Externalities
(“neighborhood effects”, spillovers) =
the actions of one agent affect another agent’s welfare by means other than
through trade.
Economists who paid central roles in developing this
topic: Sidgwick 1887, Alfred Marshall 1890,
A.C. Pigou
1920 (Supply & Demand graphs with marginal damage curves), Ronald
Coase 1960 (control via property rights), Kenneth Arrow 1972 (markets
for pollution)
Negative externalities = Pollution, noise, ugliness (Prairie
Moon?), emotional distress
Positive externalities = Beauty, (good) music, clearing
swamps to prevent mosquitoes.
Private agents will produce and buy up to the point were
Private Marginal Benefit = Private Marginal Cost. (At this point there is zero dead weight loss.)
Ideally, society chooses a quantity to produce where:
Marginal Social Cost = Marginal Social Benefit.
Note: We can find
the socially optimal quantity be either adding MD to MC, or subtracting MD from
MB. Either gives the same result for
the optimal social quantity produced and sold.
How do we control externalities to minimize DWL? We have made great progress on this in the
last thirty years.
Six
Methods for Controlling Externalities
1)
Command and control, Regulation - Set pollution to zero or some
other low level by regulating how much firms in an industry can produce, or how
they produce it.
If
regulators can only observe output, how would they mandate cutbacks in
production to reduce pollution? Optimally, firms that can reduce pollution
cheaply in terms of lost output (dirty plants) should do so, and firms where
the loss in output would be high for a given pollution reduction (clean plants)
should reduce less. Clearly in such a
case it would be sub-optimal for both firms to cut back by the same amount or
percentage.
What
difficulties might arise in running such a system? Would getting firms in concentrated industries to jointly reduce
production lead to more oligopoly profits?
Would each firm that tried to enter the market have to go to the
regulators to find out how much it would be allowed to produce? If entry would
reduce prices and profits for firms in the industry, incumbents in the business
might even press for more stringent standards to keep firms out of the
business. This has actually happened.
2)
Pigouvian taxes - Unit tax on firm output equal to the marginal
damage created by the firm's output. This will increase marginal private costs
to the point where they are equal to marginal social costs. (Pigouvian taxes
were worked out by A.C. Pigou. Arthur
Cecil Pigou, who you just know got beat up in gym class every day. At Cambridge, he was a rival of John Maynard
Keynes.)
Such
a tax would increase the price of the "under-priced" social resource,
and simulate a market where the market fails to exist due to a lack of property
rights. In effect, the tax attempts to serve as a price for the un-priced input
(such as clean air), as judged by the quantity of output. It would probably be better to tax the
pollution created directly but that can be very hard (expensive) to do. As such, since we can’t tax the externality
directly, this is a “second best” solution.
It
is always difficult to calculate marginal damage, particularly when the
marginal damage may not be a linear function of output as it is in this
example. The optimal Pigouvian tax would be equal to the marginal damage that
would be created if the firm were producing at its optimal level of output.
One
very nice feature of Pigouvian taxes is that they bring in tax revenue
(although these taxes may be expensive to enforce). These taxes can even be
used to encourage beneficial externalities as well. Evanston could put a tax on
people who do not plant flowers in their yards.
3)
Pigouvian subsidies - Pay unit subsidy to firm for each unit it reduces
its output. The subsidy would be equal to the marginal damage created by firm
output to encourage firm to reduce its production of the pollution causing
good.
This
would increase the opportunity cost of producing goods. A firm would know that for every unit it
produces, it would lose (say) $5 in subsidy.
This
is a pretty stupid idea really. It is expensive to come up with the revenue for
these subsidies and this increases taxation DWL in other markets. It may cause
firms to enter market just to get the subsidy. This effect could be reduced in
the short run by "grand-fathering" in and limiting the subsidy to the
original outputs of incumbent firms in the market. Certainly, firms in the
industry prefer Pigouvian subsidies to Pigouvian taxes.
There
are government sponsored "buy-back" programs for guns that are
examples of a Pigouvian subsidy.
(LaToya Jackson held some concerts where a person could be admitted by
turning in a gun. I wonder if many of
the people who turned in guns for those tickets later regretted not having a
gun when LaToya began to sing and there were long lines at the exits. I wonder if any of them where unsatisfied
with the concert and demanded their guns back.
My guess is that the real criminals probably held on to their weapons
anyway. Oh well, at least there are fewer stray guns around for kids to use as
playthings. Illinois considered a buy-back program to get high-polluting old
cars off the streets. However, they realized that any price they would set
would bring lots of currently dead cars out of junk yards just to get the
subsidy. The supply of cheap junk cars is highly elastic. It is not even clear
that this is a good policy. It pollutes to make a car and many of the old
junkers are driven very little. So if people turned in their old cars and
bought new ones, pollution might even go up.)
4)
Auction Pollution Permits - Calculate how much pollution is acceptable and
sell rights to produce this pollution.
The
Clean Air Act of 1990 created
a market in pollution rights. Some people see buying a right to pollute as
being akin to buying a right to murder someone. However, it has its advantages.
It is a flexible system where quantities are easily altered. Market based
approaches are nice in this way, environmental groups could just buy up these
permits and give us zero pollution (except for Volvo's). As compared to strict
regulation, this program can shelter jobs from changes in environmental
regulations and allow time for adjustments to be made.
However,
it is very hard to monitor compliance and so far works only on the pollution
from firms. To date, this approach does nothing about the biggest polluters of
all, automobiles. If policing can be worked out, this system may make for a
practical method of organizing international coordination on pollution. It is
very tough to set regulations and taxes between nations but buying and selling
is quite common. Rather than having the rich countries tell the poor ones not
to pollute, the rich countries could pay them not to.
If
set to the optimal amount and adequately policed, this system will drive the
price of this "under-priced" good to its "true" value,
which should be equal to the Pigouvian tax.
Making the firms pay for the pollution they have to "buy"
would shift their supply curves upward. If the shift is too little, DWL will
remain. If the shift is too far, DWL will be created.
One
potential problem with this sort of policy is that it is very sensitive to
local concentrations. Reducing some
pollution in fairly clean Kansas with a tradeoff of increased pollution in
dangerously smoggy LA is a bad outcome.
Examples
In
1992 Mobil Oil paid $3 million for the right to emit a certain amount of
pollutants in Torrance, California. General Motors sold the rights to Mobil
after it closed down its plant in the town. GM's saleable rights were less than
the pollution it previously emitted and the profit from the sale was an
incentive to close the old, polluting plant. Commodities exchanges like
Chicago's Board of Trade have begun selling rights and futures for these
markets. By 1995, the Clean Air Act will force all power plants in the US to
pay for the right to emit sulfur dioxide. The credits are denominated in pounds
of pollution per day and typically sell for $1,000 to $4,000 per pound. This
has become a major expense of opening a new plant.
In
1992, the Tennessee Valley Authority paid nearly $3,000,000 to a Wisconsin
utility for the right to emit 10,000 tons of sulfur dioxide. This is the
cheapest way for the two utilities to cut the cost of their pollution. This
system also makes pollution reducing devices like stack scrubbers financially
attractive to firms.
5)
Internalized the Externality
Economically connect the producers of the externality with those who
feel its effect. For instance, get the
up—stream polluting paper mill to merge with the down stream fishery. Then losses to the fishery will hurt the
company and so it will have incentives to try to reduce the pollution from its
paper mill.
6)
Property rights, Coase
Theorem
If
transactions costs don't overwhelm gains, saleable property rights will bring
social resources to their socially efficient uses, even when there are
externalities. Social welfare will be maximized. This is a simple variant on
the pollution permit auction.
Questions,
comments, typos? mwitte@northwestern.edu