Externalities and inefficiency | Microeconomics | Expertsmind.com

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  • The fee may be wrongly set due to political economy reasons – difficult to get parties to pay high fees.
  • Externalities and inefficiency | Microeconomics | Expertsmind.com

    1. 1. www.Expertsmind.com Economics Assignments | Expertsmind.com 1
    2. 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 2
    3. 3. Externalities & Inefficiency An Externality isAn 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. 4. Externalities-taxonomy Externalities can arise in  Consumption decisions  Production decisions and can be either  Positive (beneficial), or  Negative (harmful). 4
    5. 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. 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. 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. 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. 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 9
    10. 10. Negative Externalities & Inefficiency $ MSC MC P=MR MEC Optimal Market q outcome outcome 10
    11. 11. Negative Externalities & Inefficiency $ MSB D MC MSB Optimal Market q outcome outcome 11
    12. 12. Pigou Suggested that the way to proceed is1) Negative Externality – impose tax on firm equal to value of MEC – firms will then respond to MSC=MC+MEC and produce the optimal level2) 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. 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. 14. The Coasian perspective $ Damage caused (MEC) d g e f Benefit to firm a=0 b c pollutant
    15. 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. 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. 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. 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. 19. Application: policy on emissionsMSC 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 costMCA (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 19
    20. 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 requiredfirm can increase emissions firm should be required to to restrict emissions,some more restrict emissions some more E=18 units where MCA=0 20
    21. 21. Marginal Costs of AbatementDollars per unit ofemission 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. 22. Marginal Benefits of EmissionsDollars per unit of Are likely to vary between differentemission 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. 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 23
    24. 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. 25. Policies for Reducing EmissionsFeesEmission fee = charge levied on each unit of a firm’s emissions.The emissions fee can be at a flat rate, or progressive 25
    26. 26. Policies for Reducing Emissions: Suppose the government wants to reduce totalFees emissions by 16 units and impose a fee on each unit of emissions=$3Dollars per unit of Scenarioemission 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. 27. Policies for Reducing EmissionsStandardsA standard is a legal limit on the emissions of a firm.Significant monetary penalties are imposed if the legal limit is exceeded. 27
    28. 28. Policies for Reducing Emissions:StandardsDollars per unit ofemission 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. 29. Policies for Reducing EmissionsComparing Standards & FeesObjective: 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 firm2) Fees: A flat fee of $3 per unit of emissions. 29
    30. 30. Policies for Reducing Emissions: ScenarioThe 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 $8Fee per unit ofemission 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. 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. 32. Policies for Reducing Emissions:The Case for Fees over StandardsDollars per unit of Fee at $3emission 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 units4.5 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. 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. 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. 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. 36. Policies for Reducing Emissions: The Casefor Transferable PermitsIn 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. 37. Policies for Reducing Emissions: The Casefor 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. 38. Application: Transferable PermitsImagine there are only 2 firms in the localarea.The government has decided on the totallevel of pollution for the area=11,000 units ofemissions and plans release this number ofpermits 38
    39. 39. Application: Transferable PermitsFirm 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 ofindividual demand (Qd=20,000-30P)The price of permits will be determined wheresupply=demand ($300) 39
    40. 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 anequal number of permits each (5,500), trading inpermits is likely to occur between the firms•Similar to fees, differences in emissions will occurbetween firms according to their costs of abatement 40
    41. 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. 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. 43. A Past Exam Question Given the question is 15 marks you should attempt to draw diagramson Externalities to get the full marks Fees Standards Transferable permits Charge levied Legal limit Level of emissions on each unit of on emission specified; marketableDefine 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 andThe case in abatement add in abatement add benefits are uncertainfor… 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 MCANeed to Value of MCA & Value of MCA & Total level ofknow ... MSC MSC emissionsConclusion Among the 3 options, transferable permits are the best solution when costs and benefits are uncertain 43

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