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Chapter 18 - Externalities. After studying this chapter you will be able to understand: How external costs and benefits affect tradeoffs? 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?
Chapter 18 Externalities © 2014 by McGraw-Hill Education What will you learn in this chapter? • How external costs and benefits affect tradeoffs • 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 © 2014 by McGraw-Hill Education What are externalities? • 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 © 2014 by McGraw-Hill Education External costs and benefits • 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 © 2014 by McGraw-Hill Education Negative externality from the demand side 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 Market with private costs only Price ($/gal.) Tax Sprivate Market with social costs If drivers bear full social costs, the social demand curve is below the private demand curve… Price ($/gal.) Sprivate … and the equilibrium is at a lower price and quantity 3 2.5 Dprivate Dprivate Dsocial 20 Quantity of gasoline (billions of gals.) 15 20 Quantity of gasoline (billions of gals.) If drivers ignore the external cost of pollution, When drivers bear the full social cost, the they only consider the private costs and externality is eliminated and they drive less benefits of driving © 2014 by McGraw-Hill Education Negative externality from the demand side A tax increases surplus when a negative externality is present in the market Surplus under a negative externality Price ($/gal.) Surplus when a negative externality is internalized Price ($/gal.) External cost Consumer surplus Sprivate Producer surplus A Sprivate X 2.5 C B Y Dprivate 20 Quantity of gasoline (billions of gals.) • • 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 ì 20B = $20B â 2014 by McGraw-Hill Education • • • Dprivate Dsocial 15 Quantity of gasoline (billions of gals.) 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 Active Learning: Calculating the cost of negative externalities Suppose that a $1 per unit tax can mitigate a negative externality Using the following graphs: • Calculate total surplus in the presence of a negative externality • Calculate total surplus when the negative externality is internalized Surplus under a negative externality Price ($/gal.) Price ($/gal.) Consumer surplus Sprivate Sprivate Producer surplus A Surplus when a negative externality is internalized External cost X 2.5 C Y Dprivate B 1 50 Quantity of gasoline (billions of gals.) Dprivate Dsocial 37.5 Quantity of gasoline (billions of gals.) © 2014 by McGraw-Hill Education Negative externality from the demand side A negative externality always reduces surplus unless it is internalized Price ($/gal.) S private Surplus lost by consumers and producers Tax Gain in total surplus when externality is internalized 2.5 Surplus gained by pollution sufferers D private • 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 D social 15 20 Quantity of gasoline (billions of gals.) © 2014 by McGraw-Hill Education Negative externality from the supply side 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 Market with private costs only Price ($/gal.) Sprivate 3.5 3 Dprivate Tax 20 Quantity of gasoline (billions of gals.) Market with social costs If gasoline retailers bear full social costs, the social supply curve is above the private supply curve… Price ($/gal.) Ssocial Sprivate … and the equilibrium is at a higher price and quantity Dprivate 15 20 Quantity of gasoline (billions of gals.) If drivers ignore the external cost of pollution, When drivers bear the full social cost, the they only consider the private costs and externality is eliminated and they drive less benefits of driving © 2014 by McGraw-Hill Education Negative externality from the supply side A tax increases surplus when a negative externality is present in the market Surplus under a negative externality Price ($/gal.) Surplus when a negative externality is internalized External cost Price ($/gal.) Ssocial Sprivate Consumer surplus Producer surplus A X C Sprivate 3.5 Y B Dprivate Dprivate 20 Quantity of gasoline (billions of gals.) • • 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 = $20B • • • 15 Quantity of gasoline (billions of gals.) If the externality is internalized, supply shifts upward by the amount of the tax CS and PS in the market are both lower The external cost imposed on people is eliminated © 2014 by McGraw-Hill Education 10 Negative externality from the supply side A negative externality always reduces surplus unless it is internalized S social Price ($/gal.) Tax S private Surplus gained by pollution sufferers 2.5 Gain in total surplus when externality is internalized Surplus lost by consumers and producers D private • 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 15 20 Quantity of gasoline (billions of gals.) © 2014 by McGraw-Hill Education 11 Positive externalities from the demand side • 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 Price ($) 3,500 500 3,000 When homeowners capture external benefits, the social demand curve for house paintings is above the private demand curve, and … Sprivate 2.… the equilibrium point moves to a higher price and quantity 1,700 1,500 Dsocial Dprivate • Suppose a homeowner painting a house provides $500 in external benefit to the neighborhood • If homeowners are able to capture the external benefits of painting a house, demand shifts upward – Larger quantity 300 360 Quantity of houses painted © 2014 by McGraw-Hill Education 12 Positive externalities from the demand side The increase in total surplus can be calculated when a positive externality is present Surplus when a positive externality is internalized Surplus under a positive externality Price ($) 3,500 Price ($) 3,500 Consumer surplus Producer surplus External benefit 3,000 A 3,000 X Sprivate 2,000 C Sprivate 1,700 1,500 B Y Dsocial Dsocial Dprivate Dprivate 300 Quantity of houses painted • Area C is the amount of surplus gained by those outside the market and is added to consumer and producer surplus ã This surplus equals $500 ì 800 = $150K © 2014 by McGraw-Hill Education 360 Quantity of houses painted • Internalizing the externality – CS and PS increase; external benefits disappear • TS = X + Y = $540,000 13 Active Learning: Calculating positive externalities Suppose a negative externality exists and a $250 per unit subsidy resolves it • Calculate total surplus in the presence of a positive externality • Calculate total surplus when the positive externality is internalized Surplus when a positive externality is internalized Surplus under a positive externality Price ($) 1,250 Price ($) 1,250 Consumer surplus Producer surplus External benefit 1,000 A 1,000 C Sprivate 291 250 B Y Dsocial Dprivate 100 X Sprivate 500 200 Quantity of houses painted 100 Dsocial Dprivate 256 Quantity of houses painted © 2014 by McGraw-Hill Education 14 Positive externality from the demand side A positive externality always reduces surplus unless it is internalized Price ($) 3,500 Gained when externality is internalized 3,000 Gained from extra trades S private 2,000 1,500 D social Lost when externality is internalized 300 360 Quantity of houses painted © 2014 by McGraw-Hill Education D private • 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 15 Positive externality from the supply side • A positive externality also pushes quantity away from the efficient equilibrium level, reducing total surplus • A subsidy corrects this market inefficiency, increasing surplus Price ($) Surplus under a positive externality $3000 A $1500 Surplus under a positive externality $3000 Sprivate $500 $1000 Price ($) External benefit Consumer surplus Producer surplus Sprivate X $1300 C B Dprivate 300 Quantity of houses painted Under a positive externality, the surplus by those outside the market is added to consumer and producer surplus, Area C © 2014 by McGraw-Hill Education Ssocial Y Dprivate • • • 360 Quantity of houses painted If the externality is internalized through a subsidy, the supply curve shifts downward CS and PS in the market are both higher The external benefit is now internalized to only 16 market participants Positive externality from the supply side A positive externality always reduces surplus unless it is internalized Price ($) S private Lost when externality is internalized S social Gain in total surplus when externality is internalized $1500 $1000 $500 Gained when D externality is private internalized D social 300 360 Quantity of houses painted • 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 ã Surplus gain is green area â 2014 by McGraw-Hill Education 17 Dealing with externalities • 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 not hold true © 2014 by McGraw-Hill Education 18 Dealing with externalities • 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 anything to help people bearing the external cost © 2014 by McGraw-Hill Education 19 Dealing with externalities As previously analyzed, a tax can move the market equilibrium to the social optimal equilibrium (B) The effect of a Pigovian tax (A) The effect of a negative externality Price $/(gal.) Price ($/gal.) Under a negative externality, demand is above the optimal level S 2.5 A Pigovian tax can move the demand curve back to the optimal level S 2.5 Dprivate Dprivate Dsocial 15 20 Quantity of gasoline (billions of gals.) • 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 © 2014 by McGraw-Hill Education Dsocial 15 20 Quantity of gasoline (billions of gals.) • 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 20 Dealing with externalities As previously analyzed, a subsidy can move the market equilibrium to the socially optimal equilibrium Price ($) 3,500 500 1.A $500 subsidy creates a new demand curve, above the old one… 3,000 S private … if the subsidy exactly equals the positive externality, equilibrium occurs at the socially efficient outcome 1,700 1,500 Dsocial D private 300 360 • 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 Quantity of houses painted © 2014 by McGraw-Hill Education 21 Dealing with externalities • 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) (B) Gasoline consumption under a tax (A) Gasoline consumption under a quota Net benefit to driver Net benefit to driver Quantity is the same 2 Quota 1.33 1.2 Marginal benefit equals the tax level… 1.2 … but marginal benefit is different Tax level 0.8 Prius • 20 …and quantity varies accordingly Range Rover 60 Gallons of gasoline Under a quota, both drivers buy 20 gallons regardless of the difference in their net marginal benefits 10 Range Rover Prius 30 60 Gallons of gasoline Under a $1 tax, both drivers buy different amounts of gas Neither is left wanting to buy more Total gallons consumed remain 40 • • • © 2014 by McGraw-Hill Education 22 Dealing with externalities • 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) Surplus under a quota Marginal benefit to driver Surplus under a tax Marginal benefit to driver Ranger Rover surplus 2 Prius surplus Quota 1.33 1.2 Tax revenue 34 + 20 = 54 15 34 40 + + 15 = 56 1.2 1 Tax level 0.8 20 Prius 20 Range Rover 60 Gallons of gasoline At 20 gallon quota, total surplus is $54 10 + 30 = 40 Prius 10 Range Rover 30 40 60 Gallons of gasoline Under a $1 tax, total surplus is $56 © 2014 by McGraw-Hill Education 23 Dealing with externalities • 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 © 2014 by McGraw-Hill Education 24 Dealing with externalities • 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 â 2014 by McGraw-Hill Education 25 Summary ã 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 © 2014 by McGraw-Hill Education 26 Summary • 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 © 2014 by McGraw-Hill Education 27 Summary • 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 © 2014 by McGraw-Hill Education 28 Summary • 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 © 2014 by McGraw-Hill Education 29 10 ... 2014 by McGraw-Hill Education 18 Dealing with externalities • Because of the cost and difficulty of coordinating private solutions, people often turn to public policy for solutions to externalities. .. gasoline Under a $1 tax, total surplus is $56 © 2014 by McGraw-Hill Education 23 Dealing with externalities • Using a quota to deal with externalities can be extended by permitting the buying and... revenue, because no taxes are imposed © 2014 by McGraw-Hill Education 24 Dealing with externalities • Because of the difficulty of measuring externalities directly, many policies target individual