Externalities

Chapter 21

Slides by Pamela L. Hall

Western Washington University
©2005, Southwestern
 Introduction
 Driving an automobile is probably a household’s most
polluting activity
 Efforts since 1970 have greatly reduced typical vehicle emissions
• However, number of miles driven has more than doubled
 Offset benefits of controlling emissions
 Net result is only a small reduction in automobile pollutants

 Cause of automobile pollution is a major market failure in

presence of an externality (pollution) resulting from missing
markets
 With missing markets, signals in form of market prices do not exist to
reveal consumer preferences for society’s allocation of resources

2
 Introduction
 If well-defined property rights exist, markets will generally
occur for externalities
 Reduces necessity for mechanisms designed to correct externality-
generated inefficiencies
• One role for government is to provide a legal system to support well-
defined property rights for all of society’s resources
 We investigate property rights and consequences of
externalities resulting from ill-defined property rights
 Then broadly classify externalities as either bilateral or multilateral
• Discuss inefficiencies associated with bilateral externalities
• Address enforceable property rights (given Coase Theorem) as a means
for resolving these inefficiencies

3
 Introduction
 Coase Theorem states
 If a market can be created for an externality, an efficient outcome will
result regardless of how well-defined property rights are allocated
 We investigate markets where Coase Theorem does not
hold
 Discuss issue of multilateral externalities
 Evaluate government policies involving quotas, taxes, and fostering
markets for externalities (eliminating missing markets) as tools for
addressing market inefficiencies
• Government agencies develop mechanisms that assign property rights
and regulate agent behavior
 Enforcing policies through penalties for noncompliance and dividends for
compliance
 However, government mechanisms may not always result in improving
social welfare
 Such mechanisms can only result in alternative second-best Pareto-
efficient allocations 4
 Introduction
 Opportunity cost of allocating resources toward establishing
and maintaining mechanisms may exceed cost of
inefficiency associated with some externalities
 Existence of opportunity cost implies that there are still externalities
at some allocation where social welfare is maximized
• Applied economists are active in estimating costs and benefits of
alternative mechanisms for addressing externalities
 Aim in chapter is not to determine least-cost allocation for
removing an externality
 But to understand why ill-defined property rights result in missing
markets for commodities and resulting externalities
• Can determine optimal level of an externality and minimum cost of
achieving a given externality level

5
 Externalities Defined
 An externality (z) is present whenever some agent’s (say,
A’s) utility or production technology includes commodities
whose amounts are determined by other agents
 Without particular attention to effect on A’s welfare
 Definition rules out any market-price affects on agents’ utility
or production, called pecuniary externalities
 Arise when external effect is transmitted through price changes
 A pecuniary externality does not cause a market failure
 For example, suppose a new firm enters a market and drives up
rental price of land
• Market for land provides a mechanism by which parties can bid for land
 Resulting prices will reflect value of land in its various uses

6
 Externalities Defined
 Without pecuniary externalities price signals would fail to
sustain an efficient allocation
 Consumers relying on firms for supply of commodities are
not externalities
 Deliberately affecting welfare of others is not an externality
 For example, deliberate criminal actions against agents are not
externalities
 However, waiting for someone who is not particularly
concerned about your welfare is an externality

7
 Property Rights
 A bundle of entitlements defining an owner’s rights,
privileges, and limitations for use of a resource
 For example, in many cities owning a plot of land may
give you entitlement to build a house but not drill a well
 Entitlements vary considerably
 From being very restrictive in a planned community to
essentially no restrictions in some rural areas
 A well-defined structure of property rights will
provide incentives for efficient allocation of
resources

8
 Property Rights
 Following list is one set of well-defined private-property
rights that results in a Pareto-efficient allocation
 Universality
• All resources are privately owned and all entitlements completely
specified
 Exclusivity
• All benefits and costs from owning and employing resources accrue to
owner
 Transferability
• All property rights are transferable from one owner to another in a
voluntary exchange
 Enforceability
• Property rights are secure from involuntary seizure or encroachment by
others

9
 Property Rights
 Previously we implicitly assumed well-defined property
rights existed
 We demonstrated that perfectly competitive markets yield an efficient
price system for resource allocation
• Such a system is where producers maximize their profits and
households maximize their utility
 Given their respective resource constraints and current state of technology

 Presence of externalities violates assumption of well-defined

property rights
 For example, building a cabin that blocks neighbor’s view of lake
results in a cost that accrues to neighbor
 With externalities, household preferences for commodities
are not defined solely over bundle of commodities that it has
ability to choose
10
 Property Rights
 Assumption of firms freely choosing inputs is also
violated with presence of production externalities
 Generally, consumption or production externalities
exist when agents (households and firms) are
directly affected by actions (external effects) of
other agents
 Examples are
• Presence of other vehicles on a congested highway (negative
externality)
• Sight of a neighbor’s flower garden (positive externality)

11
 Property Rights
 When externalities exist, perfectly competitive equilibrium
does not correspond with a Pareto-optimal allocation
 A common property exists when no individual agent has
property entitlements
 Agent cannot employ resource for individual gain
• In a communist economy, all society’s resources are considered
common property
 In a centrally planned socialist economy, state (government) has property
entitlements and controls property (resource) allocation for common good of
society
• In a free-market economy, property entitlements are vested privately
with individual agents
 Leading to private property as dominant form of property rights

12
 Bilateral Externalities
 Where one agent’s utility or profit is affected by
another agent’s actions
 Agents could be two firms with their production
technologies linked
• Firms could be producing either same or different outputs
 For example, firms could be a chemical plant and a kayak rental
company located on the same river
 Alternatively, agents could be two households or one firm
and a household
• For example, two households living in a duplex where one
household enjoys loud music

13
 Bilateral Externalities
 For expository purposes, we will assume agents are firms
 With one firm experiencing a negative externality from the other
 Rather than well-defined property rights, assume Firm 1’s
short-run total cost function is a function of marketable
output q1 and a nonmarket output (externality) z, STC1(q1, z)
 For example, q1 could be production of steel and z the associated
river water pollution
 Assuming Stage II of production for q1, associated marginal
cost curve, ∂STC1/∂q1 = SMC1 > 0
 Has a positive slope, ∂SMC1/∂q1 > 0
• For externality z, ∂STC1/∂z < 0
 Increasing z will decrease cost of production
 Represents a marginal benefit to firm

14
 Bilateral Externalities
 Define marginal benefit as marginal benefit
of the externality (MBE)
 MBE = -∂STC1/∂Z > 0
 Associated MBE curve is illustrated in Figure
21.1, given Law of Diminishing Marginal
Returns
 As z increases, MBE declines
 Given a missing market for z, there is no positive
market price for z
• A profit-maximizing firm would produce where
∂STC1/∂z = 0 15
Figure 21.1 Negative externality

16
 Bilateral Externalities
 An increase in costs with no associated change in revenue will decrease profit
 Level of z that minimizes costs is ∂STC1/∂z = 0
 Assume firm 2’s short-run total cost function is directly affected by firm 1’s
nonmarket output z, STC2(q2, z)
 q2 denotes Firm 2’s marketable output, kayak rentals
 Firm 2’s cost of producing q2 is directly affected by amount of z firm 1 produces
 A negative externality implies ∂STC2/∂z > 0
 An increase in z increases STC2 and depresses profit
• Partial ∂STC2/∂z > 0 is called marginal social cost (MSC) of externality
 Illustrated in Figure 21.1

 Positive slope associated with MSC indicates

 As z increases, marginal social cost increases
• ∂MSC/∂z > 0 and ∂2MSC/∂z2 > 0
 Firm 2’s costs are increased by an increase in z at an increasing rate
• For example, the river may be able to assimilate initial increases in water pollution, so MSC of
water pollution for kayaking is low
 However, as water pollution increases, capacity of river for assimilating pollution may be exceeded,
resulting in marginal cost for the kayak firm increasing at an increasing rate

17
 Bilateral Externalities
 Positive slope associated with MSC indicates
 As z increases, marginal social cost increases
• ∂MSC/∂z > 0 and ∂2MSC/∂z2 > 0
 Firm 2’s costs are increased by an increase in z
at an increasing rate
• For example, river may be able to assimilate initial
increases in water pollution
 MSC of water pollution for kayaking is low
 However, as water pollution increases, capacity of river
for assimilating pollution may be exceeded
 Resulting in marginal cost for kayak firm increasing at an
increasing rate
18
 Independent Decision Making
 In its profit maximization, firm 1 has control over
both q1 and z

 p1 is per-unit price firm 1 receives for its output, q1

 Since z is a nonmarket output, there is no
associated market price
 F.O.C.s are
• ∂1/∂q1 = p1 – SMB1(q1, z) = 0
 Discussed in Chapter 9 and illustrated in Figure 21.1
• ∂1/∂z = -∂STC1(q1, z)/∂z = 0
 Establishes cost-minimizing level of z as a necessary condition for
profit maximization
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 Independent Decision Making
 Level of externality z should be adjusted to point where
additional reduction in cost of generating an additional unit
of z is zero
 Solving F.O.C.s simultaneously for z and q1 results in their optimal
levels zP and qP1
• Figure 21.1 illustrates this optimal solution
 zP is associated with -∂STC1/∂z = MBE = 0 and qP1 with SMC1 = p1
 For its profit maximization, firm 2 only has control over its
output, q2, but production of q2 is influenced by externality z,
so

 p2 is per-unit price of q2
• F.O.C. is
 ∂2/∂q2 = p2 – SMC2(q2, z) = 0
 Establishes price equaling marginal cost as a condition for profit
maximization
20
 Independent Decision Making
 Externality results from firm 2 having no control
over z, which affects its production
 Firm 1 controls level of z and has no incentive to
consider effect z has on firm 2’s production
 When firm 2’s additional social cost, MSC, associated
with firm 1’s pollution, z, is not considered by firm 1, an
inefficient high level of pollution may result
• At zP in Figure 21.1, MSC > MBE
 Decreasing z will subtract more from cost than from benefits
 Not considering additional social costs or benefits from an
externality generally results in an inefficient allocation of
resources

21
 Dependent (Joint) Decision
Making
 Internalizing social costs of a negative externality into
agent’s decisions
 Results in a Pareto-efficient allocation of resources
 Internalization of social costs results in firm 1 taking into
consideration impact its production decisions have on firm
2’s production possibilities
 With this consideration, output z is no longer an externality
• All effects of z are now internalized into firm 1’s production decisions
 Accomplished by maximizing joint profit of the two firms ( = 1 + 2)
 Equivalent to two firms merging to form one firm that produces marketable
outputs q1 and q2, with associated prices p1 and p2, along with nonmarket
output z
 With joint action, there is no longer an externality
 Additional social costs are now internalized within this one firm

22
 Dependent (Joint) Decision
Making
 Mathematically, joint profit maximization is

 F.O.C.s are
 ∂/∂q1 = p1 – SMCJ1(q1, z) = 0
 ∂/q2 = p2 – SMCJ2(q2, z) = 0
 ∂/∂z = -∂STC1(q1,z)/∂z - ∂STC2(q2, z)/ ∂z = 0
• SMCJj is short-run marginal joint cost of producing qj, j = 1, 2
 First two F.O.C.s are same as when firms act privately
 A perfectly competitive firm equates price to marginal cost
 Under joint action, optimal levels of q1 and q2, (qJ1 and qJ2) are where
price is equated with marginal cost
• For a negative externality, qJ1 < qP1, given z increases costs for
producing q2
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 Dependent (Joint) Decision
Making
 Last F.O.C. differs from independent conditions where firms
act privately
 Now optimal levels of q1, q2, and z depend on effect z has on firm 2’s
costs
 Figure 21.1 illustrates optimal levels of z and q1
 Instead of setting ∂STC1/∂z equal to zero, joint production
sets -STC1/∂z equal to marginal social cost
 -∂STC1(q1, z)/∂z = ∂STC2(q2, z)/ ∂z
 MBEJ = MSC
• MBEJ is marginal joint benefit of externality from joint production of q1
and q2
• Joint action will result in firm 1 decreasing level of z below point where
MBE = 0
• Marginal social cost derived from firm 2 is now internalized into decision
process
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 Dependent (Joint) Decision
Making
 Difference between private and joint optimal solution is illustrated in
Figure 21.1
 Optimal level of z decreases, from zP to zJ, along with a decrease in the
optimal level of output, from qP1 to qJ1
 Firm 1’s short-run marginal cost of producing q1 shifts to the left, from SMC1
to SMCJ1
• Given increased cost of internalizing production of z
• Similarly, firm 1’s marginal benefit of externality shifts to left, to MBEJ, given
decrease in q1
 Through internalization, firm 1 pays a cost for producing z
• At Pareto-efficient level of z, zJ, amount firm 1 is willing to pay for producing an
additional unit of z is equal to firm 2’s additional costs associated with this
additional unit of z
 Note that if firm 2’s cost of producing q2 is independent of z, no externality exists
 Firm 2’s cost associated with z is zero
• Firm 1 will again equate additional cost of producing an additional unit of z to zero

25
Resolving Externality Inefficiency
 In February 2002, Oakland County International Airport in
Waterford, Michigan, helped 650 residents to sound insulate
and vibration reinforce their homes against airplane takeoffs
and landings
 Such solutions to externality inefficiencies are possible when
conditions allow agents to negotiate an optimal solution
 Providing favorable negotiating conditions is one approach
to mitigating inefficiencies associated with externalities
 Based on these negotiations, a market for externality is then
established
 For example, suppose for a negative externality z,
enforceable property rights are established where firm 2 is
assigned rights to production level of z (noise)
 Firm 1 is unable to produce z without firm 2’s approval
26
Resolving Externality Inefficiency
 Denote total price (fee) for z units that firm 2
charges firm 1 as Fee
 For profit maximization, firm 2 will determine level of Fee
• Where firm 1 is indifferent between paying Fee to produce z units
of externality or not producing any of the externality
• If firm 2 charges a price below Fee, firm 1 will still produce z units
 An increase in Fee will enhance firm 2’s profits without changing
level of z
 Increasing Fee transfers some of firm 1’s producer surplus in
production of z to firm 2
 Firm 2 will increase Fee to point where all producer surplus from
producing z units is absorbed by Fee
 At this point, firm 1 is indifferent between paying Fee to
produce z units or not producing any z

27
Resolving Externality Inefficiency
 Mathematically, this occurs where
 1(q1, z) – Fee = 1(q01, 0)
 p1q1 – STC1(q1, z) – Fee = p1,q01 – STC1(q01, 0)
• q01 represents optimal level of output given z = 0
 Firm 2 will then maximize profits subject to level of
Fee where firm 1 is indifferent

 Solving for Fee in the constraint and substituting into

objective function yields

28
Resolving Externality Inefficiency
 F.O.C.s are
 ∂2/∂q2 = p2 – SMCJ2 = 0
 ∂2/∂z = -∂STC2(q2, z)/∂z - ∂STC1(q1, z)/∂z = 0 = -MSC + MBEJ = 0
• Optimal levels for q2 and z are same solutions for joint production, zJ and
qJ2
 Given this charge, Fee, for producing zJ units of a negative
externality, firm 1’s profit-maximizing problem is

 F.O.C. is
• ∂1/∂q1 = p1 – SMCJ1 = 0
 F.O.C.s are identical to F.O.C.s for joint profit maximization

 By assigning a property right to z, a market is created for z

 Allows a firm to charge a price for its production of z
• Resulting solution is the same optimal solution obtained under joint
action, zJ 29
Resolving Externality Inefficiency
 Coase Theorem
 If trade of an externality can occur (a market exists)
• Bargaining will lead to an efficient outcome no matter how property
rights are allocated
• Assumes there are no transaction costs associated with bargaining
 Any asymmetry in information between buyer and seller can
cause transaction costs
 Will not result in an efficient outcome no matter how property rights
are allocated
 Specifically, suppose firm 1 now has property rights to
produce as much of the externality z as it desires
 In absence of any trading, firm 1 will select private level of z, zP
 Firm 2 will offer to pay firm 1 to move from firm 1’s private solution zP
to joint-optimal solution zJ
30
Resolving Externality Inefficiency
 Firm 1 will be indifferent between producing an
alternative level of z and receiving S as payment
from firm 2 or producing zP and receiving no
payment
 1(q1, z) + S = 1(qP1, zP)
 p1q1 – STC1(q1, z) + S = p1qP1 – STC1(qP1, zP)
• Firm 2 will then maximize profits, subject to levels of S, where
firm 1 is indifferent

31
Resolving Externality Inefficiency
 Solving for S in the constraint and substituting into
objective function yields

 F.O.C.s are
 ∂2/∂q2 = p2 – SMCJ2 = 0
 ∂2/∂z = -∂STC2(q2, z)/∂z - ∂STC1(q1, z)/∂z = 0
• Again, optimal levels for q2 and z are the same as in joint
production, zJ and qJ2

32
Resolving Externality Inefficiency
 Firm 1’s profit-maximizing problem is

 F.O.C. is
 ∂1/∂q1 = p1 – SMCJ1 = 0
• Exactly the same optimal result as when property rights are controlled by
firm 2 or with joint production
 Given well-defined property rights and that agents can
bargain with essentially zero transaction costs, resulting
solution will be Pareto efficient
 In practice, it is rare to find externalities with these characteristics
 Normally, a profit incentive exists to either internalize the externality
by merging or establish a market for the externality
• Thus, market forces tend to remove any possible existence of a bilateral
externality
33
Resolving Externality Inefficiency
 There are distributional effects that depend on assignment of property
rights
 Property rights are a form of initial endowments, which do have market value
 For example, even though Coase Theorem states that optimal levels of
z, q1, and q2 remain unaffected by property rights assignment
 Resulting profit levels of firms are affected
 When an agent is bestowed property right, its benefits will not decrease
• Potential exists for enhancing benefits
 Greater control over property rights improves bargaining power of an agent
and, hence, potential rewards
• Distribution of benefits can change with assignment of property rights
 A market with well-defined property rights and essentially zero
transaction costs will provide a Pareto-optimal allocation
 Any improvement in social welfare is dependent on equity impacts of
resulting allocation

34
 Multilateral Externalities
 Decreasing automobile emissions can have a
major impact on air quality and on asthma in
children
 This example illustrates multilateral externalities
• Far more common than bilateral externalities
 Numerous agents create transaction costs
associated with ill-defined property rights
 Obstruct market from internalizing externalities
 Coase Theorem no longer holds under these transaction
costs
• Efforts to internalize these externalities may require some type of
government intervention into markets
35
 Government Policies
 Government actions to mitigate inefficient exploitation of resources have
taken a number of forms
 One policy is to instill some form of private-property rights on a common-
property resource
• For example, in western U.S., common- property problem of livestock overgrazing
was addressed by issuing grazing permits
 Ranchers who own grazing permits are allowed to use public rangeland for a set fee
 Original grazing permits issued by state and federal agencies were freely given to
ranchers
 Common property of public lands was transferred to private ownership
 Without a permit, one could not use public land for its major usegrazing
 Permits acquired a market value through their incorporation into land value of
ranch holding permits
 Policy of granting private-property rights to common property may result
in improving economic efficiency
 However, it raises equity issues in terms of enhancing ranchers’
endowments at expense of other agents

36
 Permit System
 Trading of emission permits represents a
government management tool for a common
property
 Government controls resource and establishes
barriers to prevent agents from exacting resource
unless licensed by the government
 For example, government may issue a permit to extract
a certain quantity and/or size of a resource
• Fishing and hunting licenses are examples

37
 Permit System
 A permit system can also be employed for reducing a firm’s
undesirable emissions that adversely affect air and water
quality
 Prior to generating a negative externality firm would be required to
obtain a permit
• Number of permits can be limited to achieve some target level
 Allocation of permits transfers certain property rights to
permit holder
 In the case of a hunting permit, hunter pays for this transfer of
property right
 In terms of firms generating some negative externality, they
may be issued permits at or below their historical emissions
level
 Given they possess a history of quasi-property rights to emission
releases 38
 Permit System
 Permits that can be traded (called marketable permits),
create a market for permits with an associated equilibrium
price
 If a firm’s marginal cost of reducing emissions is greater
than market price for a permit to release emissions
 It would minimize cost by purchasing permit and releasing emissions
 If its marginal cost is less than market price, it would
minimize cost by selling permits and reducing its emissions
 In equilibrium, each firm’s marginal cost of reducing
emissions would be equal to market price for permits

39
 Permit System
 Specifically, let’s consider two firms engaged in
generating a negative externality
 Let z1 and z2 represent emission levels of firm 1 and firm
2, respectively, with associated short-run total cost
functions STC1(q1, z1) and STC2(q2, z2)
 Assume target level of total emissions (zJ) is established,
so zJ = z1 + z2
• Determine minimum cost of achieving emissions level zJ by

 TC is total cost of reduced emissions

40
 Permit System
 Lagrangian is

 F.O.C.s are

41
 Permit System
 Minimum-cost condition of achieving a zJ level of
emissions is MBEJ1 = MBEJ2 = J
 Firms’ short-run marginal benefits of emissions are set
equal to J
 In this case, Lagrange multiplier is marginal social cost of
combined emissions by two firms, J = ∂TC/∂z
• Setting this equal to each firm’s MBEJ yields minimum cost of
establishing a zJ level of emissions
 Illustrated in Figure 21.2

 Target level zJ is obtained at minimum cost with firm

1 and firm 2 generating zJ1 and zJ2 emissions,
respectively
42
 Figure 21.2 Minimum cost of
achieving a given emission level

43
 Permit System
 Establishing a marketable permit system achieves this
minimum social cost of emissions
 Let pz represent per-unit equilibrium price of a permit and z01
and z02 initial level of permits for firms 1 and 2, respectively
 z J = z 01 + z 02
 With j = 1, 2, representing either of the firms, each firm will
maximize profits as follows

 When z0j - zj < 0, firm is using more permits than it was allocated
• It will acquire additional permits in amount of (zj - z0j) at per-unit price of
pz
 If z0j – zj > 0, firm is not using all of its permit allocation
• Will sell (z0j - zj) at per-unit price of pz

44
 Permit System
 F.O.C.s are
 ∂j/∂qj = pj – SMCJj(qj, zj) = 0
• Discussed in Chapter 9
 ∂j/∂zj = -∂STCj(qj, zj)/ ∂zj – pz = 0 = MBEJj – pz = 0, j = 1, 2
• Each firm equates their marginal benefit of emissions to pz
 A major limitation of this marketable permit system exists when spatial
distribution of externality generated by all firms is not uniform
 If agents who are being affected by externalities are not uniformly affected by each
firm
• Permit system will result in some agents receiving even more of the externality
• For example, assume households of type A are only affected by firm 1’s emissions and
households of type B only by firm 2’s emissions
 As illustrated in Figure 21.3, firm 1 sells permits to firm 2

 Thus, from initial emission levels (z01,z02) emissions for type A households are
reduced at expense of type B households, who receive a higher emissions level
 Although emissions level is now generated at a minimum cost, distribution of resulting
emissions are not optimal

45
 Figure 21.3 Minimum cost of achieving a
given emission level with marketable permits

46
 Taxes and Standards (Quotas)
 If general knowledge exists about which firms can efficiently
reduce a negative externality relative to other firms
 Direct taxes or standards may be employed
• Direct taxes on negative externalities have the theoretical foundation of
the agent receiving an inefficient price for negative externality it is
generating
 With ill-defined property rights firms would receive a zero
price for generation of emissions
 An efficient price would be a tax equivalent to marginal social cost of
negative externality
• Profit-maximizing problem for firm j is

 j is a per-unit tax for firm j on negative externality, z

47
 Taxes and Standards (Quotas)
 Potentially, firms with differing production capabilities for efficiently
reducing negative externality would face different tax levels
 On a practical level, tax would generally be the same for firms with like
production technologies within same industry and causing similar harm to
other agents
 Assuming a constant tax level across two firms, , F.O.C.s are
 ∂j/∂qj = pj – SMCJj(qj, zj) = 0
• Discussed in Chapter 9
 ∂j/∂zj = -∂STCj(qj, zj)/∂zj -  = 0 = MBEJj -  = 0, j = 1, 2
• Firm j equates its marginal benefit of emission to 
 Equating tax  to MSCj will yield an efficient level of emissions
generation by each firm, zJj
• Illustrated in Figure 21.4

48
Figure 21.4 Pigouvian tax on
emissions

49
 Taxes and Standards (Quotas)
 As illustrated in Figure 21.1, if there is only one agent being affected by
firm j’s emissions, then  = ∂STC2/∂zj
 Given well-defined property rights, Coase Theorem would apply
• No government-established price for market would be required for efficiency
• However, as number of agents increase, even with well-defined property rights
 Transaction costs of determining who are being affected by a negative externality
increases
 A government mechanism design in form of an emissions tax may be
socially desirable
 Such a tax, equivalent to MSC, is called a Pigouvian tax, after Arthur Pigou
• Assuming general knowledge exists of which firms can efficiently reduce a
negative externality relative to other firms
 Pigouvian taxes directly associated possible spatial MSC would not have spatial
distribution limitation associated with a permit system
 Aside from the problem of acquiring this general knowledge for implementation
 Pigouvian taxes are a Lindahl taxface same limitations
 Agents facing a higher tax rate relative to others may not respond well to
tax-discriminating nature of Pigouvian taxes
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 Taxes and Standards (Quotas)
 Major problem with a Pigouvian tax
 Indirect method of reducing a negative externality versus direct method of
setting some quota (called emissions standard)
• Setting emissions standards directly reduces level of a negative externality to
some stated level
 In contrast, a tax requires firms to consider effect of tax on their profits
 In a dynamic setting where MSC is continuously changing, adjusting
emissions standards to these changes will yield a direct short-run
response of establishing desired emissions level
 Whereas changing tax rate may not
• Short-run MBE curve may be rather inelastic to change in a tax
 Results in less than desired reduction in emissions
• Desired level of emissions may not be obtained until long run
 By then MSC may have changed
 Illustrated in Figure 21.5

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 Taxes and Standards (Quotas)
 An upward shift in MSC curve to MSC', indicating a higher
marginal social cost at all levels of emissions, warrants a
reduction in emissions from z0 to z"
 Changing emissions standards from z0 to z" will directly produce this
desired effect
• Firm’s response is not dependent on elasticity of MBEJ curve
• However, effect of emissions from a tax change does depend on
elasticity of MBEJ curve
 In short run, an increase in tax from 0 to “ results in a decrease in
emissions from z0 to z'
 Only in long run will emissions fall to z"

 System of taxes requires additional knowledge concerning

long- and short-run response of firms’ emissions to tax
changes

52
Figure 21.5 Standards versus taxes with
long-run and short-run adjustments

53
 Taxes and Standards (Quotas)
 An example of taxes versus standards is maintaining air
quality within an air basin (such as Los Angeles)
 Changing weather conditions will affect air quality on a daily basis
• An inversion layer, where ambient air temperatures increase with
altitude, traps air pollution within basin
 Potentially resulting in poor air quality
• Announcing stricter emissions standards when such weather conditions
occur would directly mitigate the problem
 Announcing an increase in emissions taxes may not have such immediate
effects
 In contrast, when MSC curve is relatively static (doesn’t shift), a tax will
minimize firms’ cost relative to a standard
 An example is water quality where socially desirable level of affluent
remains relatively constant

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 Taxes and Standards (Quotas)
 One of the F.O.C.s for two firms maximizing profits given a
negative externality tax is
 -∂STC1(q1, z1)/∂z1 = -∂STC2(q2, z2)/∂z2 = 
 MBEJ1 = MBEJ2 = 
• Demonstrated in Figure 21.6 for two firms located relatively close to
each other
 MSC is the same regardless of which firm changes its affluent level

 As indicated in the figure, cost-minimizing levels of affluents

are z1J and z2J for firms 1 and 2, respectively
 Only if MBEJ' for both firms is the same will z1J = z2J
 Taxation offers a lower cost for reducing a given level of
affluent compared to setting the same emissions standard
for both firms

55
Figure 21.6 Minimum cost of achieving a
given affluent level with a Pigouvian tax

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 Firms’ Preference
 Firms’ preference for emissions standards versus taxes
 Depends on which mechanism yields a higher profit for a given level
of emissions
• For example, if emissions standards directly limit total output, firms may
prefer such standards to a Pigouvian tax
 As indicated in Figure 21.7, standards may provide a cartel
situation, which can result in improved profit
 Prior to any standards, let perfectly competitive equilibrium price and
output be (pe, qe)
• With imposition of standards, socially optimal output declines to qs and
price increases to ps
 Results in a net gain in producer surplus of pepsAC - DCB
• Alternatively, imposition of a tax that reduces output price to p' with the
same output, qs, results in a loss in producer surplus of p'peBD
 Firms have incentives to support emissions standards versus Pigouvian
taxes
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Figure 21.7 Producer surplus for
standards versus taxes

58