MARKET FAILURE 1: EXTERNALITIES. BUS111 MICROECONOMICS Lecture 8

Transcription

1 MARKET FAILURE 1: EXTERNALITIES BUS111 MICROECONOMICS Lecture 8

2 Examples Externalities When I drive to work I cause congestion for all the other road-users When my neighbours paint their house, I enjoy the benefits of living in a smarter area (and can sell my house at a higher price) When farmers use nitrogen based fertilisers, the run-off reduces the stocks of fish that local fishermen will be able to catch

3 Definition Externalities An externality is a cost or benefit of an activity which accrues to an individual who is not involved in that activity

4 Externalities Some more examples: e.g. Positive Negative Production externality Consumption externality Bee farm pollinating nearby orchard Vaccinations preventing spread of disease A polluting factory reduces fishermen s catch Lung cancer caused by passive smoking

5 Why do externalities matter? When I drive to work I cause congestion for all the other road-users BUT when I choose whether to drive or not, I only consider my own personal costs and benefits Where there are external costs that I ignore, I will drive too much

6 Why do externalities matter? The costs and benefits of driving Cost / benefit MSC External cost MC MB = MSB Q opt Q Quantity

7 Why do externalities matter? When my neighbours paint their house, I enjoy some of the benefits BUT when they choose whether or not to paint their house, they only consider their personal costs and benefits Where there are external benefits that they ignore, they will paint too little

8 Why do externalities matter? Cost / benefit The costs and benefits of house-painting External benefit MC = MSC MSB Q Q opt MB Quantity

9 Solutions to Externalities Internalising the externality : altering incentives so that people take account of the external effects of their actions Private solutions Moral codes and social sanctions e.g. littering Integrate the external party e.g. merge polluter and polluted Private contracts Public policy solutions Regulation Taxes and subsidies Tradable permits

10 The Coase Theorem As long as property rights are well specified and tradable, private bargaining will solve the problem of externalities and allocate resources efficiently For efficient resource allocation, the initial distribution of rights is unimportant

11 Definition Property Rights A property right is the exclusive authority to determine how a resource is used

12 Example The Coase Theorem Dick owns a dog named Spot Negative externality: Spot s barking disturbs Jane, Dick s neighbour The socially efficient outcome maximizes Dick s + Jane s well-being If Dick values having Spot more than Jane values peace & quiet, the dog should stay Coase theorem: The private market will reach the efficient outcome on its own

13 Example The Coase Theorem CASE 1: Dick has the right to keep Spot Benefit to Dick of having Spot = 500 Cost to Jane of Spot s barking = 800 Socially efficient outcome: Spot goes Private outcome: Jane pays Dick 600 to get rid of Spot, both Jane and Dick are better off Private outcome = efficient outcome

14 Example The Coase Theorem CASE 2: Jane has the legal right to peace & quiet Benefit to Dick of having Spot = 500 Cost to Jane of Spot s barking = 800 Socially efficient outcome: Spot goes Private outcome: Dick offers Jane up to 500 to let him keep Spot, Jane refuses to accept less than 800, so Spot goes Private outcome = efficient outcome

15 Example The Coase Theorem CASE 3: Dick has the right to keep Spot Benefit to Dick of having Spot = 1000 Cost to Jane of Spot s barking = 800 Socially efficient outcome: Spot stays Private outcome: Jane not willing to pay more than 800, Dick not willing to accept less than 1000, so Spot stays Private outcome = efficient outcome

16 Example The Coase Theorem CASE 4: Jane has the legal right to peace & quiet Benefit to Dick of having Spot = 1000 Cost to Jane of Spot s barking = 800 Socially efficient outcome: Spot stays Private outcome: Dick pays Jane 900 to put up with Spot s barking Private outcome = efficient outcome

17 The Coase Theorem The private market achieves the efficient outcome regardless of the initial distribution of rights The Coase theorem breaks down when people are unable to reach or enforce an agreement. This is often the case: Externalities often affect large numbers of individuals Property rights are often poorly defined

18 Public policy solutions Two approaches: 1. Command-and-control policies regulate behaviour directly. Examples: limits on quantity of pollution emitted requirements that firms adopt a particular technology to reduce emissions 2. Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own. Examples: corrective taxes and subsidies tradable pollution permits

19 Regulation Regulation e.g. dumping poisonous chemicals in the water supply is illegal e.g. legal obligation for children to go to school Sometimes the only feasible way to deal with an externality Usually not the most efficient way because the optimal amount of negative externality is not zero

20 Pigouvian Taxes and Subsidies Pigouvian taxes are corrective taxes, designed to induce private decision-makers to take account of the social costs that arise from a negative externality Other taxes and subsidies distort incentives and move the economy away from the social optimum Pigouvian taxes & subsidies align private incentives with society s interests make private decision-makers take into account the external costs and benefits of their actions move economy toward a more efficient allocation of resources

21 Pigouvian Taxes and Subsidies Pigouvian taxes e.g. petrol duty Cost / benefit MSC = after tax MC Pigouvian tax = External cost MC MB = MSB Q opt Q Quantity

22 Pigouvian Taxes and Subsidies Pigouvian taxes e.g. petrol duty Pigouvian subsidies Cost / benefit Pigouvian subsidy = External benefit MC = MSC e.g. public spending on education Problem: how do we measure the size of the externality Q Q opt MSB = after subsidy MB MB Quantity

23 Tradeable Permits Tradeable permits e.g. EU carbon-trading scheme Cost / benefit MSC = MC including permit price If we have a better idea of Qopt than of the cost, then restrict number permits to External cost MC Qopt Otherwise, they are equivalent to a Pigouvian tax Market price of permit Q opt MB Quantity = MSB

24 Pigouvian Taxes and Subsidies Example: Petrol tax targets three negative externalities: 1. Congestion The more you drive, the more you contribute to congestion 2. Accidents Larger vehicles cause more damage in an accident 3. Air pollution Burning fossil fuels produces greenhouse gases and reduces local air quality

25 Market-based Policy vs. Regulation Different firms have different costs of pollution abatement Efficient outcome: Firms with the lowest abatement costs reduce pollution the most A pollution tax (or tradeable permit scheme) is efficient: Firms with low abatement costs will reduce pollution to reduce their tax burden (sell permits) Firms with high abatement costs have greater willingness to pay tax (buy permits) In contrast, a regulation requiring all firms to reduce pollution by a specific amount is not efficient

26 Example Market-based Policy vs. Regulation Swalec and Manweb run coal-burning power plants. Each emits 40 tons of sulphur dioxide per month, total emissions = 80 tons/month Goal: Reduce SO 2 emissions 25%, to 60 tons/month Cost of reducing emissions: 100/ton for Swalec, 200/ton for USE Policy options: 1. Regulation: Every firm must cut its emissions 25% (10 tons) 2. Tradable pollution permits: Issue 60 permits, each allows one ton SO 2 emissions. Give 30 permits to each firm, allow resale What is the cost of each scheme (to each firm and in total)?

27 Example Market-based Policy vs. Regulation Swalec and Manweb each emit 40 tons/month of SO 2 Goal: Reduce total SO 2 emissions to 60 tons/month Cost/ton of reducing emissions: 100 for Swalec, 200 for Manweb Policy option 1: Regulation Every firm must cut its emissions 25% (10 tons) Cost to Swalec: (10 tons) x ( 100/ton) = 1000 Cost to Manweb: (10 tons) x ( 200/ton) = 2000 Total cost of achieving goal = 3000

28 Example Market-based Policy vs. Regulation Swalec and Manweb each emit 40 tons/month of SO 2 Goal: Reduce total SO 2 emissions to 60 tons/month Cost/ton of reducing emissions: 100 for Swalec, 200 for Manweb Policy option 2: Tradable pollution permits Issue 30 permits to each firm, allow resale e.g. Swalec uses 20 permits and sells 10 to Manweb for 150 each Swalec cuts emissions to 20 tons (cost: 2000) and sells 10 permits to Manweb (revenue: 1500) Net cost to Swalec = 500 Manweb keeps emissions at 40 tons but buys 10 permits from Swalec (cost: 1500) Net cost to Manweb = 1500 Total cost of achieving goal = 2000

29 Market-based Policy vs. Regulation Market-based policies are better for the environment: The tax (or permit cost) gives firms incentive to continue reducing pollution as long as the cost of doing so is less than the tax (or permit cost) If a cleaner technology becomes available, the tax (or permit cost) gives firms an incentive to adopt it In contrast, firms have no incentive for further reduction beyond the level specified in a regulation

30 Summary Key Concepts Positive and negative externalities Production and consumption externalities The Coase theorem Regulation Pigouvian taxes and subsidies Tradeable permits