Externalities and inefficiency | Microeconomics Assignments Help| Expertsmind.com

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2. Learning Outcomes
 Understand the concept of externalities and why in
traditional economics they are considered to be a
source of economic inefficiency
 Understand the policies to reduce emissions
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3. Externalities & Inefficiency
An Externality is
An action by a producer or consumer which affects
others in the community, but is not accounted for
in the market price.
In traditional economics (informed by the ideas of
Pigou) externalities are a source of economic
inefficiency / market failure and a justification for
government action in the form of taxes/fees/controls.
3

4. Externalities-taxonomy
Externalities can arise in
 Consumption decisions
 Production decisions
and can be either
 Positive (beneficial), or
 Negative (harmful).
4

5. Externalities & Inefficiency:
The cows example
 There are 2 neighbouring farms: 1 produces cattle and
the other crops. Cattle sometime stray into the
neighbouring farm creating a negative external effect
(namely crop loss).

6. Externalities & Inefficiency:
The traditional Pigovian analysis:
 Focuses on the costs and benefits of
cattle production and argues for
charges to be levied on the cattle
producer that reflect the costs imposed
on the crop producer. This would
create a disincentive for cattle
production.

7. Externalities & Inefficiency: Some basic
concepts
 Marginal private cost (MC): Cattle producer’s direct
costs of production when it increases output by one
unit
 Marginal external cost (MEC): Cost imposed on the
neighbouring farm when the cattle producer increases
output by one unit
 Marginal social cost (MSC): Total marginal cost of the
firm’s production activity; MSC = MC + MEC
7

8. Externalities & Inefficiency: more basic
concepts
 Marginal private benefit = Reflected in the traditional
demand curve, D
 Marginal external benefit (MEB): Benefit to
individuals who are not part of the transaction
 Marginal social benefit (MSB): Total benefit to society
=> MSB = D + MEB
8

9. Negative Externalities & Inefficiency
 Firm’s profit-maximising/competitive output level:
 MR = MC
 Socially efficient/optimal level:
 MR = MSC; or
 MR = MC + MEC
 Because the cattle producer does not take into account
MEC:
 OUTPUT is HIGHER than the efficient/optimal level
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10. Negative Externalities & Inefficiency
$
MSC
MC
P=MR
MEC
Optimal Market q
outcome outcome
10

11. Negative Externalities & Inefficiency
$ MSB
D
MC
MSB
Optimal Market q
outcome outcome
11

12. Pigou
Suggested that the way to proceed is
1) Negative Externality – impose tax on firm equal to
value of MEC – firms will then respond to
MSC=MC+MEC and produce the optimal level
2) Positive Externality – provide subsidy equal to value
of MEB – consumers will then make decisions based
on MSB=D+MEB and consumer optimal level
12

13. Externalities & Inefficiency:
The Coasian perspective
 The benefits of the activity associated with the
externality should be weighed against the costs of
the externality. Allocative efficiency will be
fostered by allowing the cattle to stray if the value
of the additional meat supplied to the market
outweighs the value of the lost crops.
 There may not be a role for government via taxes
or fees or direct regulation

14. The Coasian perspective
$
Damage
caused
(MEC)
d
g
e f Benefit to
firm
a=0 b c pollutant

15. The Coasian perspective
 Pollution has benefits for firm
 Pollution cases damage
Optimal level of pollution is where marginal
value of damage = marginal value of benefit =
level b
Firm would like level c
Consumers would like level a

16. The Coasian perspective
 IF there are no transaction costs, the operation of
the price mechanism will achieve an efficient
solution to the problem of externalities.
 If firm has property rights it will pollute to level
c > b. Compared with b – damage of areas g+f,
benefit of area f.
So those adversely affected can pay the firm to
reduce pollution to point b.

17. The Coasian perspective
 IF consumers have the property rights they will
require pollution of level a=0. Compared with
the optimal level of b – benefit from more
pollution exceeds cost, or d+e > e.
So firm could compensate consumers and
pollute up to point b.

18. The Coasian perspective
 When transaction costs aren’t zero (and this is usually
the case) then market processes won’t lead to efficient
outcomes
 This creates an important role for the legal system and
government in achieving economic efficiency
 The creation and enforcement of property rights is an
alternative to taxes on production
 However, before any policy is introduced, its
administrative and other costs should be weighed
against the likely benefits

19. Application: policy on emissions
MSC of emissions: $ per unit of
 Social cost of each additional unit emission
of emissions MSC
 Upward-sloping function – the
higher the level of emissions the
higher the social cost
MCA (Marginal cost of abating
emissions):
 Cost to firm of abating each
additional unit of emissions
 Downward-sloping function – MCA
relatively easy to reduce emissions
when they are high, but difficult to Emission level
reduce to zero when they are (units)
already low
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20. Application: Efficient Level of Emissions
$ per unit of
emission
MCA
At E=10, MSC=MCA. This MSC
is the socially efficient
level of emissions E*
0 2 4 6 8 10 12 14 16 18 Emission level E
(units)
At E=4, MSC<MCA so the At E=14, MSC>MCA so the If the firm is not required
firm can increase emissions firm should be required to to restrict emissions,
some more restrict emissions some more E=18 units where MCA=0
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21. Marginal Costs of Abatement
Dollars per unit of
emission Are Likely to Vary Between Firms
Steep MCA Suppose emission level is
abated by 1 unit (6 to 5 units)
Steep MCA – Small changes in
B abatement add greatly to cost (A to B)
Flat MCA Flat MCA – Small changes in abatement
C add very little to cost (A to C)
A
0 2 4 6 8 10 12 14 16 Emission level
(units)
21

22. Marginal Benefits of Emissions
Dollars per unit of Are likely to vary between different
emission industries.
Steep MSC Suppose emission level is
abated by 1 unit (6 to 5 units)
Steep MSC – Small changes in abatement
add greatly to benefits (A to B = great
reduction in costs = great increase in
benefits)
C A
Flat MSC Flat MSC – Small changes in abatement
add very little to benefits (A to C)
B
0 2 4 6 8 10 12 14 16 Emission level
(units)
22

23. Policies for Reducing Emissions
 Emissions standards
 Legal limit on emission level
Pigovian
 Emissions fees
 Charge levied on each unit of emission
 Transferable emission permits
 Government determines the socially
efficient/optimal level of emissions – standard
is set
 Government issues a number of permits that Coasian
will achieve this standard – fees have to be
paid to purchase permits
 Permits are transferable among firms
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24. Policies for Reducing Emissions:
How do we Evaluate each Option?
The best policy option will depend on:
 How the cost of abatement changes as emissions levels
are reduced
 How the benefits of abatement change as emissions
levels are reduced
 Whether the MCA of firms are similar or different
 What information is available or can be accurately
determined
24

25. Policies for Reducing Emissions
Fees
Emission fee = charge levied on each unit of a
firm’s emissions.
The emissions fee can be at a flat rate, or
progressive
25

26. Policies for Reducing Emissions:
Suppose the government wants to reduce total
Fees emissions by 16 units and impose a fee on each
unit of emissions=$3
Dollars per unit of Scenario
emission 1. Flat MSC - Small changes in abatement
MCA1 add very little to benefits (to simplify, assume
a horizontal MSC)
2. 2 firms, each with a different MCA (Firm 1 -
MCA2 MCA1; Firm 2 - MCA2).
Fee at F=$3
Firm 1 (higher MCA) reduces emissions by 6 units
Firm 2 (lower MCA) reduces emissions by 10 units
Total = 16 units
3
0 2 4 6 8 10 12 14 16 Emission level
Fees - Firm 1
(units)
Fees - Firm 2 26

27. Policies for Reducing Emissions
Standards
A standard is a legal limit on the emissions of
a firm.
Significant monetary penalties are imposed if
the legal limit is exceeded.
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28. Policies for Reducing Emissions:
Standards
Dollars per unit of
emission
MCA1
Scenario
1. Flat MSC - Small changes in abatement
MCA2 add very little to benefits (to simplify, assume
a horizontal MSC)
2. 2 firms, each with a different MCA (Firm 1 -
MCA1; Firm 2 - MCA2).
Standard at E=8 units
Both firms reduce emissions
Standard - Firm 1&2 by 8 units each (total = 16)
0 2 4 6 8 10 12 14 16 Emission level
(units)
28

29. Policies for Reducing Emissions
Comparing Standards & Fees
Objective: To reduce total emissions by 16
units from the current level of 32 units.
Policy Alternatives:
1) Standards: A legal limit of 8 units per firm
2) Fees: A flat fee of $3 per unit of emissions.
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30. Policies for Reducing Emissions:
Scenario
The Case for Standards over Fees 1. Flat MCA – Small changes in
abatement add little to costs
MSC 2. Steep MSC – Small changes in
abatement add greatly to benefits
C 3. All firms have identical MCA
Optimal fee is $8
Fee per unit of
emission What if the fee is wrongly set at F=$7
E (12.5% error)?
MCA
10 ABC is the net social cost caused by the
error
A
8 Optimal standard is E*=8.
B
D What if the standard is wrongly set
6 at E=9 units (12.5% error)?
ADE is the net social cost caused
4 by the error
2 ADE<ABC
0 2 4 6 8 10 12 14 16 Emission level (units)
30

31. Policies for Reducing Emissions:
The Case for Standards over Fees
Standards are preferable over fees when …
1. When the MCA curve is flat (Small changes
in abatement add very little to costs)
2. When the MSC curve is steep (Small changes
in abatement add greatly to benefits)
3. Firms have the same/similar MCA
4. When you are more concerned about the
reduction in emissions (set standard at 8 units
in this case) than with the cost of abatement
when there is general uncertainty

32. Policies for Reducing Emissions:
The Case for Fees over Standards
Dollars per unit of Fee at $3
emission Cost-minimising: emissions are reduced to the
required level at a cost of $3 per unit
MCA1
– Firm 1 (higher MCA) reduces less emissions
– Firm 2 (lower MCA) reduces more emissions
MCA2
Standard at E=8 units
4.5 Achieves the same
reduction in emissions but
at a higher cost:
– Firm 1 incurs costs=$4.5
3
per unit to move from 10 to
8
2 – Firm 2 would incur a cost
of only $1 per unit to move
from 8 to 6
0 2 4 6 8 10 12 14 16 Emission level
(units)
32

33. Policies for Reducing Emissions:
The Case for Fees over Standards
Fees are preferable over Standards when …
1. Firm have different MCAs => Achieve same
reduction in emissions as standards at
lower cost
2. When the MCA curve is steep (Small
changes in abatement add greatly to
costs)
3. When the MSC curve is flat (Small changes
in abatement add very little to benefits)

34. Policies for Reducing Emissions:
The Case for Fees over Standards
Fees are preferable over Standards when …
4. When you want to give firms an incentive
to install new equipment to reduce
emissions
5. When the cost of abatement is a more
important consideration than the reduction
in emissions that is achieved when there is
general uncertainty

35. Policies for Reducing Emissions:
Transferable Permits
 Transferable permits grant property rights over emissions.
The policy maker must decide on the total level of
emissions and ensure that sufficient numbers of permits
are issued to achieve the efficient emission level
 They are preferable when…
 The values of the MCA or MSC are uncertain
 The MCA of firms are different
 Firms with high MCA will purchase permits from firms with low
MCA – results in cost minimisation (similar to fees)
 Transaction costs are low (e.g. Permits can be traded)
35

36. Policies for Reducing Emissions: The Case
for Transferable Permits
In the case of both fees and standards, we need to know:
 The benefits of abatement (MSC)
 The costs of abatement (MCA)
 The cow example:
 MSC or benefit of abatement is equivalent to the value
to the crop producer of using the land
 MCA is the cost borne by the cattle producer if it
reduces its use of the land
 To achieve an efficient outcome using fees or standards
the policy maker would need to know the MCA and
MSC
36

37. Policies for Reducing Emissions: The Case
for Transferable Permits
 In an transferrable permits system the producers may
be allocated permits relating to the use of the land.
 They can trade these according to the value they place
on the land
 If there are no transaction costs this should result in
an efficient use of the resource/ level of “emissions”
 The policy maker doesn’t need detailed knowledge of
MCA and MSC
37

38. Application: Transferable Permits
Imagine there are only 2 firms in the local
area.
The government has decided on the total
level of pollution for the area=11,000 units of
emissions and plans release this number of
permits
38

39. Application: Transferable Permits
Firm A has a strong demand for the permits
(Qd=10,000-10P)
Firm B’s demand is weaker (Qd=10,000-20P)
Total ‘market’ demand for permits is the sum of
individual demand (Qd=20,000-30P)
The price of permits will be determined where
supply=demand ($300)
39

40. Application: Transferable Permits
•At the market price:
•Firm A’s demand for permits will be 7000:
•Firm B’s demand for permits will be 4000
•If the government initially allocated the firms an
equal number of permits each (5,500), trading in
permits is likely to occur between the firms
•Similar to fees, differences in emissions will occur
between firms according to their costs of abatement
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41. Learning Outcomes
 Understand the concept of externalities and why
they are a source of economic inefficiency
 Positive externalities
 Negative externalities
 Policies to reduce emissions
 Emission standards
 Emission fees
 Transferable emission permits
41

42. A Past Exam Question on Externalities
 a) Compare and contrast the following three
mechanisms for treating pollution externalities
when the costs and benefits of abatement are
uncertain: (i) an emissions fee, (ii) an emissions
standard, and (iii) a system of transferable
emissions permits. (15 marks)
42

43. A Past Exam Question Given the question is 15 marks you
should attempt to draw diagrams
on Externalities to get the full marks
Fees Standards Transferable permits
Charge levied Legal limit Level of emissions
on each unit of on emission specified; marketable
Define emission level permits allocated among
firms; firms with high
MCA purchase permits
from firms with low MCA
When small changes When small changes When both cost and
The case in abatement add in abatement add benefits are uncertain
for… greatly to costs and little to costs and
little to benefits greatly to benefits
When firms have When firms have When firms have
varying MCA identical MCA varying MCA
Need to Value of MCA & Value of MCA & Total level of
know ... MSC MSC emissions
Conclusion Among the 3 options, transferable permits are the best
solution when costs and benefits are uncertain
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