1) Markets are usually efficient at organizing economic activity, but can fail due to externalities where costs and benefits of actions are not fully accounted for by the parties involved.
2) Governments can sometimes improve market outcomes by internalizing externalities through policies like corrective taxes or subsidies that align private incentives with social costs and benefits.
3) Examples of policies to address externalities include taxes on pollution to remedy negative externalities, and subsidies for activities with positive externalities like research and development. Market-based policies like tradable pollution permits can also efficiently reduce pollution.
1) Markets are usually efficient at organizing economic activity, but can fail due to externalities where costs and benefits of actions are not fully accounted for by the parties involved.
2) Governments can sometimes improve market outcomes by internalizing externalities through policies like corrective taxes or subsidies that align private incentives with social costs and benefits.
3) Examples of policies to address externalities include taxes on pollution to remedy negative externalities, and subsidies for activities with positive externalities like research and development. Market-based policies like tradable pollution permits can also efficiently reduce pollution.
1) Markets are usually efficient at organizing economic activity, but can fail due to externalities where costs and benefits of actions are not fully accounted for by the parties involved.
2) Governments can sometimes improve market outcomes by internalizing externalities through policies like corrective taxes or subsidies that align private incentives with social costs and benefits.
3) Examples of policies to address externalities include taxes on pollution to remedy negative externalities, and subsidies for activities with positive externalities like research and development. Market-based policies like tradable pollution permits can also efficiently reduce pollution.
➢ One of the principles from Chapter 1: - Supply (private cost) - Markets are usually a good way to - External cost organize economy activity. o value of the negative impact on bystanders ➢ In absence of market failures, the competitive ➢ “Internalizing the Externality” market outcome is efficient, maximizes total - Internalizing the externality: altering surplus. incentives so that people take account of the external effects of their actions ➢ One type of market failure: - When market participants must pay social - Externality, the Uncompensated impact costs, market eq’m = social optimum. of one person’s actions on the well-being - Imposing the tax on buyers would of a bystander. achieve the same outcome; market Q - Externalities can be negative or positive, would equal optimal Q. depending on whether impact on bystander is adverse or beneficial. POSITIVE EXTERNALITIES - Self-interested buyers and sellers neglect ➢ In the presence of a positive externality, the the external costs or benefits of their social value of a good includes actions, so the market outcome is not - private value – the direct value to buyers efficient. - external benefit – the value of the positive impact on bystanders ➢ Another principle from Chapter 1: - Governments can sometimes improve ➢ The socially optimal Q maximizes welfare: market outcomes. - At any lower Q, the social value of additional units exceeds their cost. ➢ In presence of externalities, public policy can - At any higher Q, the cost of the last unit improve efficiency. exceeds its social value. ➢ Examples of Negative Externalities ➢ Examples of Positive Externalities • Air pollution from a factory - Being vaccinated against contagious • The neighbor’s barking dog Late-night stereo diseases protects not only you, but people blasting from the dorm room next to yours who visit the salad bar or produce section • Noise pollution from construction projects after you. • Health risk to others from second-hand smoke - R&D creates knowledge others can use. • Talking on cell phone while driving makes the - People going to college raise the roads less safe for others population’s education level, which RECAP OF WELFARE ECONOMICS reduces crime and improves government
➢ The market eq’m maximizes consumer + EFFECTS OF EXTERNALITIES
producer surplus. ➢ If negative externality ➢ Supply curve shows private cost, the costs - market quantity larger than socially directly incurred by sellers. desirable ➢ Demand curve shows private value, the value ➢ If positive externality to buyers (the prices they are willing to pay). - market quantity smaller than socially desirable ➢ Analysis of a Negative Externality ➢ To remedy the problem, - “internalize the externality” - Firms with the lowest abatement costs reduce - tax goods with negative externalities pollution the most. - subsidize goods with positive externalities ➢ A pollution tax is efficient: - Firms with low abatement costs will reduce PUBLIC POLICIES TOWARD pollution to reduce their tax burden. EXTERNALITIES - Firms with high abatement costs have greater ➢ Two approaches: willingness to pay tax. - Command-and-control policies regulate ➢ In contrast, a regulation requiring all firms to behavior directly. reduce pollution by a specific amount is not - Examples: efficient. • limits on quantity of pollution emitted ➢ Corrective taxes are better for the • requirements that firms adopt a environment: particular technology to reduce - The corrective tax gives firms incentive to emissions continue reducing pollution as long as the cost of doing so is less than the tax. - Market-based policies provide incentives so - If a cleaner technology becomes available, the that private decision-makers will choose to tax gives firms an incentive to adopt it. solve the problem on their own. - In contrast, firms have no incentive for further - Examples: reduction beyond the level specified in a • corrective taxes and subsidies regulation. • tradable pollution permits EXAMPLE OF A CORRECTIVE TAX: THE CORRECTIVE TAXES & SUBSIDIES GAS TAX
➢ Corrective tax ➢ The gas tax targets three negative externalities:
- a tax designed to induce private decision- • Congestion makers to take account of the social costs that - The more you drive, the more you contribute to arise from a negative externality congestion. - Also called Pigouvian taxes after Arthur • Accidents Pigou (1877-1959). - Larger vehicles cause more damage in an - The ideal corrective tax = external cost accident. - For activities with positive externalities, ideal • Pollution corrective subsidy = external benefit - Burning fossil fuels produces greenhouse gases - Other taxes and subsidies distort incentives and move economy away from the social TRADABLE POLLUTION PERMITS optimum. - align private incentives with society’s interests ➢ A tradable pollution permits system reduces - make private decision-makers take into pollution at lower cost than regulation. account the external costs and benefits of their - Firms with low cost of reducing pollution sell actions whatever permits they can. - move economy toward a more efficient - Firms with high cost of reducing pollution buy allocation of resources. permits. ➢ Result: Pollution reduction is concentrated CORRECTIVE TAXES VS. REGULATIONS among those firms with lowest costs. ➢ Different firms have different costs of TRADABLE POLLUTION PERMITS IN pollution abatement. THE REAL WORLD ➢ Efficient outcome: ➢ SO2 permits traded in the U.S. since 1995. ➢ Nitrogen oxide permits traded in the northeastern WHY PRIVATE SOLUTIONS DO NOT U.S. since 1999. ALWAYS WORK ➢ Carbon emissions permits traded in Europe since 1. TRANSACTION COSTS: The costs parties January 1, 2005. incur in the process of agreeing to and following ➢ As of June 2008, Barack Obama and John through on a bargain. These costs may make it McCain each propose “cap and trade” systems to impossible to reach a mutually beneficial reduce greenhouse gas emissions. agreement. CORRECTIVE TAXES VS. TRADABLE 2. STUBBORNNESS: Even if a beneficial POLLUTION PERMITS agreement is possible, each party may hold out for a better deal. ➢ Like most demand curves, firms’ demand for the 3. COORDINATION PROBLEMS: If the ability to pollute is a downward-sloping function number of parties is very large, coordinating of the “price” of polluting. them may be costly, difficult, or impossible - A corrective tax raises this price and thus reduces the quantity of pollution firms demand. - A tradable permits system restricts the supply of pollution rights, has the same effect as the tax. ➢ When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely. OBJECTIONS TO THE ECONOMIC ANALYSIS OF POLLUTION ➢ Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment. ➢ However, people face tradeoffs. The value of clean air & water must be compared to their cost. ➢ The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment. PRIVATE SOLUTIONS TO EXTERNALITIES ➢ Types of private solutions: - Moral codes and social sanctions, e.g., the “Golden Rule” - Charities, e.g., the Sierra Club - Contracts between market participants and the affected bystanders. PRIVATE SOLUTIONS TO EXTERNALITIES ➢ The Coase theorem: - If private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own.