Chapter 18: Externalities

11© 2014 by McGraw-Hill Education Chapter 18 Externalities 2© 2014 by McGraw-Hill Education • How external costs and benefits affect trade- offs. • What effects externalities have on market price, quantity, and surplus. • What private solutions to externalities exist. • How taxes, subsidies, quantity regulations, and tradable allowances can be used to counteract an externality. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • When individuals make calculated decisions, they weigh the costs and benefits of the action. – Private benefit that accrues directly to the decision maker. – Private cost that falls directly on an economic decision maker. • Sometimes other people are affected by our decisions or have a stake in the outcomes. – External cost describes a cost imposed without compensation on someone other than the person who caused it. – External benefit describes a benefit that accrues without compensation to someone other than the person who caused it. What are externalities? 24© 2014 by McGraw-Hill Education • The total cost of a decision, the social cost, includes both private costs and external costs. • The total benefit of a decision, the social benefit, includes both private benefits and external benefits. • External costs and external benefits are collectively referred to as externalities. – Negative externality: external costs. – Positive externality: external benefits. • A network externality is the effect that an additional user of a good or participant in an activity has on the value of that good or activity for others. – Can be positive or negative. External costs and benefits 5© 2014 by McGraw-Hill Education How can drivers be forced to consider external costs, and thus operate on the social demand curve? • The most straightforward option is to implement a gasoline tax. Negative externality from the demand side Market with private costs only 0 Quantity of gasoline (billions of gals.) Price ($/gal.) 3 20 Sprivate Dprivate 0 3 20 Quantity of gasoline (billions of gals.) Price ($/gal.) Sprivate Dprivate Market with social costs Tax 1 Dsocial 1. If drivers bear full social costs, the social demand curve is below the private demand curve 2.5 15 2. and the equilibrium is at a lower price and quantity. If drivers ignore the external cost of pollution, they only consider the private costs and benefits of driving. When drivers bear the full social cost, the externality is eliminated and they drive less. 6© 2014 by McGraw-Hill Education X Y Producer surplus B A Consumer surplus A tax increases surplus when a negative externality is present in the market. Negative externality from the demand side Quantity of gasoline (billions of gals.) Surplus when a negative externality is internalized 0 Quantity of gasoline (billions of gals.) Price ($/gal.) Sprivate Dprivate 2.5 15 Dsocial Surplus under a negative externality 0 3 20 Price ($/gal.) Sprivate Dprivate 2 1 C External cost • Under a negative externality, the surplus lost to those outside the market due to the external cost is subtracted from consumer and producer surplus, C. • Area C is equal to $1 × 20B = $20B. • If the externality is internalized, demand shifts downward by the amount of the tax. • CS and PS in the market are both lower. • The external cost imposed on people is eliminated. 37© 2014 by McGraw-Hill Education X Y Producer surplus B A Consumer surplus Suppose that a $1 per unit tax can mitigate a negative externality. Using the following graphs: • Calculate total surplus in the presence of a negative externality. • Calculate total surplus when the negative externality is internalized. Active Learning: Calculating the cost of negative externalities Quantity of gasoline (billions of gals.) Surplus when a negative externality is internalized 0 Quantity of gasoline (billions of gals.) Price ($/gal.) Sprivate Dprivate 2.5 37.5 Dsocial Surplus under a negative externality 0 3 50 Price ($/gal.) Sprivate Dprivate 2 1 C External cost 1 5 1 5 8© 2014 by McGraw-Hill Education Gain in total surplus when externality is internalized. Surplus lost by consumers and producers. A negative externality always reduces surplus unless it is internalized. Negative externality from the demand side 0 20 Quantity of gasoline (billions of gals.) Price ($/gal.) S private D private D social 2.5 15 Tax 1 Surplus gained by pollution sufferers. 3 2 • When the negative externality is internalized by imposing a tax, the demand curve shifts downward. – Smaller quantity sold. • CS and PS is lost from imposing a tax. • Surplus is gained by others in society when they receive surplus from tax revenue. • Surplus gain is yellow area. 9© 2014 by McGraw-Hill Education How can drivers be forced to consider external costs, and thus operate on the social supply curve? • The most straightforward option is to implement a gasoline tax. Negative externality from the supply side Market with private costs only 0 Quantity of gasoline (billions of gals.) Price ($/gal.) 3 20 Sprivate Dprivate 0 3 20 Quantity of gasoline (billions of gals.) Price ($/gal.) Sprivate Dprivate Market with social costs Tax 1 1. If gasoline retailers bear full social costs, the social supply curve is above the private supply curve 2. and the equilibrium is at a higher price and quantity. If drivers ignore the external cost of pollution, they only consider the private costs and benefits of driving. When drivers bear the full social cost, the externality is eliminated and they drive less. Ssocial 3.5 15 410© 2014 by McGraw-Hill Education X Y Producer surplus B A Consumer surplus A tax increases surplus when a negative externality is present in the market. Negative externality from the supply side Quantity of gasoline (billions of gals.) Surplus when a negative externality is internalized 0 Quantity of gasoline (billions of gals.) Price ($/gal.) Sprivate Dprivate Surplus under a negative externality 0 3 20 Price ($/gal.) Sprivate Dprivate External cost • Under a negative externality, the surplus lost to those outside the market due to the external cost is subtracted from consumer and producer surplus, C. • This area equals $1 × 20B = $20B. • If the externality is internalized, supply shifts upward by the amount of the tax. • CS and PS in the market are both lower. • The external cost imposed on people is eliminated. 4 1 C Ssocial 3.5 15 11© 2014 by McGraw-Hill Education Gain in total surplus when externality is internalized. Surplus lost by consumers and producers. A negative externality always reduces surplus unless it is internalized. Negative externality from the supply side 0 20 Quantity of gasoline (billions of gals.) Price ($/gal.) S private D private S social Tax 1 Surplus gained by pollution sufferers. 3 2 • When the negative externality is internalized by imposing a tax, the supply curve shifts upward. – Smaller quantity sold. • CS and PS is lost from imposing a tax. • Surplus is gained by others in society when they receive surplus from tax revenue. • Surplus gain is yellow area. 2.5 15 12© 2014 by McGraw-Hill Education • A positive externality also pushes quantity away from the efficient equilibrium level, reducing total surplus. • Internalizing a positive externality, the market reaches an equilibrium with a higher quantity based on social costs and benefits. Positive externalities from the demand side 3,000 0 Quantity of houses painted Price ($) Sprivate Dprivate 1,500 300 Dsocial 3,500 1. When homeowners captureexternal benefits, the social demand curve for house paintings is above the private demand curve, and 500 2. the equilibrium point moves to a higher price and quantity. 1,700 360 • Suppose a homeowner painting a house provides $500 in external benefit to the neighborhood. • If homeowners are able to capture the external benefits of painting a house, demand shifts upward. – Larger quantity. 513© 2014 by McGraw-Hill Education A Consumer surplus B Producer surplus The increase in total surplus can be calculated when a positive externality is present. Positive externalities from the demand side • Internalizing the externality – CS and PS increase; external benefits disappear • TS = X + Y = $540,000 Sprivate X Y Dsocial Dprivate Surplus under a positive externality 0 3,000 3,500 300 Quantity of houses painted Price ($) Sprivate Dsocial Dprivate Surplus when a positive externality is internalized 0 1,700 3,000 3,500 360 Quantity of houses painted Price ($) 1,500 2,000 C External benefit • Area C is the amount of surplus gained by those outside the market and is added to consumer and producer surplus. • This surplus equals $500 × 800 = $150K. 14© 2014 by McGraw-Hill Education A Consumer surplus B Producer surplus Active Learning: Calculating positive externalities Sprivate X Y Dsocial Dprivate Surplus under a positive externality 0 1,000 1,250 200 Quantity of houses painted Price ($) Sprivate Dsocial Dprivate Surplus when a positive externality is internalized 0 291 1,000 1,250 256 Quantity of houses painted Price ($) 250 500 C External benefit Suppose a negative externality exists and a $250 per unit subsidy resolves it. • Calculate total surplus in the presence of a positive externality. • Calculate total surplus when the positive externality is internalized. 100 100 15© 2014 by McGraw-Hill Education Gained from extra trades. • When the positive externality is internalized by imposing a subsidy, the demand curve shifts upward. – Larger quantity sold. • CS and PS is lost from internalizing externality. • Surplus is gained by market participants receiving a subsidy from tax revenue. • Surplus gain is green area. Positive externality from the demand side Lost when externality is internalized. Gained when externality is internalized. Sprivate Dprivate 3,000 0 Quantity of houses painted Price ($) 300 1,500 2,000 3,500 Dsocial 360 A positive externality always reduces surplus unless it is internalized. 616© 2014 by McGraw-Hill Education • A positive externality also pushes quantity away from the efficient equilibrium level, reducing total surplus. • A subsidy corrects this market inefficiency, increasing surplus. Positive externality from the supply side Under a positive externality, the surplus by those outside the market is added to consumer and producer surplus, Area C. • If the externality is internalized through a subsidy, the supply curve shifts downward. • CS and PS in the market are both higher. • The external benefit is now internalized to only market participants. B Producer surplus A Consumer surplus Quantity of houses painted Surplus under a positive externality 300 Price ($) Sprivate Dprivate C $1500 $1000 $500 External benefit $3000 X Ssocial $1300 Y Quantity of houses painted Surplus under a positive externality 0 360 Price ($) Sprivate Dprivate $3000 17© 2014 by McGraw-Hill Education Positive externality from the supply side 0 300 Quantity of houses painted Price ($) Sprivate Dprivate Dsocial 360 $1000 $1500 Ssocial Lost when externality is internalized. Gained when externality is internalized. $500 Gain in total surplus when externality is internalized. A positive externality always reduces surplus unless it is internalized. • When the positive externality is internalized by imposing a subsidy, the supply curve shifts downward. – Larger quantity sold. • CS and PS is lost from internalizing externality. • Surplus is gained by market participants receiving a subsidy from tax revenue. • Surplus gain is green area. 18© 2014 by McGraw-Hill Education • External costs and benefits can be diffuse, complex, and hard to control. • Solutions must ensure that individuals experience costs and benefits that are equal in value to the true social costs and benefits of their choices. – This may require coordinating across millions of people. • The Coase theorem states that if there are zero transaction costs to negotiate and agreements are enforceable, then an efficient equilibrium through private trades can be reached, even in the presence of an externality. • Often, these two assumptions do not hold true. Dealing with externalities 719© 2014 by McGraw-Hill Education • Because of the cost and difficulty of coordinating private solutions, people often turn to public policy for solutions to externalities. • A Pigovian tax counters the effects of a negative externality. • There are two main problems with this solution: – Setting the tax at the right level. – No guarantee that the government can or will do anything to help people bearing the external cost. Dealing with externalities 20© 2014 by McGraw-Hill Education As previously analyzed, a tax can move the market equilibrium to the social optimal equilibrium. Dealing with externalities 0 15 20 1 2.5 3 4 5 S Quantity of gasoline (billions of gals.) Price $/(gal.) Under a negative externality, demand is above the optimal level. • Under a negative externality, the demand curve is above the optimal demand curve by the amount of the external cost. • This causes quantity to be higher than the efficient level. (A) The effect of a negative externality Dprivate Dsocial A Pigovian tax can move the demand curve back to the optimal level. 0 15 20 1 2.5 3 4 5 S Quantity of gasoline (billions of gals.) Price ($/gal.) • A Pigovian tax counteracts a negative externality. • If the tax is set equal to the value of the external cost: • The externality cost is canceled. • Quantity goes to the efficient level. (B) The effect of a Pigovian tax Dprivate Dsocial 21© 2014 by McGraw-Hill Education • Suppose government estimates that painting houses creates $500 worth of external benefits for neighbors. • If this subsidy exactly equals the external benefit of painting houses, equilibrium occurs at the socially efficient outcome. – Increased efficiency does not imply increased fairness. – Troublesome to quantify the externality. Dealing with externalities 0 300 3,000 1,500 Dprivate Sprivate Price ($) Quantity of houses painted Dsocial 3,500 500 1.A $500 subsidy creates a new demand curve, above the old one 360 1,700 2. if the subsidy exactly equals the positive externality, equilibrium occurs at the socially efficient outcome. As previously analyzed, a subsidy can move the market equilibrium to the socially optimal equilibrium. 822© 2014 by McGraw-Hill Education Rover Gallons of gasoline Gallons of gasoline (B) Gasoline consumption under a tax Net benefit to driver 1. Marginal benefit equals the tax level Tax level1 2. but marginal benefit is different. 0 60 1.2 2 Prius Range (A) Gasoline consumption under a quota Net benefit to driver 0 60 1.2 2 Prius Range Rover 1. Quantity is the same 20 1.33 0.8 Quota 2. and quantity varies accordingly. 10 30 • One solution is to regulate quantity to be socially optimal. • This does not make the market efficient if individuals make decisions based on net benefit (marginal benefit – marginal cost = 0). Dealing with externalities • Under a quota, both drivers buy 20 gallons regardless of the difference in their net marginal benefits. • Under a $1 tax, both drivers buy different amounts of gas. • Neither is left wanting to buy more. • Total gallons consumed remain 40. 23© 2014 by McGraw-Hill Education Prius surplus Tax revenue Prius Range Rover Marginal benefit to driver Gallons of gasoline Surplus under a tax 0 10 30 40 60 1 1.2 2 Prius Range Rover Quota 0 20 60 1.2 1.33 0.8 2 Gallons of gasoline Marginal benefit to driver Surplus under a quota Tax level 34 + 20 = 54 20 34 40 + 1 + 15 = 56 15 1 10 + 30 = 40 Ranger Rover surplus • Total surplus is higher under the tax than under the quota. • The quota brings the two drivers to the same combined quantity of gas consumption as the tax does, but does it inefficiently (smaller total surplus). Dealing with externalities At 20 gallon quota, total surplus is $54. Under a $1 tax, total surplus is $56. 24© 2014 by McGraw-Hill Education • Using a quota to deal with externalities can be extended by permitting the buying and selling of quota allowances, a tradable allowance. – Market quantity is socially optimal (efficient). – Total surplus is maximized. – Tradable allowance does not create any government revenue, because no taxes are imposed. Dealing with externalities 925© 2014 by McGraw-Hill Education • Because of the difficulty of measuring externalities directly, many policies target individual goods and processes. • The downside of targeting individual activities is that it risks misaligning the incentives that consumers and producers face with the goal of minimizing the externality. • A policy that directly taxes or subsidizes the externalities encourages the development of technology and processes. – Consumers and producers have an incentive to find new ways of doing things that don’t generate externalities. – This allows them to avoid having to pay for a tax or the rights to an allowance, aligning their incentives with the end goal of the policy. Dealing with externalities 26© 2014 by McGraw-Hill Education • Any cost that is imposed without compensation on someone other than the person who caused it is an external cost. • A benefit that accrues without compensation to someone other than the person who caused it is called an external benefit. • External costs and benefits are collectively referred to as externalities. • The total cost of the decision, including any externalities, is referred to as the social cost. Summary 27© 2014 by McGraw-Hill Education • A negative externality causes the individuals who bear only the private cost to demand or supply an inefficiently high quantity at any given price. • A positive externality causes individuals who enjoy only the private benefit to demand or supply an inefficiently low quantity at any given price. • In the presence of externalities, markets fail to maximize total surplus. Summary 10 28© 2014 by McGraw-Hill Education • If agreements are enforceable and transaction costs are small, the Coase theorem states that individuals reach an efficient equilibrium through private trades. • A Pigovian tax counterbalances the effects of a negative externality. • A subsidy counterbalances the effect of a positive externality. Summary 29© 2014 by McGraw-Hill Education • Setting a quota to counteract inefficiently high consumption due to a negative externality can lower quantity to the socially optimal efficient level, but it does not maximize surplus. • A tradable allowance is a production or consumption quota that can be bought and sold. – Efficient quantity. – Total surplus is maximized. Summary