6 - Externalities

Question 1

What is an externality in economics?

Answer 1

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

Question 2

What are the two main types of externalities?

Answer 2

Answer: Negative externalities (adverse impacts) and positive externalities (beneficial impacts).

Question 3

What is the formula for Marginal Social Cost (MSC)?

Answer 3

Answer: MSC = Marginal Private Costs (MPC) + Marginal External Costs (MEC)

MEC is the cost to the bystanders

Question 4

What does the Coase Theorem state?

Answer 4

Answer: Private parties can solve externality problems through bargaining without cost over the allocation of resources without government intervention.

Question 5

What are transaction costs?

Answer 5

Answer: Expenses incurred during bargaining and implementation of solutions to externality problems.

Question 6

What are the two property right approaches?

Answer 6

Laissez Faire Rule
Polluter Pays Rule

Question 7

Name four limitations of private solutions to externalities.

Answer 7

• high transaction costs
• Unclear property rights
• Coordination challenges with multiple parties
• Free-riding problems

Question 8

What are the three evaluation criteria for policy instruments?

Answer 8

Answer:
- Ecological effectiveness
- Cost effectiveness
- Dynamic efficiency

Question 9

When does the efficient level of pollution occur? What costs do we need to consider?

Answer 9

Answer: The efficient level occurs where marginal abatement costs equal marginal damage costs.

• Damage costs to environment
• Abatement costs (technology and production adjustments)

Question 10

What is required for a cost-effective solution regarding pollution?

Answer 10

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

Question 11

What are Pigouvian Taxes?

Answer 11

Answer: Taxes enacted to correct the effects of negative externalities.

profit maximizing firms will reduce emissions until the marginal cost of reduction = tax

Question 12

Why are command-and-control policies considered to have poor dynamic efficiency?

Answer 12

Answer: Once standards are fulfilled, firms have no incentive for further reductions and technical progress.

Question 13

What makes tradeable permits ecologically effective?

Answer 13

Answer: They set an overall emissions cap that ensures a specific environmental target is met.

Question 14

How do tradeable permits achieve cost-effectiveness?

Answer 14

Answer: Through market forces (supply & demand) where firms can trade permits based on their marginal abatement costs.

Question 15

What are two types of costs considered when determining optimal pollution levels?

Answer 15

Answer: Damage costs to environment and abatement costs (technology and production adjustments).

Question 16

Why might command-and-control policies have limited cost-effectiveness?

Answer 16

Answer: Due to uniform standards that don’t consider individual firms’ marginal abatement costs (MAC).

Question 17

What happens when profit-maximizing firms face Pigouvian taxes?

Answer 17

Answer: They will reduce emissions until the marginal cost of reduction equals the tax.

Question 18

What are examples of private solutions to externalities?

Answer 18

Answer: Moral codes and social sanctions, charitable organizations, and contracts between parties.

Question 19

What makes market-based policies more dynamically efficient than command-and-control?

Answer 19

Answer: They provide ongoing incentives for technological improvement and innovation.

Question 20

What is a challenge in implementing Pigouvian taxes?

Answer 20

Answer: Determining the optimal tax rate, which should equal marginal damage.

Question 21

What are the policy instruments governments can use to tackle externalities?

Answer 21

• 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

Question 22

What is the ecological effectiveness of command and control policies?

Answer 22

• 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

Question 23

What is the cost effectiveness of command and control policies?

Answer 23

• 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

Question 24

What is the ecological effectiveness of taxes?

Answer 24

• 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

Question 25

What is the cost-effectiveness of taxes?

Answer 25

• 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

Question 26

How do tradeable permits promote dynamic efficiency?

Answer 26

Promotes dynamic efficiency through incentives for technological progress (more than command and control)