Week 11 � ECMA04 - DOC by TO2Z2JmP


									Week 12 – ECMC02
Externalities and Public Goods

Adam Smith:
When can self-interest (i.e., greed) be
harnessed to serve the social interest?

 -   competition
 -   limited government
 -   no external effects
 -   no public goods

Otherwise, there will be “market failure”

Special role for government when markets

 1.   Natural monopoly – government can
      regulate privately-owned monopoly or
      produce good itself (electricity,
      telephone, natural gas pipelines)

 2. Positive and negative externalities
    (spillover effects) – government can
    regulate, tax, fine, or issue permits

 3. Public goods (goods which are nonrival
    and nonexcludable - lighthouse,
    mosquito control, public health)
    government can provide or purchase.

Positive and Negative Externalities

  - education
  - beautiful garden
  - raising bees
  - raising well-behaved, well-educated

 - pollution
 - second-hand smoke
 - noisy activities

When there are external effects
(externalities), markets do not receive the
right signals, and therefore make the wrong

Market price does not correctly reflect social

Consumers and/or producers do not receive
all the benefits and pay all the costs (some of
the costs or benefits are received by others).
Therefore, consumers and producers do not
face the correct incentives.

They will consume and/or produce too much
(external costs) or too little (external
benefits) of the good.

($/Q)                                                  MSC (marginal
                                                       social cost)

                                                          Supply or MC
                                                          (marginal private


                                               Demand for Wood
                                               Pulp (marginal private

        0                                                 Quantity

                        Market for Wood Pulp
                        (MPC + MEC = MSC)
What is the gain to society (GTS) from
producing wood pulp? What is the efficiency
loss from producing the market quantity
(instead of the optimum quantity)?

Problem can be viewed as incorrect pricing of
the product, giving the wrong signals to
producers and consumers.

Can a tax on the output of this industry
provide the right signals?

How much tax?

Problems with carbon taxes:
- taxes production, not emissions
- does not reward producers who pollute
  less (carbon sequestration, other
  technological change)
- hard to determine marginal external cost
  to set right amount of tax
- hard to adjust taxes over time

View problem differently….optimum amount of
pollution reduction (i.e., abatement), rather
than optimum amount of production of
polluting good

Design policy to give correct amount of
pollution abatement

Focus attention on Marginal Cost of
Abatement (MCA), which is a function of the
level of pollution (of greenhouse gas
emission). This is the marginal cost of
cleaning up pollution

Also focus on the Marginal Benefits of
Abatement – the marginal benefit of reducing
GHG [which reflects the Marginal Social Cost
(MSC) of pollution (of not abating)].

Global warming
CO2 emissions (fossil-fuel-burning power
plants, cars and fossil fuels)

Effects of global warming on U.S.
    Melting glaciers, early snowmelt and severe
     droughts will cause more dramatic water
     shortages in the American West.

    Rising sea levels will lead to coastal flooding on
     the Eastern seaboard, in Florida, and in other
     areas, such as the Gulf of Mexico.

    Warmer sea surface temperatures will fuel
     more intense hurricanes in the southeastern
     Atlantic and Gulf coasts.

    Forests, farms and cities will face troublesome
     new pests and more mosquito-borne diseases.

    Disruption of habitats such as coral reefs and
     alpine meadows could drive many plant and
     animal species to extinction.

Are there substitutes for fossil fuels? Are
there new technologies?

How can we encourage substitution?

$ per unit of



                                  % Pollution

   GHG emissions
                   FOSSIL FUELS
Three alternatives to get to optimum
  (1) Direct controls – direct regulation of
      emissions permitted

  (2) Taxation of emissions (not production)

  (3) Tradeable emissions permits

“Efficient” amount of abatement occurs where
MCA = MBA, and further where the MCA of
each firm is the same (so that abatement
comes from those firms who can abate most

Does this make sense?

Imagine two industries. Each produces 20
units of GHG per day. In Industry #1, the
marginal cost of reducing pollution is $4 for
each of the first four units, $8 for each of
the next four units, $12 for each of the next
four units and so on. For Industry #2, the
first 10 units cost $10 each to clean up and
the second 10 cost $30 to clean up.

(a) if the optimum amount of pollution
    abatement is 8 units, who should do the
    cleaning up? Why? Is this fair? Is this
(b) If the optimum amount of pollution
    reduction is 26 units, who should do the
    cleaning up? Why? Is this fair? Is this

(c) Imagine a regulation to achieve the result
    in (a). What would this regulation say?
    What about a regulation to achieve the
    result in (b)

(d) Imagine a fine to achieve (a) and then (b).
    What fine would achieve this?

(e) Imagine a tax on emissions to achieve (a)
    and then (b). What tax would achieve

(f) Imagine issuing 32 permits, each allowing
    for 1 unit of pollution, distributing them
    equally to these producers, and allowing
    them to trade these permits. What would
    happen? What if the government issued
    14 permits?

   Tradeable emissions permits

Each firm is allocated certain number of
emission permits each year. These permits
may be used or traded. Firms who have the
highest costs of abatement will seek to buy
extra permits. Firms who have low costs of
abatement will seek to sell permits. Demand
and supply for permits will establish
equilibrium price of fixed amount of pollution

 Public authority will determine amount of
emissions that are allowed.

Since the market sets the price of the
emissions permits, there is, in effect, a fee
for polluting (which allows different firms to
make different decisions). Therefore, more
efficient distribution of adjusting emissions
to new level.

Creates a “market” for externalities.

Internalizes the external cost.

1990 U.S. Congress Clean Air Act established
tradeable permits for acid rain. Sulphur
dioxide emissions now cost about $150 per

To compare the effects of different policy
approaches, imagine that MCA is made up of
two firms. One is a firm with low marginal
costs of abatement; the other is a firm with
high marginal costs of abatement. Put both
on same graph, and consider the effects of
direct controls, taxation of emissions and
tradeable emissions permits on behaviour.

$ per unit of

                                            MCA –
                                            Firm #2

                                            MCA –
                                            Firm #1

                share of
                                   Abatement Pollution
                Optimal                      abatement
                Abatement    FOSSIL FUELS
Direct controls:
  - Politically appealing; appearance of equity
  - Easier to set amount of permitted
    emissions than tax level
  - everyone faces same standard, no matter
    what their marginal costs of abatement

Taxation of emissions:
 - gives revenue to government
 - difficult to measure emissions. No
   incentive to disclose
 - difficult to set correct level of taxation
 - provides incentives to reduce emissions
   when this is cost-effective

Tradeable emissions permits:
 - can set amount of permitted emissions
 - those with high costs of controlling
   emissions will purchase credits, others
   will sell
 - cost of emissions credit is set by market,
   market is responsible for business
   failures, not government
 - strong incentives to innovation, reduction

$ per unit of



                                  % Pollution

   GHG emissions
                   FOSSIL FUELS
1, A country has two industries, each of which are
currently generating greenhouse gas (GHG)
emissions equal to 25 tonnes per day. The two
industries (“1” and “2”) can each clean up some of
the pollution. If we call R1 the amount of reduction
of emissions from industry #1 and R2 the amount
of reduction of emissions from industry #2, then
the total cost of cleanup for each industry
(measured in millions of dollars) is:
         TC1 = 1.5R12 and TC2 = 0.75R22
The harm caused by the pollution in this country
depends on the total amount of pollution generated
by the two industries. If we call RT the total
amount of cleanup from the two industries (where
RT= R1+ R2), then the harm (i.e., Total Social Cost)
suffered by the country from GHG emissions
(measured in millions of dollars) is

        H = 10 (50- RT) + 0.5 (50 - RT)2

a) Derive the functions which give the MC of
abatement (MCA) and the Marginal Social Cost of
emissions (MB from abatement of pollution, or
MBA), and solve for the optimum level of emissions
(i.e., optimum amount of abatement).

Try this problem……

b) Suppose that the government decides to
   eliminate all GHG emissions, and orders each
   industry to cease all its emissions.
   Demonstrate that such a policy would be

c) Suppose that the government adopts a policy
   to achieve the optimum abatement by simply
   ordering each industry to reduce emissions by
   the same percentage. What would that
   percentage be? Demonstrate that such a
   policy would be inefficient.

d) Now the government decides to achieve the
   optimum abatement by assessing a tax on each
   industry for each unit of GHG emissions
   generated (i.e., a tax on emissions). What
   would this tax be? How would the tax affect
   each industry? Demonstrate that such a tax
   would be efficient.

e) Instead the government decides to achieve
   the optimum abatement by issuing pollution
   permits. Each permit allows the industry
   holding the permit to emit one tonne per day
   of GHG emissions. One possible approach
   would be to issue half the permits to industry
   #1 and the other half to industry #2. If the
   permits are tradeable, explain what will
   happen next, and why this outcome would be

f) An alternative to the policy in part e would be
   for the government to issue the permits, but
   to auction them off itself to the two
   industries. What will happen? Would the
   outcome be efficient? Why might you prefer
   the policy in part e? Why might you prefer
   the policy in part f?

g) Explain why policy in part f looks a lot like the
   tax in part d. Given that, when would you
   prefer taxes, and when would you prefer
   emissions permits?

Many external cost situations arise when
there is a “common property” resource.
Resource is owned in common and can be used
without payment. Leads to overutilization of
the free resource.

Examples: overfishing in a common pond, too
much extraction of oil from a common pool of

With fishers (formerly, fishermen), fishing
continues until MR = MC, ignoring the social
costs of depleting the stock of fish.

Island of Pago-Pago
2 lakes, 20 fishers
Fishers get to keep average amount of fish
taken from that lake.

“Production” functions for fishing are:
On Lake X: FX = 10LX – ½ LX2
On Lake Y: FY = 5LY
In each case, L refers to number of fishers on

Sketch these production functions to get a
sense of what is driving this problem.

If fishers can fish where they like (individual
choice), what will happen?

Fishers will fish where the average product is
highest, since they get to keep average

Average product on Lake X is:
FX/LX = (10LX – ½ LX2)/LX

Average product on Lake Y is:
FY/LY = (5LY)/LY = 5

Fishers will fish on each lake until
Or (10LX – ½ LX2)/LX = 5

Therefore, in equilibrium, LX = 10
And LY = 10

What is the optimum number of fishers on
each lake? What distribution of fishers will
maximize fish output (fully taking into account
the diminishing marginal returns)?

Should equalize the marginal product on each
lake, rather than average product.

FX = 10LX – ½ LX2
So dFX/dLX = 10 - LX
FY = 5LY
So dFY/dLY = 5

Equating marginal products:
10 - LX = 5 or LX = 5
Therefore, LY = 15

Compare the total number of fish caught,
using the production functions

With individual decision making about which
lake to fish on, we have:
(10 x 10) – ½ (10 x 10) + (5 x 10) = 100

At the optimum distribution, we have:
(10 x 5) – ½ (5 x 5) + (5 x 15) = 112.5

Public Goods
Think about “rivalry” and “excludability”

Public goods are:
- non-rival (collective consumption, or cost
  of accommodating an extra consumer = 0)

- non-excludable (if one consumer has
  access, all consumers have access;
  therefore, free rider problem)

- therefore, private markets generally
  cannot sell the good to individual
  consumers (i.e., market failure)

      Excludable        Non-excludable
Rival Private Goods:    Common-property
      -chocolate bar,   resources:
      haircut           fisheries, lakes and
Non- Art galleries,     Public Goods:
rival movies, roads,    National defence,
      bridges, cable    public health, police,
      TV signal         justice, mosquito
                        spraying, knowledge

Problem with public good: Individual marginal
benefit is generally not high enough to cover
marginal cost of provision. Private markets
will not have incentives to provide.

Solution: governments should provide or pay
others to provide and raise revenues by
taxation to pay…..but how much of each public
good should be provided?

            How much of a public good?


                                                         Quantity of
                                Quantity of
                                                         Public Good
                                Public Good

            Overall MU


                         Quantity of Public Good
                                          38       100
If Frank has MUF = 100 - QF
And John has MUJ = 100 – QJ
And MC = 2Q
What is the optimum value of Q
This is a public good

Overall demand for public good

Marginal benefit = marginal cost

How would government determine MU’s?

Non-excludability is what causes market to
fail. Many goods are not “pure” public goods
but it is difficult or inconvenient or costly to
exclude consumers.

  -   police
  -   fire fighting
  -   bridges
  -   highways
  -   clean air
  -   parks

How will the public good be financed?

Who will provide the public good?


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