. area increases local
standards of living
-new transport built for
industry encourages greater
tourism
Consumption -excess alcohol intake at
pub causes vandalism
-increased car use leads
to delays and lost work
-improving one’s garden
adds value to a neighbour’s
property
-higher education improves
prospects for the next
generation
Production
** you only need to be able to discuss external costs from production
and external benefits from consumption**
Private Costs & Social Costs
• Producers are only concerned with “private
costs” so this is all they take into account when
deciding their quantity of output
• Consumers are only concerned with “private
benefit” so this is all they take into account when
deciding their quantity of consumption
• Social Cost = private cost + external cost
• Social benefit = private benefit + external benefit
External Costs
Cost
MSC
Externality
MPC=S
Quantity
If the negative externality were included in the “cost”, MPC would shift to MSC
by the vertical amount of the negative externality. S would decrease.
External Benefits
Cost
Externality
MSB
MPB=D
Quantity
If the positive externality were included in the “demand”, MPB would shift to MSB
by the vertical amount of the positive externality. D would increase.
Market Optimum vs.
Socially Optimum Output
• Free market equilibrium is where marginal
private cost = marginal private benefit
(MPC=MPB)
• Socially optimum equilibrium is where
marginal social cost = marginal social
benefit (MSC = MSB)
Market Optimum vs.
Socially Optimum Output
MSC
Cost
MPC=S
P socially
optimum
P free mkt
MPB=MSB=D
Q
Q
socially free
optimum mkt
Quantity
Where there are external costs, the free market will overproduce and underprice.
Market Optimum vs.
Socially Optimum Output
Cost
MPC=MSC=S
P socially
optimum
P free mkt
MSB
MPB=D
Q
Q
free
mkt
socially
optimum
Quantity
Where there are external benefits, the free market will underconsume & underprice.
Welfare Loss
Cost
WELFARE LOSS
MPC=MSC=S
P socially
optimum
P free mkt
MSB
MPB=D
Q
Q
free
mkt
socially
optimum
Quantity
- loss to society from not producing at the socially optimum output and price = area
between the two curves from the free market output to the socially optimum output
Remedies for External Costs &
Demerit Goods
• Direct Controls
• Tradable Permits
• Extending Property Rights
• Taxes
• Subsidies of Alternatives
Direct Controls
• Restriction or prohibition of production or
consumption of a good
• Eg. smoking ban in public places, using
cannabis is illegal, production of refrigerators
using ozone-depleting chemicals is forbidden,
restrictions on pollution levels
• A full ban is rational when MSC > MPB at all
levels
Restriction of Output
MSC
Cost
MPC=S1
MPC=S
P socially
optimum
P free mkt
MPB=MSB=D
Q
Q
socially free
optimum mkt
Quantity
Pros/Cons of Direct Controls
Advantages
Disadvantages
-Clear limits are
defined
-Major offenders may
be shut down (either
by restriction or
prohibition)
-expensive to monitor
-extra admin costs to firms
-difficult to assess the
correct monetary impact of
the externality (S may shift
too far or not far enough)
-may lead to gov’t failure if
resources end up being
allocated incorrectly
Tradable Permits
1. Gov’t sets quantitative limit (quota) on the
amount of an externality allowed in an industry
2. Each firm is allocated permits to produce their
share of the externality
3. Firms who want to produce less than their
permits allow can sell their permits to another
firm who wants to produce more – everyone
gets what they want
4. The total in the industry remains the same
Advantages of Tradable Permits
• externality controlled by the price mechanism as
producers decide how much they are willing to
pay to continue producing the externality
• permits can be ↓ over time to gradually phase
out the externality (↓supply of permits →↑price of
the externality → ↓quantity produced
• encourages firms to invest in going “cleaner”
with revenue from selling permits
• firms producing the externality pay for it,
(“internalising the externality”)
Disadvantages of Tradable Permits
• ↑ production and admin costs for firms
• ↓ pressure for offenders to clean up their act
(just buy more permits!) – gives impression it’s
okay
• Valuation of the correct value & quantity of
permits with respect to the true social cost is
difficult
• May lead to fraud/bribery/bullying by big
polluting firms
Extending Property Rights
• Gov’t allocates ownership to
people/organisations for certain resources
(eg. air, river, sea, etc.)
• Often externalities arise due to lack of
property rights (nobody owns the sea so
no one minds if we dump this waste!)
• Once someone owns the resource, they
can sue anyone who damages it
Pros/Cons of Extending Property Rights
Advantages
Disadvantages
-enforcement is moved
away from gov’t to
private individuals &
courts
-firms pay to change
their production
method or pay when
they get sued – either
way “internalising the
externality”
-may be difficult to extend
property rights in all cases
(eg. which fisherman owns
which piece of the sea)
-difficult to trace the source
of externalities where there
are multiple offenders
-may be imbalance of
power between ‘big’
polluters and ‘little’
individuals
Taxes
• Indirect tax imposed on offending firms to
charge them for their externality
(internalise the externality)
MSC
Cost
MPC=S1
consumer pays
tax
MPC=S
P so
P fm
MPB=MSB=D
producer pays
Q
Q
socially free
optimum mkt
Quantity
Pros/Cons of Taxes
Advantages
Disadvantages
-the offenders pay for the
externality – not the 3rd party
-monetary incentive for
producers or consumers of
good to ↓ externality
-↑tax revenue can be used
to clean up or compensate
sufferers
-elastic goods may see
significant reduction in
demand
-difficult to measure the
exact value of the
externality – ie. to set the
correct tax
-↑ production costs for firms
-firms may relocate to less
taxed countries
-inelastic goods may not
see a significant decrease
in demand
Subsidies of Alternatives
• Provided to encourage production and
consumption of a more socially beneficial
alternative
• Eg. subsidies for construction of gas-fired power
stations, subsidies for public transport, subsidies
for nicorette?
S
Price
S1
P
P1
D
Q
Q1
Quantity
Pros & Cons of Subsidies
Advantages
Disadvantages
-should ↓ use of good
with negative externality
or demerit good
-increase consumer
surplus (shifting S
outward)
-expensive for gov’t
-firms may become
inefficient if relying on
subsidies
-may be difficult to make
people shift if demand
for the demerit good is
inelastic (not price
sensitive)