ECONOMICS 103. Topic 5: Externalities. External costs and benefits

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1 ECONOMICS 103 External costs and benefits Topic 5: Externalities Marginal external costs, marginal external benefits Marginal social costs and benefits v marginal private costs and benefits Environmental policy: Pigovian taxes, emissions taxes, emissions standards, cap and trade programs. 1

2 Recall the definition of external costs and benefits from Topic 4. - External costs (EC): activities in a market impose costs on those outside the market. - External benefits (EB): activities in a market yield benefits to those outside the market. Presence of external costs/benefits means mkt surplus SS. - Market surplus (MS) = private (or market) benefits (PB) - private costs (PC). - Social Surplus (SS) = social benefits (SB) - social costs (SC). SB = PB + EB. SC = PC + EC. Principles of Microeconomics MARKET SURPLUS V SOCIAL SURPLUS 2

3 MARKET SURPLUS V SOCIAL SURPLUS Can also think about externalities on the margin. Marginal external costs (MEC) = external costs imposed by an additional unit of output. - Similar definition for MEB. Marginal social costs (MSC) = all costs imposed by an additional units of output. - MSC = MPC + MEC. - Similar definition for MSB. 3

4 MARKET SURPLUS V SOCIAL SURPLUS We know markets are excellent at maximizing market surplus. - But when market surplus SS, we have a problem. - Mkt ignores EC/EB, even though these are real costs & benefits. Recall: - Competitive mkt equ is where MPC = MPB (Q S = Q D ). - SS is maximized where MSC = MSB. Q that maximizes mkt surplus will not typically be the same Q that maximizes SS, if there are EC and/or EB. Means government intervention in markets can result in SS. 4

5 NEGATIVE EXTERNALITIES Assume EC > 0 & EB = 0. - A negative externality: MSC = MPC + MEC. Example: gasoline consumption GHG emissions. - Note: MPB = MSB, since EB = 0. $ MSC = MPC + MEC MPC (S) MEC MSB (D) Comp equ yields Q E. We know Q E maxes market surplus. Want to prove social surplus will be at Q* than it is at Q E. Q* Q E Q (gas) 5

6 NEGATIVE EXTERNALITIES Note two things: - At Q*, MSC = MSB. - At Q E, MSC > MSB. This is enough to tell us that Q E does not max SS. For units from Q* to Q E, SC >SB, so their production SS. $ C B MSC MPC If Q from Q E to Q*: - SB by A + B. - SC by A + B + C. A MSB - SS by C. Q* Q E Q (gas) 6

7 NEGATIVE EXTERNALITIES Another way to look at it: - At Q E, market surplus = B + F + G. But market surplus SS. - SS = SB - SC. At Q E : $ MSC MPC - SB = F + G + H + A + B. F G H B A Q* Q E MSB Q 7

8 NEGATIVE EXTERNALITIES Another way to look at it: - At Q E, market surplus = B + F + G. But market surplus SS. - SS = SB - SC. At Q E : $ MSC MPC - SC = G + H + A + B + C. G H Q* C B A Q E MSB Q 8

9 NEGATIVE EXTERNALITIES Another way to look at it: - At Q E, market surplus = B + F + G. But market surplus SS. - SS = SB - SC. At Q E : $ MSC MPC - SS = F - C. F C MSB Q* Q E Q 9




13 NEGATIVE EXTERNALITIES At Q *, SS = F. At Q E, SS = F - C. SS would be higher by C if we could reduce Q from Q E, to Q *. $ F C MSC MPC C = DWL at unregulated equilibrium. MSB Q* Q E Q 13

14 DWL DUE TO EXTERNALITIES SS at comp equ is C less than it would be at Q* rather than Q E. Tells us the C is the DWL due to the unaddressed externality. - The market has failed to maximize SS. This what economists mean when they say market failure. - Market outcomes are not always the best outcomes. If could Q from Q E to Q*, better outcome for society. Luckily, we already know lots of ways that policy can Q. - Note: not everyone will be better off at Q* than at QE. This won t be a win-win. Principles of Microeconomics - But, in aggregate, society is better off (as measure by SS). Note again: the source of the DWL 14 is due to MSC > MSB.

15 POLICIES TO ADDRESS MARKET FAILURE We know we need to Q from Q E to Q*. - Lots of policies can get us there (see Topic 4). - We ll look in detail at an output tax. $ MSC = MPC + MEC MEC MPC (S) If we levy t = MEC, then MPC + t = MSC. Obviously changes equ Q from Q* to Q E. Q* Q E MSB (D) Q 15 Looking once more at gains versus losses.

16 POLICIES TO ADDRESS MARKET FAILURE Losers are consumers and producers - just as in Topic 4. Winners include the government, but now there is also an extra social gain in terms of EC. - i.e., lower pollution costs. CS = b + c + g < 0 P C $ b P E c g f h n P P MSC = MPC + MEC MSB (D) MPC (S) MEC = t PS = f + h + n < 0 Total losses to market surplus are identical to those in Topic 4. Q* Q E Q 16

17 POLICIES TO ADDRESS MARKET FAILURE Government gains revenue = b + c + f + h: same as in Topic 4. The difference is in terms of EC. - Before tax, EC = m + h + c + n + g + k. - After tax, EC = m + h + c. $ MSC = MPC + MEC MPC (S) EC = n + g + k < 0. EC < 0 a gain. P C k b P E c g f h n P P m MEC = t MSB (D) Q* Q E Q 17

18 POLICIES TO ADDRESS MARKET FAILURE Losses in market surplus: b + c + f + h + n + g Total gains: b + c + f + h + n + g + k. Gains > losses by k, the DWL due to the uncorrected externality. Just as in Topic 4, policy creates winners and losers. But, for 1st time in this $ MSC = MPC + MEC course, gains from MPC (S) policy outweigh the losses. P C k b P E c g f h n P P Q* Q E MEC = t MSB (D) Q 18 Not everyone is better off, but society is better off, as measured by SS. - Tax SS.

19 Recall that the source of the original DWL was the EC. - Agents in the market ignored EC, even though they exist and are just as real as any other cost. - It was like they were getting a factor of production for free. Market activities used a scarce resource - environmental quality - without paying for it. How to fix? Make agents in the market internalize those costs. - That s what the tax does. Principles of Microeconomics INTERNALIZING THE EXTERNALITY - The tax doesn t make market agents directly pay those who bear the pollution costs. - Instead it makes them pay an amount to the government that is equal to those costs. 19

20 INTERNALIZING THE EXTERNALITY Policies such as this are often described as having the effect of internalizing the externality. - What was once an external cost is now internal. - Taxes in this context are often referred to as Pigovian taxes. - Also sometimes hear the language of user pays in this context. A couple more things to note. Principles of Microeconomics - The Pigovian tax does not eliminate pollution. There are still EC > 0 at taxed equilibrium. - It instead makes sure that pollution is at it s optimal level. There are benefits to pollution as well as costs (all else equal, we like output, right?). Pigovian-t ensures mkt weighs those costs & benefits properly. 20

21 WHAT TO TAX? Pigovian tax we have considered here is an output tax. - Example: we know burning gas pollution, so we tax gas. This gets the right outcome, but only given a certain MEC. In particular, Pigovian output tax creates no incentive to come up with new production techniques that result in lower EC. - Creates no incentive to make output cleaner on the margin. Not a problem if think there is little scope to MEC. - E.g., 1 litre of gas always 2.7 kg of CO2; due to physics & stuff. Nothing producers of gas can really about it. 21

22 WHAT TO TAX? Principles of Microeconomics Much bigger problem if there is possibly a lot of scope to MEC. - E.g., electricity can be produced with a lot or a little carbon. - If we set a t-rate for electricity that reflects current MEC, there is no incentive for producers to MEC. Taxing electricity w/out reference to CO2 is not smart policy. Alternative: tax pollution directly, rather than indirectly via output. - Set tax rate t not on units of Q, but on units of pollution. Obviously will have effects in output markets. Indeed, in world where MEC just can t be, will exactly replicate Pigovian output tax. - Benefit is in cases where MEC can change: now there is an incentive to make output cleaner on the margin. 22

23 POLICIES TARGETING POLLUTION To look at policies that target pollution levels directly, rather than indirectly, we need to think more about production. Why do firms pollute? Presumably, because there are benefits. - Equivalently, producing output in dirty ways is cheaper for firms than producing output in clean ways. We can think about firms polluting decisions using the same framework as we use for all decision making: - Polluting firms weighs marginal benefit of pollution against marginal cost of pollution. - But, firms only weigh the MC and MB to them, not to society. We ll denote pollution as P, but in some context you will see it denoted as E (E for emissions of pollution). 23

24 POLICIES TARGETING POLLUTION Benefits: might seem odd to talk about the benefits of pollution, but reducing pollution entails a resource cost. - Terminology: we call reducing pollution pollution abatement. - So, the benefits of pollution are avoided abatement costs. Means the MB of P is just the avoided MC of abatement (note: MB of pollution is what text calls demand for pollution rights ). - Denote the MC of abatement as MC A. There are good reasons to believe that at high levels of P, abatement is relatively cheap. - If firms are not making any effort to reduce pollution, there is typically low hanging fruit: quick and cheap ways to clean up. But, as firms clean up their act (i.e., at lower levels of P), abatement becomes more costly on the margin. 24

25 ABATEMENT POLICIES Principles of Microeconomics So, MC A likely to be low at high P and high at low P. Tells us the MB of P is low at high P and high at low P. - Recall that MB of P is avoided MCA. Can represent MB of P/ MC A graphically: $ Important to remember: MB P = MC A - MC A a component of social costs. - We will and should account for them when thinking about policy. P Resources used to make production cleaner are resources that can t be used for something else. 25

26 ABATEMENT POLICIES Principles of Microeconomics Recall that the area under any marginal curve gives us total. So the area under MC A will measure costs of P. Suppose firms P from P MAX to P1 (i.e. abates A1). $ MB P = MC A At P MAX it is making to effort to reduce P, so A costs are zero. At P1 it has incurred costs = area under MC A. P1 P MAX A1 = P MAX - P1 P Red triangle tells us the resource costs associated with cleaning up production process. 26

27 ABATEMENT POLICIES So benefits of P to a firm = the avoided A costs. What about costs of P to a firm? - Is there a downside to polluting, to the firm s bottom line? We will assume, that, absent regulation, there is no downside to polluting for firm (doesn t have to be true, in reality). Means that private benefits to the firm from abatement are zero. - MPC of pollution = MPB of abatement. - By our assumption, MPC of P = MPB of A = 0. Of course there are social costs of P (we ll come back to them soon), but if the firms are free to choose the level of P and MPC of P = 0, they will pollute until MB = 0. 27

28 ABATEMENT POLICIES Principles of Microeconomics Graphically, the firm will choose P = P MAX if MB of A = 0. $ MC A =MB P P MAX P Obviously, there are social costs associated with P (SB of A). Policy design is about trying to get polluting firms to account for those costs, somehow. We want to think about what the SC of P are, and in particular what the MSC P curve looks like. There are good reasons to believe that: - At low P, MSC P is relatively low, and - At high P, MSC P is relatively high. 28

29 ABATEMENT POLICIES Principles of Microeconomics Graphically, the firm will choose P = P MAX. $ MC A =MB P MSC P Means that the MSC P curve is upward sloping. And SS max is P = P *. P * P MAX P We want to think about what the SC of P are, and in particular what the MSC P curve looks like. There are good reasons to believe that: - At low P, MSC P is relatively low, and - At high P, MSC P is relatively high. 29

30 ABATEMENT POLICIES Principles of Microeconomics Policy problem is clear in this context: - If we can know/measure MSC P, we can identify P *. - Just need to implement policies to get firms to set P = P *. Reality problem: we know P is costly, but it is extremely hard to get anyone to agree on exactly how costly. Measuring environmental costs is hard. Means that we can t really expect to be able to identify P *. Instead, the real world of environmental policy ends up being about settling on some target level of abatement, that we think seems about right. Typically, pollution control targets are set via a political process, not by a bunch of economists estimating the MSC P. 30

31 ABATEMENT POLICIES Principles of Microeconomics But, economics can tell us a lot about various ways to achieve politically determined pollution control targets. Factors that matter for choosing environmental policies - Costs: all else equal, if there are low cost ways of improving the environment, these preferable to high costs way. - Simplicity of implementation, especially information limits. - Distribution: environmental policy is going to involve costs. Who is going to pay those costs? We want to look at two policies, with the above in mind: - Pollution taxes. - Tradable pollution permits (a.k.a. cap and trade ). 31

32 POLLUTION TAXES Recall that the source of the problem is that the MPB of abatement (MPB A ) to firms of reducing P is zero. Pollution taxes offer a simple fix: if firms must pay a per unit tax t for every unit of P, MPB A = t. - By reducing pollution (abating) by one unit, firm avoids paying t. When firm chooses level of P it weighs MC A against MPB A = t. - If MC A > t, better to pay the tax and pollute. - If MC A < t, better to avoid the tax and abate. Tells us that firm will now choose P such that MC A = t. Instead of polluting P MAX, firm will abate at least some P. The amount of abatement depends on the tax: Higher t more A less P. Principles of Microeconomics 32

33 POLLUTION TAXES Firm optimally chooses P such that MC A = t. $ MC A MPB A < MC A MPB A > MC A At P MAX, MPB A > MC A better for the firm to abate and avoid t. t MPB A So at high P, firm will want to P. P L P E P MAX P At low P, MPB A < MC A better for the firm to pollute and pay t. So at low P, firm will want to P. At P = P E, firm is doing the best it can, given t. 33

34 POLLUTION TAXES Principles of Microeconomics If every polluting firm faces same tax t, then each will optimally choose P such that MC A = t. each firm will have the same MC A, at the level of P they emit. This is important. - Recall from Topic 2 that we want production to reflect MCs. - To get a given level of output at least cost, we want to exploit low MC production opportunities. - If one firm has high MC and another has low MC, we can get the same output at lower cost by reorganizing. The same is true here; in this context the good we are producing is environmental improvement. 34

35 POLLUTION TAXES Principles of Microeconomics If some firms can P at relatively low MC A, then we want theses firm P by more than firms who have relatively high MC A. Climate policy is costly; if we can get a given environmental improvement at low rather than high cost, this is a good thing. So emissions taxes ensure that the level of abatement we achieve is achieved at least cost. One potential downside of emissions taxes arises if there is uncertainty about exactly what abatement costs are. We know each firm will choose P such that MC A = t. But if we don t know what firms MC A s are, we can t know in advance the level of P that will be achieved. 35

36 POLLUTION TAXES In practice, we can adjust the tax over time as we observe the behavioural response of emitters: - If the initial t doesn t get the environmental improvement we are looking for, we can increase the t over time. Downside to this is that economic agents don t typically like tax uncertainty: businesses like regulatory certainty. Ideally, we d like a policy that achieves a target level of abatement with certainty, and does so at least cost. This is what tradable emissions permit schemes are all about. - Such policies also referred to as cap and trade. 36

37 CAP AND TRADE Principles of Microeconomics How do cap and trade programs work? Government sets a target for abatement/pollution. Prints permits equal in number to to the target pollution level. Distributes permits to polluting firms. - Various ways to do this, turns out to make no difference in terms of overall policy effectiveness. Each firm must own permits that are equal in number to the level of pollution it emits. - If firms have more permits they need, can sell permits. - If firms have fewer permits than they need, must buy permits. 37

38 CAP AND TRADE Recall: source of the problem of externalities is that firms have access to a scarce resource (the environment) at zero cost. Cap and trade literally creates a market for this scarce resource: - Means that firms now must pay for use, just like they must for all other inputs to production. We want to think about why would a firm want to buy or sell permits, then use this to look at equilibrium in the permit mkt. For each permit a firm holds, it faces a choice: - Use the permit to pollute, thus so avoiding having to incur abatement costs. - Sell the permit in the mkt, thus having to incur abatement costs. 38

39 CAP AND TRADE Principles of Microeconomics What a firm will do depends on relationship between the price of permits p and the firm s MC A. If MC A < p, then the firm can make money by selling the permit and reducing its own pollution. If MC A > p, then the firm is better off buying permits in the mkt and polluting. Tells us that, in the mkt for permit: - Firms for whom MC A < p will be sellers. - Firms for whom MC A > p will be buyers. As sellers of permits abate more, MC A will. As buyers of permits pollute more, MC A will. We will see that, in equilibrium all firms MC A s will be equal. 39

40 CAP & TRADE Principles of Microeconomics Example: suppose we have 2 polluting firms. In the absence of regulation, each firm would produce 800 tonnes of CO2 /yr. - That is, we have P1 max = P2 max = 800 & aggregate P T = Govt decides it wants to reduce aggregate emissions to That is, we want P T = 700. So government prints 700 permits in total, where each permit allows firm to emit one tonne of CO2. Assume government gives each firm one half of permits. - Initial allocation gives each firm right to pollute 350 tonnes. - Denote level of P at initial allocation of permits as P^. - So we have P1^ = P2^ =

41 CAP & TRADE Principles of Microeconomics Prior to regulation we have: - P1 = P1 max = P2 = P2 max = 800. At initial allocation of permits we have: - P1 = P1^ =350 - P2 = P2^ =350. So if no firm buys of sell permits, each much abate 450 units. Will see that if MC1 A MC2 A at P = 350, there will be trade: - Low MC A firm sells and abates more than 350 units and - High MC A firm buys and abates less than 350. In equilibrium, we will have permit price p = MC1 A = MC2 A, meaning that we reach aggregate target at least cost. 41

42 CAP & TRADE Suppose our two firms MC A s are as drawn below. Recall each firm s baseline P = 800, but each only gets 350 permits. $ MCA1 MCA2 Note: at initial allocation, MC A 1 > MC A 2. Means that at any p such that MC A 1 > p > MC A 2: - Firm 1 will buy permits and - Firms 2 will sell permits P 42

43 CAP & TRADE Firm 1: pays p, saves MC A 1 net gain = (MC A 1 - p ) per permit. Firm 2: gets p, incurs MC A 2 net gain = (p - MC A 2) per permit. $ MCA1 MCA2 Firm 1: P1 MC A 1 Firm 2: P2 MC A 2 Trade reallocates abatement: - Away from high MC A firm - Towards low MC A firm P Same env. benefits at lower cost than before trade. 43

44 CAP & TRADE Principles of Microeconomics Note that incentive for trade exists as long as MC A 1 > MC A 2. So trade continues until P1 = 500 & P2 = 200. $ MCA1 A P1 = 200 & P2 = 500, MC A 1 = MC A MCA2 No further incentive for trade P Environmental target achieved at least cost. 44

45 CAP & TRADE Given P1 = 500 & P2 = 200, equil. number of permits traded =150. What about equilibrium price of permits? $ MCA1 If permit mkt is perfectly competitive, equilibrium price p E = $ MCA2 p E Only at p E = $15 is Q D = Q S in permit mkt. Note: p E = MC A 1 = MC A P Price is mechanism that ensures least cost abatement. Q S Q D 45

46 CAP & TRADE Equilibrium in permit market: Principles of Microeconomics - p adjusts so Q S = Q D ; each firm chooses P s.t. p = MC A. - Abatement target is met at least cost. - Each firm incurs compliance costs: Total abatement costs + cost of permits for buyers Total abatement costs - permit revenue for sellers. Another important point to note: equil abatement levels and p E are independent of the initial distribution of permits. Extremely important in the context of global climate policy. To see this, rework previous ex, but give all 700 permits to firm 2. - Now, regulation makes firm 2 better off (at expense of firm 1). - Think about relevance for distributional effects of climate policy. - This is also part of what we are doing in labs this week. 46

47 CAP & TRADE Principles of Microeconomics Why do we care about distribution of permits and compliance costs if it doesn t matter for achieving efficient abatement? Because distribution matters in political processes. The realities of global climate change problem: - Poorer/less developed countries are low MCA. - Richer countries are higher MCA. Efficient abatement dictates abatement activity takes place in poorer countries, but many feel this is unfair. - Only unfair if we make them pay for it too. Permit policy can allow abatement to take place in poorer countries, but paid for by richer countries. - We just need to allocate poorer countries enough permits, which they will then sell to richer countries. 47

48 ROUND-UP What have we learned in Topic 5? External costs matter, and unregulated markets don t ensure best outcome for society where there are external costs. - External benefits matter too (read text; we ll come back to this at the end of term, time-permitting). There are a bunch of ways we can regulate. - Pigovian taxes in output markets. OK approach, but doesn t create incentive to come up with new, cleaner ways to produce goods. Abatement policies: Principles of Microeconomics - Emissions taxes, cap and trade, emissions standards. All target pollution directly and create incentives to come up with new, cleaner ways of doing things. 48

49 ROUND-UP Principles of Microeconomics Emissions taxes: - Simple approach: set a tax rate and let firms respond. Policy determines price, market determines quantity. - We know we get least cost abatement. - Problem: have to adjust t if we don t hit target from the outset. Cap and trade: - Bit more complicated (perhaps than a straight emissions tax). Policy determines quantity of aggregate abatement, and distribution of permits, market determines price. - Upside: get least cost abatement & hit our target from outset. Emissions standards: straightforward policy, but more expensive than either of the other two options. 49

50 ROUND-UP Principles of Microeconomics Whatever approach we take, there will be costs. Costs will end up being passed on to consumers in output mkts. - For instance, BC carbon t raises the price of carbon-intensive products, and hurts consumers (while helping environment). Distribution matters for political and equity reasons. - There are good reasons to believe that carbon taxes hit poor people disproportionately hard. Poorer people spend a greater % of income on carbon intensive goods such as gas and heating. Can lessen hardship on low income household through rebates. - In BC, low income households actually receive a check from the government each year to compensate for carbon tax. 50

51 ROUND-UP This rebate is a flat amount, independent of carbon consumption. Might raise a couple of questions: Principles of Microeconomics - Why do we make rebate independent of carbon consumption? - Won t people just use rebate on gas etc., making policy ineffective? Remember: point of policy is to change people s behaviour. Rebate is like increase in income: won t our carbon D curves shift out and have an overall effect of increasing carbon consumption? Important to understand the following: - To ensure policy effectiveness, rebate must be independent of carbon consumption: everyone should face a MC of pollution. - Even with rebate check, people s behaviour will change; we will get an overall reduction in carbon consumption. To understand this last point, we need to understand Topic 6. 51