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Public Economics

Chikako Yamauchi
Assistant Professor, GRIPS
Lecture 5
Rosen, Ch. 5 (Externalities)


The Nature of Externalities

Graphical Analysis
Private Responses to Externalities
Public Responses to Externalities
Implications for Income Distribution


Paper mills produce the chemical dioxin as a byproduct, which ends up in human fat tissue and in the
milk of nursing mothers. Some scientists say that
dioxin is responsible for birth defects and cancer, etc.

The output choice of paper mills directly affects the

utility of the neighboring people

This negative effect does not go through price changes.

Different from the situation where an increase in the price of

paper leads to a decrease in the level of utility among paper

Externality Defined
An externality is present when the
activity of one entity (person or firm)
directly affects the welfare of another
entity in a way that is not reflected in
the market price
Negative externality: These activities
impose damages on others.
Positive externality: These activities
create benefits for others.

1 The Nature of Externalities

Inefficient choice and ownership

Bart dumps industrial waste into a river no one owns
Lisa fishes from the river, and is worse off from Barts
dumping without any reflection in prices
Does Bart produce and contaminate water too much
or inefficiently? Why?

Lisas production
-Fishing rod & line
-Fishing basket
-Clean water

Inefficient choice and ownership

Efficiency requires that Bart pays a price that
reflects the waters value as a scarce resource
that can be used for other activities (such as
BUT no one owns the river
No market for clean water; anyone can use it for free

Externality is a consequence of the failure or

inability to establish property rights
1st welfare theorem assumes a market exists for all
goods. This is because price carries information on
how valuable the good is to society
Bart uses his other inputs efficiently because he must
pay their owners prices that reflect their value in
alternative uses

Inefficient choice and ownership

If someone owns a resource, its price reflects the value
for alternative uses, and the resource is used efficiently
If Lisa owned the river
she could charge Bart a fee for polluting that reflected the damage
to her catch
Bart would take the charges into account, and would no longer use
the water inefficiently

If Bart owned the river

he could make money by charging Lisa for fishing in it
Lisas willingness to pay for fishing in Barts river would depend on
the amount of pollution.
Hence, Bart would have an incentive not to pollute excessively

If resources are owned in common, they tend to be overused

Examples of Externalities
Negative Externalities
Car exhaust

Positive Externalities
Research &
A neighbors nice
Students asking good
questions in class

Nature of Externalities
Arise because there is no market price attached to
the good
Can be produced by people or firms
Can be positive or negative
Public goods are special case
An externality can be a public good if it is positive
and felt by everyone
E.g. a device for electrocuting mosquitoes in my
If it kills all the mosquitoes in the community, public good
If it kills mosquitoes in a few neighbors, positive externality

2 Graphical Analysis

Figure 5.1: An externality problem

Marginal private
cost to Bart has a
fixed component,
and increases as
Q increases
Marginal damage
to Lisa increases
as Q increases
Marginal benefit to
Bart decreases as
Q increases [MB is
a horizontal line if
he is a price taker]

Figure 5.1: An externality problem

Bart maximizes
profits at MB=MPC.
This quantity is
denoted as Q1 in
the figure.
However, marginal
social cost is
Social welfare is
maximized at
MB=MSC, which is
denoted as Q* in
the figure.

Q1[output level with negative externality] >
Q*[socially efficient output level]
Bart privately produces too much, because he does
not account for the damages to Lisa
When externalities exist, private markets do not
produce the socially efficient output level

What if Q=0? [Lisas damages are minimized]

But Bart cannot produce anything!
Q* is not the preferred quantity for either party, but is
the best compromise
In general, socially efficient allocation entails some

Figure 5.2: Gains and losses from

moving to Q*
The area between
the MB and MPC
curve going from Q1
to Q* is the loss to
the area under the
MD curve going from
Q1 to Q* is the gain
to Lisa [cdhg is the
same as abfd]
The net gain to
society from
producing at Q*
instead of Q1 is the
triangle dgh

Reality is more complicated

Implementing the framework of Fig. 5.2 requires
identifying real MD and MB curves
How large is the amount of pollution associated
with each Q?
Which discharge creates harmful pollution?

How should the damage from the pollution be

There may be many fishermen
Each fisherman may be affected differently

3 Private Responses to

Potential Solutions for Externalities

Private Responses
1. Assign Property Rights / Coase Theorem
2. Mergers
3. Social conventions

Public Responses
1. Taxes
2. Subsidies
3. Incentive-based regulation
1. Emissions fees
2. Cap-and-trade programs

4. Command-and-control regulation

Private Response #1:

Suppose property
Property Rights rights to the river are
How the net gain dhg is
divided depends on
relative bargaining power

assigned to Bart, and

it is costless for Bart
and Lisa to bargain
with each other
regarding Q
Bart will decrease Q if
he is paid more than
Lisa will pay for
decreased Q if
payment < MD
if MD > payment >MB
MPC, there is room
for a bargain
At efficient level, MD=

Coase Theorem
The Coase Theorem states that once property
rights are established and transaction costs are
small, then one of the parties will pay the other to
attain the socially efficient quantity.
The socially efficient quantity is attained regardless
of to whom the property rights were initially
Once property rights are established, government
intervention is not required to deal with externalities
Insight: root of the inefficiencies from externalities is
the absence of property rights.

When Is the Coase Theorem

Low transaction costs
Few parties involved

Source of externality
well defined
Example: Several
polluting firms

Not relevant with high

transaction costs or
ill-defined externality
Example: Air pollution

Private Response #2: Mergers

Mergers between firms internalize the
A firm that consisted of both Barts firm and
Lisas fishery would only care about
maximizing the joint profits of the two firms,
not eithers profits individually.
Thus, it would take into account the effects
of increased production on the fishery.

Private Response #3:

Social Conventions
Certain social conventions can be viewed as
attempts to force people to account for the
externalities they generate.
Examples include conventions about not
littering, not talking in a movie theater, etc.

4 Public Responses to

Potential Solutions for Externalities

Private Responses
1. Assign Property Rights / Coase Theorem
2. Mergers
3. Social conventions

Public Responses
1. Taxes
2. Subsidies
3. Incentive-based regulation
1.Emissions fees
2.Cap-and-trade programs

4. Command-and-control regulation

Public Response #1: Taxes

Return to the Bart/Lisa example.
Bart produces inefficiently because the price of
water incorrectly signals social costs. Natural
solution is to levy a tax on a polluter.
A Pigouvian tax is a tax levied on each unit of a
polluters output in an amount just equal to the
marginal damage it inflicts at the efficient level of

Public Response #1: Taxes

How can we levy tax

on Bart, so that he
chooses to produce

Public Response #1: Taxes

Figure 5.4: Analysis of a Pigouvian tax

the marginal
damage Bart
inflicts at the
efficient level of
output, Q*, = dc
With new
marginal cost =
MPC + cd, Bart
chooses to
produce less, at
Pigouvian tax =
Pigouvian tax

Public Response #1: Taxes

Note: Compensating the victim isnt necessary
and may cause more problems
More people will join the activity receiving

Practical problems in implementing a

Pigouvian tax system
How to find the correct tax rate or taxable goods?
Sensible compromises
Suppose we want to reduce emissions from automobiles
Instead of taxing on the number of miles driven at certain
locations [polluted areas] and time [congested time], a
gasoline tax could be levied

Public Response #2: Subsidies

Another solution is paying the polluter to not pollute.
Government announces that it will pay Bart a
subsidy equal to the marginal damage at Q*, for
each unit of output below Q1 he does not produce.
Now if Bart does not reduce Q, he will forgo the
subsidy he could have obtained
i.e., perceived marginal cost is MPC + subsidy

Public Response #2: Subsidies


Barts perceived cost (MPC + cd)




This incentive
continues till he
reaches Q*




With Pigouvian
subsidy introduced at
Q1, Barts perceived
cost (MPC + cd)
exceeds MB, so he
has incentive to cut
back his production


For Q<Q*, Barts

opportunity cost is
less than MB, so he
has incentive to
increase Q

Q per year

Public Response #2: Subsidies

The solution assumes that Q1 is known firms

might game the system by undertaking inefficient
actions that increase Q1

The subsidy leads to a socially efficient Q, but

different distributional consequences: now the
polluter receives a payment rather than paying
Subsidy could induce new firms to enter the
market, which might increase overall pollution.
Also, it may be ethically undesirable to pay

Public Response #3: Incentive-based

regulation [emissions fee]
Taxes on each unit of output might not give Bart
the incentives to search for ways to reduce
pollution other than reducing output
How about levying a tax on each unit of
Emissions fee
Government levies an emissions fee, f*, for each unit of
pollution emitted
f* is the marginal social benefit of pollution reduction at
the efficient level

Emissions Fee
e < e*: Barts cost of
reducing pollution,
MC, is smaller than
emission fee, f*, so
Bart has incentive to
reduce pollution

e > e*: Barts cost of

reducing pollution,
MC, is larger than
emission fee, f*, so
Bart has incentive to
increase pollution

MSB: Marginal Social

Benefit of each unit of
pollution Bart reduces
Efficient level of
emission reduction, e*,
arises when MSB = MC


MC: Marginal cost of

reducing a unit of

Without fee, e=0 (no

reduction). With fee f*,
MSB Bart reduces emission
by e* units

Pollution reduction

Emissions Fee to Multiple Firms



Suppose Bart and

Homer produce 90 units
of emission, and Homer
incurs higher cost than
Bart in reducing a unit
of emission
Suppose that
government wants to
reduce emission by 100





90 Homers

How can the government allocate the burden of emission reduction?

Is the equal allocation (50 to Bart and 50 to Homer) efficient?

Emissions Fee to Multiple Firms



Suppose Bart and

Homer produce 90 units
of emission, and Homer
incurs higher cost than
Bart in reducing a unit
of emission
Suppose that
government wants to
reduce emission by 100





90 Homers

If government tells each firm to cut emission by 50, MC for Bart is lower
than MC for Homer
If Bart reduces more and Homer reduces less, it would achieve the
same reduction at a lower (aggregate) cost
The total cost of emissions reduction is minimized only when the
marginal costs are equal across all polluters: cost effective outcome

Emissions Fee to Multiple Firms


Bs reduction


Hs reduction

50 75 90

Suppose that
government wants to
reduce emission by 100

Hs tax

25 50

Suppose Bart and

Homer produce 90 units
of emission, and Homer
incurs higher cost than
Bart in reducing a unit
of emission

90 Homers

If emissions fee, f, is applied to both firms, each firm reduces emission

up to the point where MC=f
Thus emissions fee achieves cost effective outcome: MCB=MCH
It also rewards firms with better technology (which can reduce
emissions more) by charging less tax

Public Response #3: Incentive-based

regulation [cap-and-trade scheme]
Alternative to Emissions fee
Cap-and-trade scheme
Government sets the desired pollution level, or the
number of permits which allow polluters to emit
Provide those permits to polluters
Let polluters trade the permits

Even if firms incur differing costs to reduce

emission, the cap-and-trade scheme also leads
to cost-effective outcome

Cap-and-trade Scheme





Suppose government
decided to reduce
emission by 100, or
allow total pollution to be
80 units
Government gives Bart
80 permits to emit
As Bart was emitting 90,
with 80 permits, he has
to reduce emission by 10

90 Homers
pollution As Homer was emitting
reduction 90, with no permit, he
has to reduce emission
by 90

Without trading of permits, Homers marginal cost is far higher than

Barts marginal cost
As long as MCH > price of permit > MCB, there is a scope for trade
Trade settles when MCH =MCB , which is cost effective

Emissions Fee v.s. Cap-and-trade

Inflation lowers the real emissions fee and leads
to less pollution reduction
Legislative adjustment is needed
the cap-and-trade scheme leads to the same amount of
pollution reduction

When marginal cost of reducing emission

With the emissions fee, pollution reduction decreases
With the cap-and-trade scheme, the price of permits
increases, but pollution reduction is constant

Neither system automatically leads to an efficient

outcome when the costs of pollution reductions

Emissions Fee v.s. Cap-and-trade

Safety valve price
Combine the cap-and-trade system with the emissions
fee system
Government sells as many additional permits as is
demanded at a pre-established (HIGH) price (Safety
valve price)
Likely to be used only when the cost of pollution
reduction is much higher than expected

Responsiveness to Uncertainty
When the costs of reducing pollution is uncertain,
emission fees and cap-and-trade system could
lead to different outcomes
Implications differ depending on the elasticity of
marginal social benefit curve
Inelastic MSB
The reduction of the first unit is highly valued, but the
value for the additional units tapers off quickly

Elastic MSB
The value of reduction remains relatively constant

Inelastic MSB Schedule

Emission fee, f*, is
determined by MSB =
MC. Since it is based
MC: true MC
on underestimated
cost, f* is too low and
ef too little compared
MC*: governments to the efficient
guess on MC
allocation, e



Under cap-and-trade
scheme, government
produces enough
permits to reduce up
to e*, which is too

Pollution reduction e* is closer to e

Elastic MSB Schedule

It remains the case
that ef is too little and

MC: true MC

e* is too much

compared to the
efficient allocation, e

MC*: governments But e is now closer to

guess on MC


Pollution reduction

When costs are uncertain and MSB is inelastic, a
cap-and-trade system is preferable to an
emissions fee
When costs are uncertain and MSB is elastic, an
emissions fee is preferable to a cap-and-trade
How to find out the shape of MSB?
Information from various fields is required

Distributional effects
Cap-and-trade system can produce no revenue to
government if permits are given to polluters for free

Public Response #4: Command-andcontrol regulation

Incentive-based regulations (emissions fees, cap-andtrade system)
Allow polluters great flexibility in how to reduce their emissions

Command-and-control regulations
Require a given amount of pollution reduction with limited or no
flexibility with respect to how it may be achieved
Performance standard: firms must meet certain amounts of
pollution reduction
Technology standard: firms must use certain technology
E.g., U.S. Corporate average fuel economy standards
All new passenger cars must attain 27.5 miles per gallon
Manufacturers cannot shift the burden among each other to lower
overall cost
It is estimated that, if alternatively gasoline consumption is taxed,
the same reduction in gasoline consumption can be achieved with
$700 million less per year

Limitation of incentive-based
Incentive-based regulations may not work well if
Pollution reductions cannot be monitored well
There is a possibility of creating hot spots, or
localized concentrations of emissions

Command-and-control regulations may be the

second-best, feasible solutions

5 Implications for Income


Who Benefits?
In reality, individuals in different areas suffer
differently from various externalities
Poor neighborhoods tend to have more exposure to air
pollution [Gayer, 2000]
Removing air pollution would benefit low-income families more
Cleaning recreational parks would benefit high-income families

Larger damage may not lead to higher willingness

to pay
A cleanup program may reduce the physical amount of
pollution faced by low-income families
But high-income families might show higher willingness
to pay for the program

Who Bears the Cost?

Implications of emissions reduction
Less inputs bought by polluters -> the owners of these
inputs are worse off
Possible layoffs at polluters factories -> fired workers are
worse off
If these people are low-income earners, income
inequality is worsened

Polluters may also increase the price of their

Consumers of polluters products are worse off
If these people are low-income earners, income
inequality is worsened