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Externalities: Problems and Solutions

131 Undergraduate Public Economics Emmanuel Saez UC Berkeley

OUTLINE

Chapter 5

5.1 Externality Theory

5.2 Private-Sector Solutions to Negative Externalities

5.3 Public-Sector Remedies for Externalities

5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities

5.5 Conclusion

EXTERNALITY THEORY: ECONOMICS OF

NEGATIVE PRODUCTION EXTERNALITIES

Negative production externality: When a firm’s production reduces the well-being of others who are not compensated by the firm.

Private marginal cost (PMC): The direct cost to producers of producing an additional unit of a good

Marginal Damage (MD): Any additional costs associated with the production of the good that are imposed on others but that producers do not pay

Social marginal cost (SMC = PMC + MD): The private marginal cost to producers plus marginal damage

Example: steel plant pollutes a river but plant does not face any pollution regulation (and hence ignores pollution when deciding how much to produce)

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Externality Theory

Economics of Negative Production Externalities

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Externality Theory

Negative Consumption Externalities

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The Externality of SUVs

„ A P P L I C A T I O N

„ The typical driver today is in a car that weighs 4,089 pounds. The major culprits in this evolution of car size are sport utility vehicles (SUVs) with an average weight size of 4,500 pounds. „ The consumption of large cars such as SUVs produces three types of negative externalities: „ Environmental Externalities: „ The contribution of driving to global warming is directly proportional to the amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas to go to work or run their errands, increasing fossil fuel emissions. „ Wear and Tear on Roads: „ Each year, federal, state, and local governments spend $33.2 billion repairing our roadways. Damage to roadways comes from many sources, but a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to vehicle weight. „ Safety Externalities: „ One major appeal of SUVs is that they provide a feeling of security because they are so much larger than other cars on the road. Offsetting this feeling of security is the added insecurity imposed on other cars on the road.

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Externality Theory

Positive Externalities

EXTERNALITY THEORY: MARKET OUTCOME IS

INEFFICIENT

With a free market, quantity and price are such that P M B = P M C

Social optimum is such that SM B = SM C

⇒ Private market leads to an inefficient outcome (1st welfare theorem does not work)

Negative production externalities lead to over production

Positive production externalities lead to under production

Negative consumption externalities lead to over consumption

Positive consumption externalities lead to under consumption

PRIVATE-SECTOR SOLUTIONS TO NEGATIVE

EXTERNALITIES

Key question raised by Ronald Coase (famous Nobel Prize winner Chicago libertarian economist):

Are externalities really outside the market mechanism?

Internalizing the externality: When either private negotia- tions or government action lead the price to the party to fully reflect the external costs or benefits of that party’s actions.

PRIVATE-SECTOR SOLUTIONS TO NEGATIVE

EXTERNALITIES: COASE THEOREM

Coase Theorem (Part I): When there are well-defined prop- erty rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity.

Coase Theorem (Part II): The efficient solution to an exter- nality does not depend on which party is assigned the property rights, as long as someone is assigned those rights.

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Private-Sector Solutions to Negative Externalities

The Solution

THE PROBLEMS WITH COASIAN SOLUTIONS

In practice, the Coase theorem is unlikely to solve many of the types of externalities that cause market failures.

1. The assignment problem: In cases where externalities affect many agents (e.g. global warming), assigning property rights is difficult ⇒ Coasian solutions are likely to be more effective for small, localized externalities than for larger, more global externalities involving large number of people and firms.

2. The holdout problem: Shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution)

As with the assignment problem, the holdout problem would be amplified with an externality involving many parties.

THE PROBLEMS WITH COASIAN SOLUTIONS:

BOTTOM LINE

Ronald Coase’s insight that externalities can sometimes be internalized was useful.

It provides the competitive market model with a defense against the onslaught of market failures.

It is also an excellent reason to suspect that the market may be able to internalize some small-scale, localized externalities.

It won’t help with large-scale, global externalities, where only a “government” can successfully aggregate the interests of all individuals suffering from externality

PUBLIC SECTOR REMEDIES FOR

EXTERNALITIES

The Environmental Protection Agency (EPA) was formed in 1970 to provide public-sector solutions to the problems of ex- ternalities in the environment.

Public policy makers employ two types of remedies to resolve the problems associated with negative externalities:

1. price policy: corrective tax or subsidy equal to marginal damage per unit

2. quantity regulation: government forces firms to produce the socially efficient quantity