PE slide 4.ppt

8/14/2019 PE slide 4.ppt

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Externality Problem: Harvey Rosen Ch. 5

Pecuniary Externality : When the effects of the actions of one

economic entity on the other are transmitted through

changes in the market price there is pecuniary externality.

Example: Rural-urban migration increases the rents of urban

houses. This affects house owners positively and negatively

affects those people who were living in rented house

previously .


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Real Externalities: A real externality occurs when the actions

of one economic entity directly affects the other economic

entity. In this case effects are not transmitted through the

market.

An externality is a consequence of the failure to establish

property rights. Owned resources are used efficiently

however common property resources are misused.

Externalities can be produced by consumers as well as firms.

Externalities are reciprocal in nature.

Public good is a special case of externality.


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MPC+MD = MSC

MD

MPC

Rs.

QUANTITYQS Qe

e

fg

h

a

bc

d

MB

Externality Problem

Socially

efficient

output

Actual

Output

1. In the case of negative externality

market does not bring socially efficient

production level.

2. If output is reduced from Qs to Qe

Bart looses some profit shown by

triangle egh.

3. For each unit of output reduced Lisa

gains an amount equal to her marginal

damage (MD).

4. Her total gains are measured by area

efgh.

5. Hence there are net gains to society

shown by triangle efg.

Bart (Factory) and Lisa (Fishery)


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Externality Problem: The Coase Theorem

MPC+MD = MSC

MD

MPC

Rs.

Quantity

per year

QS Qe

MB

Socially

efficient

output

Actual

Output

Bart (Factory) and Lisa (Fishery)Bargaining and Coase theorem:

1. When property rights are assigned

people respond to the externality by

bargaining. It is possible after thebargaining that the output reach at

socially efficient level Qs.

2. Bart would agree to reduce his

output so long he gets a payment

exceeding (MB-MPC).3. Lisa would be paying to Bart for

output reduction so long her

payments are less then MD for each

unit.

4. Output reduction will go on so longMD > (MB-MPC).

5. The amounts paid and received

depend on their relative bargaining

strength however the final output

level will be at Qs


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Externality Problem: The Coase Theorem

Even if the property rights are in favour of Lisa final

outcome of bargain would be at socially efficient level. The

difference now is that Bart will have to pay a price to Lisa to

produce.

Two necessary assumptions:1. The cost of bargaining to the parties are low

2. The owners of the resources can identify the source of

damage to their property and legally prevent damage.

Under these assumptions the efficient outcome is achieved

independently of who is assigned the property rights. This

is known as the Coase Theorem.


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Pigouvian Tax

MPC+MD = MSC

MD

MPC

Rs.

Q per yearQ*

d

c

MB

a

b

MPC+ cd

Pigouvian Tax

RevenuesA Pigouvian tax is a tax levied on each unit of

polluters output in an amount just equal to

the marginal damage it inflicts at the efficientlevel of output.

Barts effective marginal cost increases after

the tax (MPC to MPC + cd).

For profit maximizationMPC + cd = MPC which occurs at Q* output.

Total tax revenues are cd OQ* = area abcd

Should Lisa be compensated now? No,

because that would lead to overfishing.

Problem: How to calculate MD so how to find

correct rate of tax?

How to know who is polluting and in what

quantity?

O


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Pigouvian Subsidy

MPC+MD = MSC

MD

MPC

Rs.

QS Qe

g

d

c

MB

f

h

a

b

MPC+ cd

Q per year

Assuming fixed number of firms,

Pollution can be regulated by paying some

money as subsidy to the polluter for notpolluting or for not producing beyond the

efficient level.

The Pigouvian subsidy increases to

effective production cost of the polluters.

A subsidy, at a uniform rate equal to the

MD at efficient level of output (cd), for

not producing should be given.

After subsidy Barts production costincreases so that his perceived marginal

cost schedule becomes ( MPC + cd ).

Hence Bart will choose to produce at Qs

and receive a subsidy equal to dfhc.


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Problems with the subsidy scheme:

How to calculate MD so how to find correct rate of subsidy?

How to know who is polluting and in what quantity?

The subsidy will increase the profitability of the polluting firm. Hencethere is an incentive for other firms to locate on the river bank. As a

result there will be so many firms that the actual amount of pollution

will increase.

Subsidies to polluters may be called unethical.

It may be noted here that efficient outcomes may be associated with

different income distributions. (analogous to infinite number of efficient

allocations in the Edgeworth Box.

Pigouvian Subsidy


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Rs.

p

eryear

Right to produce

sulfur oxide (Parts

per 100 million

per year)

DL

SL

Z*

Market For Clean Water & Air etc.

Creating market for certain resources for which

market do not exist (missing market).

Govt. may choose optimal amount of pollution (Z*

associated with output level Qs) and then sell

pollution permits to the firms in open market.

Market supply of permits is therefore vertical.

Price P* shows the value of one permit to

producers to pollute.

The pollution rights Z* may alternatively be

assigned to a various firms that can then sell them in

open market on bidding basis.

Efficiency remains the same but distributional

effects change. In the first scheme the sale proceeds

goes to the govt. while in the second one it goes to

those firms who were assigned property rights.

P*


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Which scheme is better: tax, subsidy or permit?

a) Given the difficult associated with the tax and subsidy

schemes the policy of devising pollution permit has anadvantage over them.

b) With the permit scheme the uncertainty about the

ultimate level of pollution is less.

c) Under the permit scheme if the polluting firms are profit

maximizers they will have an incentive to adopt cost

minimizing technology.

d) In case of inflation the price of the pollution permits would

be automatically adjusted. However changing the tax rate

require a lengthy administrative procedure.


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e) Since MPC, MB and MD schedules are not known to govt.

with uncertainty there will remain an element of

arbitrariness in determining the tax or subsidy rate.

f) If the pollution standards are to be chosen arbitrarily it

would be better to choose the permit scheme.

g) However there may occur a problem even with the

pollution permit scheme. The incumbent firms might be

able to buy pollution rights in excess of their cost

minimizing requirements to deter the other firms to enter

the market.


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REGULATING POLLUTERS

Rs.

o

d

Z* X* X1= Z1

MB1

MB2

MPC1 = MPC2

(MPC1+ d)= (MPC2 + d)

QUANTITY PER

YEAR

Under regulation each polluting firm is simply

ordered to reduce the level of pollution up to a

certain level otherwise face legal sanctions.

This policy would become inefficient when

there are multiple firms different from each

other. An example is sighted in the diagram

here.

In the absence of the regulation both the

firms are producing same output (X1= Z1).

The regulation in place require them to

produce where their respective MB intersects

(MPC+d). Where it is known that MD at

efficient level of O/P is d. Hence their efficient

outputs are X* and Z*.

The cut in outputs of X and Z are different. If

firms are ordered to decrease emissions by

equal amounts, some firms produce too muchand others too little.


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Positive Externality

MC

Rs.

RESEARCH PER YEAR

MSB = MPB + MEB

MPB

MEB

a

b

a'

b'

R1 R*o

When an individual or firm

produces positive externality the

market will under provide the activityor good. An appropriate subsidy can

solve the problem.

A subsidy is appropriate only when the

producers of positive externality are

unable to capture full marginal return.

The subsidy should be provided

judiciously because it has distributional

implications. The income redistributions

takes place from the taxpayers to the

recipients of the subsidies.

Look at the desirability of the

distributional implications from subsidy on

the basis of the value judgments embodied

in the SWF.For examples of +ve ext. please see the

texts by Rosen and Cullis & Jones.

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