Lecture 31: Externalities and Market

Failure
economic efficiency
externalities
policies for externalities

Economic Efficiency
Economists make a distinction between private costs and external costs. Private costs
are those costs paid by the firm producing the good. External costs are borne by
someone not involved in the transaction. The same distinction is made between
private and external benefits. Private benefits are the benefits to people who buy and
consume a good. External benefits are the benefits to a third party, someone who is
not the buyer or the seller.

Social costs = private costs + external costs

Social benefits = private benefits + external benefits

Economic efficiency
occurs at the level of
output at which the
marginal social benefits
(MSB) equal the
marginal social costs
(MSC). Demand and
supply determine
equilibrium prices and
quantities in a free
market. A free market
will result in efficiency
when (1) the demand
curve is the same as
the MSB curve and (2)
the supply curve is the
same as the MSC curve,
that is, when there are
no external costs or
external benefits.
Externalities
Externalities are side effects of production or consumption.

When there are external costs or benefits, a free market produces too much or too
little of the good.
When there is a harmful production externality, the production of a good imposes
external costs. The marginal social costs exceed marginal private costs by the amount
of the external costs. When choosing how much to produce, firms are only concerned
with their own costs, the marginal private costs (MPC). The market supply curve is the
MPC curve. Although the firm is unconcerned with the external costs, society counts
these costs as part of the cost of producing the good. So the free market results in too
much of the good being produced.

Policies for Externalities

1. regulation

Regulation is a mandated level of performance that is enforced in law. Regulations can

specify either (1) the maximum rate of emissions that is legally allowed or (2) the
technologies or practices potential polluters must adopt (for example, chemical truck
drivers must obtain a commercial drivers' license and be drug tested). Regualtions are
typically applied uniformly to all situations but this cannot be efficient or cost effective

2. taxes/subsidies

An emission tax is a per unit tax on emissions of some pollutant. For example, in
1970, President Nixon proposed a 15 cents per pound tax on sulfur emissions from
large power plants. With an emission tax, firms responsible for emissions must pay for
the services of the environment just like any other input. So, they have an incentive
to conserve on their use of environmental services. How do they do this? Polluters are
free to determine how best to reduce emissions. Therefore, they will find the least
cost way. A subsidy for reducing pollution works, in principle, the same way as a tax
on polluting activities. Emissions taxes are utilized more in Europe (as a source of
revenue for environmental cleanup) than in the U.S.

3. pollution permits

Each permit entitles the holder to emit one unit of the pollutant specified during some
specified period of time. Permits can be bought and sold at whatever price the
participants agree on.

Suppose we own a power plant emitting 8000 tons of sulfur per year and the
government wants an overall reduction of 25% in SO2 emissions. We will initially be
given 6000 discharge permits.

options:

reduce emissions to 6000 tons

buy additional permits and emit at a higher level
educe emissions below 6000 and sell excess permits

Our choice depends on our costs of reducing emissions and the price of a permit. We
will do whatever is the most profitable.

The advantage of pollution permits over simple regulation is that we get the same
overall level of environmental quality at a lower cost since those power plants that
find it inexpensive to reduce emissions will do so and sell permits to power plants that
have high abatement costs.

4. assign property rights

Giving someone ownership of a resource gives them an incentive to mange it in a way

that maximizes its value.

For example, suppose a group of college students is having a noisy party that keeps
up the old lady across the street. Can solve the problem by giving someone ownership
of the right to make noise.

Suppose the students own the right to make noise. The old lady can pay them to
reduce the noise. Suppose the old lady owns the right to make noise. The amount of
noise would be zero. The students can pay the old lady to allow them to make some
noise. In principle we get the same level of noise no matter who was initially given the
property right.