6 - Externalities Flashcards
What is an externality in economics?
Answer: An externality occurs when one person’s actions affect a bystander’s well-being without compensation.
they cause markets to be inefficient and thus fail to maximize total surplus
What are the two main types of externalities?
Answer: Negative externalities (adverse impacts) and positive externalities (beneficial impacts).
What is the formula for Marginal Social Cost (MSC)?
Answer: MSC = Marginal Private Costs (MPC) + Marginal External Costs (MEC)
MEC is the cost to the bystanders
What does the Coase Theorem state?
Answer: Private parties can solve externality problems through bargaining without cost over the allocation of resources without government intervention.
What are transaction costs?
Answer: Expenses incurred during bargaining and implementation of solutions to externality problems.
What are the two property right approaches?
Laissez Faire Rule
Polluter Pays Rule
Name four limitations of private solutions to externalities.
- high transaction costs
- Unclear property rights
- Coordination challenges with multiple parties
- Free-riding problems
What are the three evaluation criteria for policy instruments?
Answer:
- Ecological effectiveness
- Cost effectiveness
- Dynamic efficiency
When does the efficient level of pollution occur? What costs do we need to consider?
Answer: The efficient level occurs where marginal abatement costs equal marginal damage costs.
- Damage costs to environment
- Abatement costs (technology and production adjustments)
What is required for a cost-effective solution regarding pollution?
Answer: Equal marginal abatement costs across all firms.
- the cost of reducing one additional unit of pollution should be the same across all companies
- the cost effective solution may not be the most efficient solution
What are Pigouvian Taxes?
Answer: Taxes enacted to correct the effects of negative externalities.
profit maximizing firms will reduce emissions until the marginal cost of reduction = tax
Why are command-and-control policies considered to have poor dynamic efficiency?
Answer: Once standards are fulfilled, firms have no incentive for further reductions and technical progress.
What makes tradeable permits ecologically effective?
Answer: They set an overall emissions cap that ensures a specific environmental target is met.
How do tradeable permits achieve cost-effectiveness?
Answer: Through market forces (supply & demand) where firms can trade permits based on their marginal abatement costs.
What are two types of costs considered when determining optimal pollution levels?
Answer: Damage costs to environment and abatement costs (technology and production adjustments).
Why might command-and-control policies have limited cost-effectiveness?
Answer: Due to uniform standards that don’t consider individual firms’ marginal abatement costs (MAC).
What happens when profit-maximizing firms face Pigouvian taxes?
Answer: They will reduce emissions until the marginal cost of reduction equals the tax.
What are examples of private solutions to externalities?
Answer: Moral codes and social sanctions, charitable organizations, and contracts between parties.
What makes market-based policies more dynamically efficient than command-and-control?
Answer: They provide ongoing incentives for technological improvement and innovation.
What is a challenge in implementing Pigouvian taxes?
Answer: Determining the optimal tax rate, which should equal marginal damage.
What are the policy instruments governments can use to tackle externalities?
- Command-and-Control Policies:
- A regulatory approach where governments directly set specific rules, standards, or requirements that businesses and individuals must follow, rather than using economic incentives or market mechanisms
- Market-Based Policies - Taxes
- use of taxes to align private incentives with social efficiency
- Market-based policies - Tradeable Permits
- Sets overall emissions cap
- Allows permit trading between emitters via the market
What is the ecological effectiveness of command and control policies?
- Ecological effectiveness
- total emissions targets can only be achieved if total number of firms (for absolute emissions standards) or total level of output (for relative meission standards) remain constant
- zero emissions target canbe achieved
What is the cost effectiveness of command and control policies?
- Limited cost-effectiveness due to uniform standards → MAC of individual firms not considered
- government usually does not have sufficient information for a cost-effective allocation of pollution
What is the ecological effectiveness of taxes?
- Ecological effectiveness
- given emission target can be met when MAC is known → though usually it is not
- finding the necessary tax rate can be time consuming
What is the cost-effectiveness of taxes?
- Cost-effective when uniform across firms
- leads to an efficient distribution of pollution reduction efforts, as firms with lower abatement costs will reduce more while those with higher costs will reduce less (and pay more)
- easy to implement as no knowledge of individual firms’ MAC required
- however, challenges in determining optimal tax rate
- tax rate is efficient if tax rate = marginal damage
How do tradeable permits promote dynamic efficiency?
Promotes dynamic efficiency through incentives for technological progress (more than command and control)
