Introduction to Externalities - Section 14, Module 74

External Costs - an uncompensated cost that an individual or firm imposes on others

• ex: pollution and traffic congestion

external benefits - benefits that individuals or firms give others without receiving compensation

• ex: planting trees gives the passerby the external benefit of beauty

externalities - external benefits + external costs

negative externalities - external costs

positive externalities - external benefits

externalities lead to inefficient market outcomes

• market failure - the inefficiency in a market

How much of an negative externality should be allowed/produced? - How much questions are answered by individuals/firms by comparing MB w MC

• negative externalities are usually not wanted to be completely eliminated bc they are byproducts of good things - ex, pollution (bad thing) is a byproduct of power plants that make our life easier (good thing)

marginal social costs - the additional cost imposed on society as a whole by one additional unit

marginal social benefits - the additional benefit society gains from one additional unit

• MSB can be the amount of money saved that companies would otherwise have to pay if regulations had been placed on them

socially optimal quantity - the quantity that makes society as well off as possible, taking all costs and benefits into account

• upward sloping MSC because, for example, nature can take low levels of pollution, but as pollution increases, it is harmed more and more

  • basically costs increasing

• downward sloping MSB because for each additional unit of the externality, the benefit gained is smaller and smaller

socially optimal point is where MSC = MSB

• this is not automatically reached by the economy - the benefits go directly to the firm, as they are the ones that do not need to comply to expensive regulations

  • however, the costs are typically paid by the public, who had no say in the decision

unregulated market will produce until MSB = 0 → until there are no more benefits to accrue

• also bc those who derive the benefits of producing more of the externality don’t have to compensate those who suffer from the costs

theoretically, in an ideal world, the private sector can achieve efficient outcomes w/o govt intervention → Coase Theorem - payments btwn the parties involved can achieve an efficient solution, give that the legal rights of the parties are clearly defined and the costs of making the deal are low enough

• transaction costs - costs of making a deal

• basically externalities aren’t always inefficient bc individuals have incentives to make mutually beneficial deals that require them to take the externality into account

• internalizing the externality - when individuals take externalities into account when making decisions

• doesn’t always happen bc of high transaction costs: communication, making legally binding agreements, and delays in bargaining

when transaction costs are too high and prevent the private sector from dealing w externalities, the govt becomes involved

the economy depends on a proper environment and the external costs threaten that environment

environmental standards - rules that protect the environment by limiting actions of producers and consumers

• inflexible and don’t allow reductions in pollution to be achieved at the lowest possible cost → more efficient policy would allow more pollution at a plant where it is expensive to reduce pollution levels

emissions tax - a tax that depends on the amount of pollution a firm produces

• ex: a $200 tax for every ton of SO2 emitted

• an emissions tax equal to the marginal social cost at the socially optimal quantity forces polluters to internalize the externality

• challenging bc policy makers do not know how much to charge - too little is charged = small improvement only; too much is charged = emissions are reduced by more than is efficient

tradable emissions permit - licenses to emit limited quantities of pollutants → can be bought and sold by producers

• usually issued according to some formula reflecting the firms history - ex a permit for 50% of the emissions before the system went into effect

• cap and trade program → are tradeable → creates a market in rights to pollute

  • firms w differing costs of reducing pollution will engage in mutually beneficial transactions → for firms in which reducing pollution is easy, they will sell to firms that find it harder to reduce pollution

  • some firms that have more permits than they need (they are not polluting as many tons that they have a permit for) but they can sell these permits to gain $$

• problem is tht bc it is difficult to determine the optimal quantity of pollution govts end up issuing too many/few permits

both emissions taxes and TEPs have the same benefit over EPA = those who can reduce pollution more cheaply are the ones that do

• they also encourage technological innovation, etc bc firms will look for alternative sources/sources that do not pollute as much - changes HOW electricity is produced rather than reducing electricity entirely