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ECN104 Notes - Chapter 10 and 11

10 Pages

Course Code
ECN 104
Tsogbadral Galaabaatar

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Chapter 10: Externalities • Questions o What is an externality? o Why do externalities make market outcomes inefficient? o What public policies aim to solve the problem of externalities? o How can people solve the problem of externalities on their own? Why do such private solutions not always work • Introduction o One of the principles from Chapter 1:  Markets are usually a good way to organize economy activity  In absence of market failures, the competitive market outcome is efficient, maximizes total surplus o One type of market failure  Externality: the uncompensated impact of one person’s actions on the well-being of a bystander • Can be negative or positive, depending on whether impact on bystander is adverse or beneficial o Self-interested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient o Another principle from Chapter 1:  Governments can sometimes improve market outcomes  In presence of externalities, public policy can improve efficiency • Examples of Negative Externalities o Air pollution from a factory o The neighbour’s barking dog o Noise pollution from construction projects o Health risk to others from second-hand smoke • “Internalizing the Externality” o Altering incentives so that people take account of the external effects of their actions o When market participants must pay social costs, market equilibrium = social optimum  Example: $1/gallon tax on sellers makes sellers’ costs = social costs o Imposing tax on buyers would achieve the same outcome; market quantity = social optimum quantity) • Examples of Positive Externalities o Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you o Research and Development creates knowledge others can use o People going to college raise the population’s education level, which reduces crime and improves government • Positive Externalities o If the presence of a positive externality, the social value of a good includes:  Private value – the direct value to buyers  External benefit – the value of the positive impact on bystanders o The socially optimal Q maximizes welfare:  At any lower Quantity, the social value of additional units exceeds their cost  At any higher Quantity, the cost of the last unit exceeds its social value • Effects of Externalities: SUMMARY o If negative externality  Market quantity larger than socially desirable o If positive externality  Market quantity smaller than socially desirable o To remedy the problem, “internalize the externality”  Tax goods with negative externalities  Subsidize goods with positive externalities • Public Policies Toward Externalities o Two approaches:  Command-and-control policies regulate behaviour directly.  Examples • Limits on quantity of pollution emitted • Requirements that firms adopt a particular technology to reduce emissions  Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own  Examples • Corrective taxes and subsidies • Tradable pollution permits • Corrective Taxes and Subsidies o Corrective Tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality o Also called Pigovian taxes after Arthur Pigou (1877-1959) o The ideal corrective tax = external cost o For activities with positive externalities, ideal corrective subsidy = external benefit o Other taxes and subsidies distort incentives and move economy away from the social optimum o Corrective taxes and subsidies  Align private incentives with society’s interests  Make private decision-makers take into account the external costs and benefits of their actions  Move economy toward a more efficient allocation of resources • Corrective Taxes vs. Regulations o Different firms have different costs of pollution abatement o Efficient outcome: Firms with the lowest abatement costs reduce pollution the most o A pollution tax is efficient:  Firms with low abatement costs will reduce pollution to reduce their tax burden  Firms with high abatement costs have greater willingness to pay tax o In contrast, a regulation requiring all firms to reduce pollution by a specific amount not efficient o Corrective taxes are better for the environment:  The corrective tax gives firms incentive to continue reducing pollution as long as the cost of doing so is less than the tax  If a cleaner technology becomes available, the tax gives firms an incentive to adopt it  In contrast, firms have no incentive for further reduction beyond the level specified in a regulation • Example of a Corrective Tax: The Gas Tax o The gas tax targets three negative externalities:  Congestion – the more you drive, the more you contribute to congestion  Accidents – larger vehicles cause more damage in an accident  Pollution – burning fossil fuels produces greenhouse gases • Tradable Pollution Permits o A tradable pollution permit system reduces pollution at a lower cost than regulation  Firms with low cost of reducing pollution do so and sell their unused permits  Firms with high cost of reducing pollution buy permits o Result: pollution reduction is concentrated among those firms with lowest costs • Corrective Taxes vs Tradable Pollution Permits o Like most demand curves, firms’ demand for the ability to pollute is a downward-sloping function of the “price” of polluting  A corrective tax raises this price and thus reduces the quantity of pollution firms demand  A tradable permit system restricts the supply of pollution rights, has the same effect as the tax o When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely. • Objections to the Economic Analysis of Pollution o Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment o However, people face tradeoffs.  The value of clean air and water must be compared to their cost o The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment • Private Solutions to Externalities o Types of private solutions:  Moral codes and social sanctions • Example: the “Golden Rule”  Charities • Example: Salvation Army  Contracts between market participants and the affected bystanders o The Coase Theorem:  If private parties can bargain over the allocation of resources without cost, they can solve the externalities problem on their own  Example: • Dick owns a dog named Spot • Negative Externality: Spot’s barking disturbs Jane, Dick’s Neighbour • The socially efficient outcome maximizes Dick’s and Jane’s well-being o If Dick values having Spot more than Jane values peace & quiet, the dog should stay • Coase theorem: The private market will reach the efficient outcome on its own… • CASE 1: o Dick has the right to keep Spot o Benefit to Dick of having Spot = $500 o Cost to Jane of Spot’s barking = $800 o Socially efficient outcome: Spot goes away o Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off o Private outcome = socially efficient outcome • CASE 2: o Dick has the right to keep Spot o Benefit to Dick of having Spot = $100 o Cost to Jane of Spot’s barking = $800 o Socially efficient outcome: Spot stays o Private outcome: Jane not willing to pay more than $800, Dick not will to accept less than $1000, so
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