Topics on externalities

(References: Leach, 2004, chapter 6; Hindriks and Myles, 2006, chapter 7)

Correcting externalities through prices: Pigouvian taxation

Simple example:
• Two consumers, two goods economy

• Utility functions:

x1 + u1 ( z1 ) + υ1 ( z 2 )
U1 =
x 2 + u 2 ( z 2 ) + υ 2 ( z1 )
U2 =

 Consumption of goods z generates an externality

• Endowment of individual h : wh , h = 1, 2

• Relative price of good x and good z is normalized to 1

• Budget constraint: x h + z h =
wh

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Consumption decisions of consumers will satisfy:

uh' ( z h ) = 1, h = 1, 2
 Private marginal benefit for each good is equal to private marginal cost

 Does not take into account the external effect

Pareto efficient allocation: Maximize total utility of individuals subject to production

possibilities

Max U 1
+ U 2
=  x1 + u1 ( z1 ) + υ1 ( z 2 )  +  x 2 + u2 ( z 2 ) + υ2 ( z1 ) 
{xh , z h}    

Subject to: x1 + z1 + x 2 + z 2 = w1 + w2

 Pareto efficient consumption of good z satisfies:

u1' ( z1 ) + υ2' ( z1 ) =
1
u2' ( z 2 ) + υ1' ( z 2 ) =
1

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 Positive externality: υh' > 0

Under-consumption of good z in the market outcome relative to the Pareto

efficient allocation

Negative externality: υh' < 0

Over-consumption of good z

• Pigouvian taxation: Fixed tax per unit of consumption - t1 and t2

Impose a tax equal to the negative of the marginal externality:

t1 = −υ2' ( z1 ) and t2 = −υ1' ( z 2 )

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The consumption decisions of individuals will be efficient, i.e. will satisfy:

u1' ( z1 ) = 1 + t1
u1' ( z1 ) = 1 − υ2' ( z1 )
u1' ( z1 ) + υ2' ( z1 ) =
1

Similarly: u2' ( z 2 ) + υ1' ( z 2 ) =

1

Positive tax if externality is negative, and vice versa

Problem with pigouvian taxation:

If the size of externalities differs across goods and across individuals, need
differentiated taxes across goods and individuals

A single tax rate cannot achieve efficiency

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Topics on externalities – Continued
 Government may face information constraints

Correcting externalities under imperfect information –an example

(Reference: Varian, American Economic Review, 1994)

• Agents have perfect information about production technologies and externality

costs, but the regulator does not.

• Mechanism designed to induce the agents to reveal the information required to

achieve the efficient allocation.

• Mechanism also achieves a desirable distribution of utilities.

⇒Compensation mechanism

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Setup:
• 2 profit-maximizing firms

• Firm 1 produces output x to maximize:

π=
1 rx − c ( x )

r : competitive price of output

c ( x ) : increasing and convex cost function

• Firm 1’s output imposes an externality on firm 2. Firm 2’s profits:

π 2 = −e ( x )

e ( x ) : positive, increasing and convex

• The cost function and the externality function are known to both firms but unknown
to the regulator.

• The level of output chosen by firm 1 is not efficient since it ignores the externality
imposed on firm 2.

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• If the regulator had full information, it could impose a pigouvian tax of p* = e ' ( x *) ,
where x * is the efficient level of production.

 Firm 1 would solve:

Max rx − c ( x ) − p * x
x

 First-order condition: r − c ' ( x *) − e ' ( x *) =

0

 Would produce at the efficient level.

• Problem: the regulator does not know the externality function, and therefore cannot
determine the required p *

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Compensation mechanism:

– Stage 1: Firms simultaneously announce the magnitude of the appropriate tax.

• Announcements: p1 and p2

– Stage 2: Regulator makes side payments to firms so that profits functions are:
∏1 = rx − c ( x ) − p2 x − α1 ( p1 − p2 )
2

∏ 2= p1 x − e ( x )

– α1 is positive and of arbitrary magnitude

 Firm 1 pays a tax based on the marginal social cost of the externality as
reported by firm 2.

 Firm 2 receives compensation based on marginal social cost reported by firm 1.

 Firm 1 pays a penalty if the reports are different.

 The size of the penalty is irrelevant but it must be minimized when the
reports are the same.

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 Unique subgame-perfect equilibrium:
– Firms’ reports: p1 = p2
– Firm 1 produces the efficient amount of output.

Solving backwards:

• Stage 2: firm 1 maximizes profits taking the tax as given.

 FOC: = r c ' ( x ) + p2 (1)

 Optimal choice: x ( p2 ) , x ' ( p2 ) < 0
 The higher the tax that firm 2 announces, the less firm 1 produces.

• Stage 1:

– If firm 1 believes that firm 2 will announce p2 , it will want to announce

p1 = p2 (2)

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 – Firm 2’s announcement has an indirect effect on its profits through its effect on
x.

 Differentiating firm 2’s profit function with respect to p2 and setting equal to
zero:

∏ '2 ( p2 ) = p1 − e ' ( x )  x ' ( p2 ) =

0

 p1 = e ' ( x ) (3)

Combining (1), (2) and (3), we get:=r c '( x ) + e '( x )

 Subgame perfect equilibrium: efficient level of x

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Topics on externalities - Continued

Correcting externalities through restrictions on quantities: An example with

pollution control

(Reference: Leach, 2004, chapter 7)

Two types of quantity control instruments: Direct emissions control and permit trading

In general, both types of instruments can correct the externality problem, both not
necessarily at the same social cost.

Simple example:

• Two firms: 1, 2

• Fixed production level

• Each emits x units of pollution

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• ai : abatement level of firms i

 Emissions: xi= x − ai

mi 2
• Abatement cost: ci = ai
2

dci
 Marginal abatement cost: = mi ai
dai
– mi : Efficiency parameter

• We assume that m1 < m2

– e.g. Different production technologies across firms

• We want to compare the social cost of reducing emissions through either:

o Regulation (direct quantity control)

o Creation of a market for emission permits

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Direct control

• The government forces each firm to reduce its emissions to some level x̂ < x

 m1 + m2 
= c1 + c2  ( − )
2
 Total cost:  x ˆ
x
 2 

 Does not minimize the total cost associated with emissions reduction

• Need to equalize the marginal abatement cost across firms to minimize the total cost

 At a given level of abatement, the marginal cost differs across firms

 The most efficient firm should reduce emissions by a larger amount

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Permit trading

• Government issues x̂ permits to each firm

• Firms can buy and sell permits

 Total emissions: 2xˆ

• p : market price for a permit

mi 2
 Cost of firm i : c=i ai + p ( x − ai − xˆ )
2

 ( x − ai − xˆ ) : number of additional permits required – can be positive or negative

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• Level of emissions reduction that minimizes costs:

dci
= mi ai − p= 0
dai

p
 ai* =
mi

 The higher the market price for permits, the more abatement will be undertaken by
the firm

 We consider an interior solution (both firms have permits at the market equilibrium)

– implies that the price p is such that ai < x

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 Excess demand for permits by firm i : EDi = ( x − ai* ) − xˆ = x − xˆ −
p
•
mi
 (+) or (-)

• Equilibrium price is such that: ED1 + ED2 =

0

 In equilibrium, the firm with the lowest abatement cost will sell permits (firm 1)

• The market is in equilibrium when:

 1 1 
2 ( x − xˆ ) − p  + =0
 1
m m2 

−1
 1 1 
 2 ( x − xˆ )  +
p= 
 1
m m2 

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 p 2 ( x − xˆ )  1
−1
1 
Therefore: =
ai =  + 
mi mi  m1 m2 

At ( a1* , a2* ) , the marginal cost of each firm is:

−1
 1 1 
2 ( x − xˆ )  +
mi ai = 
 m1 m2 

 Equal marginal cost across firms

 Total cost of reducing emissions is minimized

• We can reduce emissions further, while minimizing the cost, by reducing the number of
permits available

 Equilibrium price increases

 Firms will reduce their emissions until the marginal cost of abatement is equal to the
price

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Issues/problems:

• Initial allocation of permits

• Transaction costs

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