Download Externalities - Intermediate Microeconomics - Lecture Slides and more Slides Microeconomics in PDF only on Docsity!
Externalities
- Negative
- Action by one party imposes a cost on another party
- Scenario
- Steel plant dumping waste in a river
- The entire steel market effluent can be reduced by lowering
output (fixed proportions production function)
- Marginal External Cost (MEC) is the cost imposed on
fishermen downstream for each level of production.
- Marginal Social Cost (MSC) is MC plus MEC.
- Negative Externalities encourage inefficient firms to remain in the
industry and create excessive production in the long run.
MC
S = MCI
D
P 1
Aggregate social cost of negative externality
P 1
q 1 Q 1
MSC
MSCI
When there are negative externalities, the marginal social cost MSC is higher than the marginal cost.
External Costs
Firm output
Price
Industry output
Price
MEC
MECI
The difference is the marginal external cost, MEC.
q*
P*
Q*
The industry competitive output is Q 1 while the efficient level is _Q._*
The profit maximizing firm produces at q1 while the efficient output level is q*.
Ways of Correcting Market Failure
- Options for Reducing Emissions to E*
- Emission Standard: Set a legal limit on emissions at
E* (12) which increases the cost of production and the threshold price to enter the industry. Enforced
by monetary and criminal penalties.
- Emissions Fee: Charge levied on each unit of
emission.
- Assumptions:
- Policymakers have asymmetric information
- Administrative costs require the same fee or
standard for all firms
The Case for Fees
Firm 2’s Reduced Abatement Costs
Firm 1’s Increased Abatement Costs
MCA 1
MCA 2
Level of Emissions
Fee per
Unit of
Emissions
The cost minimizing solution would be an abatement of 6 for firm 1 and 8 for firm 2 and MCA 1 = MCA 2 = $3.
The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA 2 < MCA 1.
If a fee of $3 was imposed Firm 1 emissions would fall From 14 to 8. Firm 2 emissions would fall from 14 to 6. MCA 1 = MCA 2 : efficient solution.
Ways of Correcting Market Failure
- Advantages of Fees
- When equal standards must be used, fees achieve the same
emission abatement at lower cost.
- Fees create an incentive to install equipment that would
reduce emissions further.
- Summary: Fees vs. Standards
- Standards are preferred when MSC is steep and MCA is flat.
- Standards (incomplete information) yield more certainty on
emission levels and less certainty on the cost of abatement.
- Fees have certainty on cost and uncertainty on emissions.
- Preferred policy depends on the nature of uncertainty and the
slopes of the cost curves.
Ways of Correcting Market Failure
- Transferable Emissions Permits
- Permits help develop a competitive market
for externalities.
- Agency determines the level of emissions and
number of permits
- Permits are marketable
- High cost firm will purchase permits from low
cost firms
Example: Bargaining with Alternative Property Rights: Fishermen and
a Factory!
No Cooperation
Profit of factory $500 $
Profit of fishermen $200 $
Cooperation
Profit of factory $550 $
Profit of fishermen $250 $
Right to Dump Right to Clean Water
Externalities and Property Rights
- Costly Bargaining - The Role of Strategic Behavior
- Bargaining requires clearly defined rules and property rights.
- A Legal Solution - Suing for Damages
- Fishermen have the right to clean water
- Factory has two options
- No filter, pay damages
- Profit = $100 ($500 - $400)
- Filter, no damages
- Profit = $300 ($500 - $200)
Common Property Resources
- Common Property Resource
- Everyone has free access.
- Likely to be overutilized
- Examples: Air and water; Fish and animal populations
- Solution: Private ownership
- Question: When would private ownership be impractical?
Common Property Resources
Fish per Month
Benefits,
Costs
($ per
fish)
Demand
However, private costs underestimate true cost. The efficient level of fish/month is _F_* where MSC = MB (D)
Marginal Social Cost
F*
Private Cost
FC
Without control the number of fish/month is FC where PC = MB.
