Incentives against Pollution and Incentives for Safety Juergen Bracht University of Aberdeen, Scotland Department of Economics juergen.bracht@abdn.ac.uk
Incentives against Pollution -- Objectives • What externalities are and why they can lead to inefficiency and government intervention in a market. • The difference between negative, positive and network externalities • The importance of the Coase theorem, which explains how private individuals can sometimes solve externalities • Why some government policies to deal with externalities — such as emissions taxes, tradable permits, or Pigouvian subsidies — are efficient, but others — like environmental standards — are inefficient
Economics of Pollution • Pollution is a bad thing. Yet most pollution is a side effect of activities that provide us with good things. Our air is polluted by power plants that generate the electricity that lights our cities, and our rivers are damaged by fertilizer runoff from farms that grow our food. • Pollution is a side effect of useful activities, so the optimal quantity of pollution isn’t zero. • Then, how much pollution should a society have? What are the costs and benefits of pollution?
Cost and Benefits • The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution. • The marginal social benefit of pollution is the additional gain to society as a whole from an additional unit of pollution. • The socially optimal quantity of pollution is the quantity of pollution that society would choose if all the costs and benefits of pollution were fully accounted for.
The Socially Optimal Quantity of Pollution Marginal social cost, marginal social benefit Marginal social cost, MSC , of pollution Socially optimal point O $200 Marginal social benefit, MSB , of pollution 0 Q Quantity of OPT pollution emissions (tons)
Pollution: An External Cost • An external cost is an uncompensated cost that an individual or firm imposes on others. • An external benefit is a benefit that an individual or firm confers on others without receiving compensation. • Pollution is an example of an external cost , or negative externality; in contrast, some activities can give rise to external benefits, or positive externalities . • External costs and benefits are known as externalities. • Left to itself, a market economy will typically generate too much pollution because polluters have no incentive to take into account the costs they impose on others.
A Market Produces Too Much Pollution Marginal social cost, marginal social benefit MSC of pollution Marginal $400 social cost at Q MKT The market outcome is 300 inefficient: marginal social cost O Optimal of pollution 200 Pigouvian tax exceeds on pollution marginal social benefit 100 MSB of pollution Marginal social benefit at 0 Q Q Q Quantity of pollution Q MKT OPT H M K T emissions (tons) Socially optimal Market-determined quantity of pollution quantity of pollution
Private Solutions to Externalities • In an influential 1960 article, the economist Ronald Coase pointed out that, in an ideal world, the private sector could indeed deal with all externalities. • According to the Coase theorem , even in the presence of externalities, an economy can always reach an efficient solution provided that the transaction costs — the costs to individuals of making a deal — are sufficiently low. • The costs of making a deal are known as transaction costs . • The implication of Coase’s analysis is that externalities need not lead to inefficiency because individuals have an incentive to find a way to make mutually beneficial deals that lead them to take externalities into account when making decisions. • When individuals do take externalities into account, economists say that they internalize the externality . • Why can’t individuals always internalize externalities? • Transaction costs prevent individuals from making efficient deals.
Private Solutions to Externalities • Examples of transaction costs include the following: • The costs of communication among the interested parties — costs that may be very high if many people are involved. • The costs of making legally binding agreements that may be high if doing so requires the employment of expensive legal services. • Costly delays involved in bargaining — even if there is a potentially beneficial deal, both sides may hold out in an effort to extract more favorable
Policies Toward Pollution Environmental standards are rules that protect the environment by specifying actions by producers and consumers. Generally such standards are inefficient because they are inflexible. An emissions tax is a tax that depends on the amount of pollution a firm produces. Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. Taxes designed to reduce external costs are known as Pigouvian taxes .
Environmental Standards vs Emissions Taxes (a) Environmental Standard (b) Emissions Taxes Marginal Marginal benefit to benefit to individual individual polluter polluter MB MB $600 $600 B B S MB MB B A A 300 T T A B 200 S A 150 Emissions tax 0 300 600 0 200 400 600 Quantity of Quantity of pollution pollution Environmental Without emissions emissions Plant A has a lower standards government (tons) (tons) marginal benefit of forces both action, each Plant B has a higher pollution and reduces plants to cut plant emits 600 marginal benefit of emissions by 400 tons tons emission by pollution and reduces half emissions by only 200 tons
Policies Toward Pollution • When the quantity of pollution emitted can be directly observed and controlled, environmental goals can be achieved efficiently in two ways: emissions taxes and tradable emissions permits . • These methods are efficient because they are flexible, allocating more pollution reduction to those who can do it more cheaply. • An emissions tax is a form of Pigouvian tax, a tax designed to reduce external costs. • The optimal Pigouvian tax is equal to the marginal social cost of pollution at the socially optimal quantity of pollution.
Production, Consumption, and Externalities • When there are external costs, the marginal social cost of a good or activity exceeds the industry’s marginal cost of producing the good. • In the absence of government intervention, the industry typically produces too much of the good. • The socially optimal quantity can be achieved by an optimal Pigouvian tax, equal to the marginal external cost, or by a system of tradable production permits.
Positive Externalities and Consumption (a) Positive Externality (b) Optimal Pigouvian Subsidy Price, marginal social Price of flu shot benefit of flu shot Marginal external S S benefit Price to producers O after subsidy O Optimal E MKT E MKT Pigouvian MSB of subsidy flu shots Price to consumers D D after subsidy Q MKT Q OPT Q MKT Q OPT Quantity of flu shots
Private versus Social Benefits • The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to consumers, plus its marginal external benefit. • A Pigouvian subsidy is a payment designed to encourage activities that yield external benefits. • A technology spillover is an external benefit that results when knowledge spreads among individuals and firms. The socially optimal quantity can be achieved by an optimal Pigouvian subsidy equal to the marginal external benefit. • An industrial policy is a policy that supports industries believed to yield positive externalities.
Private versus Social Costs • The marginal social cost of a good or activity is equal to the marginal cost of production, plus its marginal external cost.
Negative Externalities and Production Price, marginal (b) Optimal Pigouvian Tax (a) Negative Externality social cost Price of of livestock livestock Marginal MSC of livestock external cost Price to consumers after tax S S Optimal E MKT E MKT Pigouvian Tax D D Price to producers after tax Quantity of Quantity of Q OPT Q MKT Q MKT Q OPT livestock livestock
Network Externalities • A good is subject to a network externality when the value of the good to an individual is greater when a large number of other people also use the good. • Examples include: communication systems: telephones, telegraphs, fax machines, etc. railway systems air travel: hub and spoke • Any way in which other people’s consumption of a good increases your own marginal benefit from consumption of that good can give rise to network effects. Example: computer operating systems like Windows
Network Externalities • Windows is used widely so it attracts more attention from software developers. As a result, there are more programs that run on Windows than on any other operating system. • A good is subject to positive feedback when success breeds greater success and failure breeds failure.
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