ECO309: Public Finance Chapter 5: Externalities

Tanvir Hussain1
1 Assistant Professor Department of Economics and Social Sciences BRAC University

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What is an Externality?

An externality arises when an individual is aected by someone elses actions without getting compensated for damages, or, when an individual enjoys the benets of someone elses actions without paying a price. Negative externality occurs when someone incurs a loss without being compensated for it. Positive externality occurs when someone enjoys a spillover benet without paying a price for it. In either of the above cases, the single most important issue is that a market is missing; this is a classic instance of market failure. A market failure happens when market fails to allocate resources eciently in the sense that there is a mismatch (or discrepancy) between private and social optima. One can also distinguish between externalities in the context of consumption and production. Consumption externality occurs when an individuals set of consumption possibilities and/or preferences is aected by the actions of another consumer or rm. Production externality occurs when one rms set of production possibilities is aected by the actions of another rm or consumer.

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Figure: Private and Social Optimal

social marginal cost firm's marginal cost

marginal cost, damage ($)

A B marginal damage

marginal benefit

Q*

Q1

output (Q)

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What is Happening?
So, lets build a simple story to understand the gure from last slide. Imagine that Bart operates a factory (producing output Q) that dumps waste into a river which is used by Lisa for shing. The river is a common property resource, that is, not owned by anyone in particular. The problem is that Barts waste dumping creates a negative externality, because, unhealthy water reduces the size of the sh population and lowers Lisas utility (or the number of sh she catches). Private optimal occurs when Bart equalizes his (private) marginal production cost with marginal benet. Imagine Bart as just another perfectly competitive rm who maximizes prot and sets quantity following: price = MR = MB = MC Social optimal, in contrast, occurs when social marginal cost is equalized with marginal benet. But, rst, we have to obtain the social marginal cost this is done using vertical summation. For each level of output, Barts (or rms) marginal cost is added to the marginal damage to obtain the social marginal cost function. And, social optimal (or ecient) output is set by following: price = MR = MB = SMC = (MC + MD)

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A Numerical Example

The Finger Lakes region of New York State attracts tourists who wish to sample its superb wines. In recent years, hog-raising farms, some with more than a thousand hogs, have taken root in the region. The smells emanating from the massive amounts of pig manure adversely aect tourism. Basically, wine and swine is not a good combination. Imagine that the Little Pigs (LP) hog farm is situated near the Tipsy vineyard. The table below shows, for each level of LPs output, the marginal cost of raising a hog, the marginal benet to LP, and the marginal damage done to Tipsy: Output (number of hogs) 1 2 3 4 5 6 Marginal Cost MC ($) 3 6 10 13 19 21 Marginal Benet MB ($) 13 13 13 13 13 13 Marginal Damage MD ($) 5 7 9 11 13 15

How many hogs does LP produce? Justify your answer using correct logic. What is the ecient number of hogs?

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A Model of Production Externality

Consider another example of production externalities; A rm produces steel output (s) and also produces a certain amount of pollution as byproduct of steel production. The rm just dumps the waste into a river, which is also used by a downstream shery producing quantity of sh (f ). Steel and sh are sold at competitive prices Ps and Pf . The steel rms cost function is Cs = Cs (s), where costs are usually assumed to be increasing in steel production. The externality comes in to the picture through the sherys cost function. The shery cost function is given by Cf = Cf (f , s), where, costs are assumed to be increasing in sh harvests as well as steel production. That is Cf > 0, and Cf > 0. f s The presence of s (quantity of steel produced) in the shery cost function captures the negative externality eect incurred by the shery.

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Optimality Conditions What is Missing?

The private optimality conditions are given by: Cs s Cf Pf = f Ps = steel mills prot maximization sherys prot maximization (1) (2)

What is missing from the above? The shery is doing everything it can, but, the steel mill is completely ignoring the external eect steel production has on the shery, that is Cf . s Unfortunately, individual prot maximization behavior will always make the steel mill ignore this externality eect. To understand fully the eect of the above, create the social benchmark (or optimal model). Imagine a single rm owning the steel mill and the shery. This joint rms prot maximization problem will lead to the following optimal conditions: Cs Cf + s s Cf Pf = f Ps = for steel production for shery production (3) (4)

In this case, the externality is said to be internalized.

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Private Responses

One way to achieve the social optimal is assigning property rights and bargaining this is where Coase Theorem comes in. Coase Theorem suggests that social eciency will be achieved regardless of whoever is assigned the property rights, as long as the following are true:
(a) Bargaining (or transaction) costs are zero (or very very low). (b) Sources of damages can be accurately identied and appropriately prevented.

Of course, pollution problems rarely involve only two parties (one polluter and one pollutee). And, in such instances, zero transaction costs are extremely unlikely. In addition, not all polluters are equally responsible for observed pollution. Another way to deal with an externality problem is a merger between the two rms similar to what we saw in case of the joint production rm. Yet another way, especially in case of consumption externality, is to establish a set of social conventions.

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Public Responses

Pigovian tax/subsidy a tax imposed on each unit of output produced by the polluter. Tax rate equals the marginal damage (per unit) incurred at the ecient level of output. A subsidy is just the opposite, that is, a polluter is paid (an amount of money) for each unit of output not produced. Emission fee an emission fee is similar to a Pigovian tax, but, it is levied on each unit of emission (instead of output). Generally, a Pigovian tax, even though it reduces output, does not provide rms with appropriate incentives to invest in emission reduction technologies. In such instances, an emission fee is thought to be better suited than a Pigovian tax. Cap-and-trade programs also referred to as the tradable permit scheme. The government, after deciding on a total allowable level of pollution, issues and distributes permits to the rms. A permit gives the holder (or the rm) legal right to generate a pre-specied amount of pollution. The rms can, then, trade these permits as total emission (for all rms) reaches the socially ecient level.

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Public Responses Command and Control

In general, all of the above fall under the rubric of incentive based systems; because, they all attempt to provide rms with incentives to reduce pollution. Unfortunately, real-life pollution problems are often complex and multi-dimensional and, hence, dierent situations require dierent mechanisms. Another method of tackling externality problems are command and control strategies. Command and control regulation are much less exible than incentive based mechanisms. Some of the common ones include:
(a) Technology standard stipulates that rms are legally required to reduce pollution using a pre-specied technology. Firms have to use the specic pollution reduction technology regardless of how cost eective that particular technology is. (b) Performance standard this regulation imposes an emission goal for each rm. And, the rm is free to choose the specic emission reduction technology to use (following usual cost minimization principles). But, an individual rms goal is not always set according to its abatement costs (eciency requires that low abatement cost rms carry a larger share of pollution reduction responsibilities).

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