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Chapter 10

Chapter 10 - Externalities.pdf

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Enrico Moretti

Chapter 10: Externalities • previously saw that market typically allocates resources efficiently • however, sometimes fail and government intervention improves market outcomes • externality: arises when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives any compensation for the effect • negative externality: when the externality affects the bystander negatively • positive externality: when the externality affects the by stander positively I. Externalities and Market Inefficiency • examination of how externalities affect economic well-being • analysis shows why externalities cause markets to allocate resources inefficiently A. Welfare Economics:ARecap • e.g. aluminum market • demand curve reflects the willingness to pay of the marginal buyer; i.e. it shows the value to the consumer of the last unit of aluminum bought • supply curve reflects the costs of producing aluminum; i.e. it shows the cost to the producer of the last unit of aluminum sold • in the absence of government intervention, price adjusts to balance supply and demand • maximizes total value to consumers who buy and use aluminum minus total costs to the producers who make and sell aluminum B. Negative Externalities • aluminum factories emit pollution: each unit of aluminum, certain amount of smoke enters atmosphere and creates health risk for those who breathe air • this is a negative externality • because of the externality, the cost to society of producing aluminum is larger than the cost to aluminum producers • for each unit of aluminum produced, social cost includes private costs of aluminum producers plus costs of those bystanders affected • social-cost curve is above the S curve because takes into account the external costs imposed on society by aluminum production • difference in two curves reflects cost of pollution emitted • optimal Q produced is where the D curve intersects the social cost curve • do not produce more than this level because social cost of producing additional aluminum exceeds the value to customers • how to decrease consumption/raise P? • tax aluminum producers • the tax would shift the supply curve for aluminum upward by size of tax • if tax accurately reflect external cost of pollutants released into atmosphere, new supply curve would coincide with social-cost curve • use of such a tax is called internalizing the externality because gives buyers and sellers in market incentive to take into account external effects of actions • in essence causes producers to take costs of pollution into account when deciding how much aluminum to supply because tax makes them pay for external costs • because market price reflects tax on producers, consumers of aluminum have incentive to use smaller quantity C. Positive Externalities • e.g. education • although to large extent, education benefit is private, has positive externalities such as: • more education population leads to more informed voters, which means better government for everyone • more educated population tends to mean lower crime rates • more educated population may encourage development and dissemination of technological advances, leading to higher productivity and wages for everyone • because social value is greater than private value, the social value curve lies above the demand curve • optimal quantity is where social-value curve and the supply curve (which represents costs) intersect • thus, socially optimal quanity is greater than Q determined by private market • government can correct by inducing market participants to internalize the externality • subsidizing goods/services helps increase Q to socially optimal level; for education, government subsidizes public schools and government scholarships II. Public Policies Towards Externalities • this section considers various governmental solutions to externalities • generally, governments can respond in two ways: • command-and-control policies: policies that regulate behaviour directly • market-based policies: policies that provide incentives so that private decision makers will choose to solve the problem on their own A. Command-and-Control Policies: Regulation • government can remedy externality by making certain behaviours either required or forbidden • e.g. it’s crime to dump poisonous chemicals in water supply • in this case, external costs to society far exceed benefits to polluter • thus, government institutes a command-and-control policy that prohibits act altogether • however, some situations not as simple • impossible to prohibit all polluting activity • e.g. virtually all forms of transportation produce some undesirable polluting by-products • not sensible to ban all transportation • create environmental regulations that dictates levels of allowed pollution • in all cases, to design good rules, government regulators need to know details about specific industries and about alternative technologies that those industries could adopt • information often difficult for government regulators to obtain • results in inefficiency B. Market-Based Policy 1: Corrective Taxes and Subsidies • corrective taxes: taxes enacted to deal with the effects of negative externalities • also called Pigovian taxes afterArthur Pigou, early advocate of their use • economists usually prefer corrective taxes to regulations because can reduce pollution at lower cost to society • e.g. 2 factories – paper mill & steel mill – that each dump 500 tons of flop into river annually; EPAdecides that it wants to reduce the amount of pollution • considers 2 solutions: • regulation: EPAtells each factory to reduce its pollution 300 tons of glop next year • requires every factory reduce by same level • an equal reduction, however, is not necessarily the least expensive way to clean up water • possible that paper mill can reduce pollution at lower cost than steel mill • if so, paper mill would respond to tax by reducing pollution substantially to avoid tax whereas steel mill would respond by reducing pollution less and paying the tax • corrective tax: EPAlevies tax on each factory of $50,000 for each ton of glop it emits • higher the tax, larger the reduction in pollution • if tax high enough, factories will close down altogether, reducing pollution to 0 • more efficient • better for environment • under command-and-control policy, no reason to reduce emission further once reached target • by contrst, tax gives factories incentive to develop cleaner technologies • corrective tax essentially puts price on the right to pollute • just as markets allocate goods to buyers who value them most highly, corrective tax allocates pollution to those factories that face the highest cost of reducing it • corrective taxes unlike most other taxes • most taxes distort incentives and move allocation of resources away from social optimum • the reduction in economic well-being (that is, in consumer and producer surplus) exceeds the amount the government makes in revenue resulting in DWL • in contrast, when externalities present, society cares about well-being of affected bystanders; corr
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