Externalities Flashcards
Market Failure (2)
1) Market failure occurs when the free market price mechanism fails to allocate resources to the socially optimum amount. (The non-Pareto effect - ineffective distribution in the free market).
2) Market failure is caused by over/under allocation of goods and services.
Concept of externalities using price mechanism (3)
1) It is the idea that the free market does not recognize when there is external costs or benefits to other people.
2) In a free market the price mechanism is designed to allocate resources efficiently based on supply and demand. However, this mechanism fails when externalities are present because it does not capture the total social costs and benefits.
3) Producers lack the incentive to account for these externalities, leading to outcomes that represent a market failure or loss in social welfare.
Without externalities (2)
1) In the ideal free market, no externalities, consumers make decisions based on their marginal private benefit, and producers make decisions based on their marginal private costs.
2) They do not account for the social costs of the consumption or production of the goods or service.
What is an externality?
A benefit or cost to the third party who are not apart of the transaction caused by the production or consumption of good.
When externalities exist, private beenfit/cost differ from social benefits/cost
What is a negative externality of production (+why does it arise)
1) It is the cost that is endured by the third party from the production of a good or service.
2) It arises because producers only focus on the marginal private cost and do not account for any external cost to the society.
Government-based policies (Rules and Legislations) (6) Negative production
Government command approaches (based on the use of government authority to make decisions; see p 2) include regulations, legislation, advertising, education, and direct government provision.
1) Impose restrictions on emissions
2) Limit the amount of output produced
3) Force firms to install non-polluting technologies
4) Ban dangerous substances eg. asbestos
5) Create protected areas
6) Restrictions on logging, fishing etc.
Government-based policies evaluation - Negative production
Pros -
1) Simpler to implement than market- based.
2) Quite effective eg. Banning harmful substances.
3) Regulations force firms to comply.
Cons -
1) Involves costs of monitoring and implementing.
2) No incentive to switch to cleaner technologies
3) Incomplete knowledge of the extent of externality and thus how much to restrict
4) Are inefficient, as they do not differentiate between firms with higher or lower costs of reducing pollution/environmental harm.
Market based policies evaluation - Negative production
Market-based policies use methods that change relative prices (such as indirect taxes and subsidies) and therefore change the incentives facing decision-makers and hence their behavior.
Pigovian Tax
1) An indirect tax that is placed on the expenditure of goods or services and paid by producers to the government.
2) It helps to internalize the external costs associated with the market participants.
3) Purpose: The tax ensures that the good reflects not just the Cost of Production (COP) but also the external cost (such as environmental damage).
Indirect (pigovian) taxes neg prod stake holder consumer+producer
1) Consumers
Short-term
a) The price of the good increases
b) Availability of the good decreases if it is elastic so consumers may find it difficult to purchase. The reduced availability of the goods, combined with higher prices, puts a financial strain on consumers who still need the product.
Long run
a) Availability will decrease of the good if it is inelastic - Over time, consumers are more likely to fully transition to substitutes or alternatives.
Positive outcome: If substitutes are greener or healthier (e.g., renewable energy instead of coal, electric vehicles instead of gas-powered ones), consumers benefit from higher-quality goods and reduced harm.
b) Healthier environment - due to the tax, harmful production would have decreased, and hence there would have been a decrease in harmful pollutants, in turn cleaning the environment. Improved life expectancy and quality of life for individuals and communities.
c) A healthier workforce due to improved environmental conditions leads to higher productivity, as fewer workers are absent due to illness or pollution-related health issues.
Producer -
Short Run
a) Higher Costs - The producers face higher costs , hence, a reduction in profit margin.
b) Decrease in output - Given the higher cost of production, firms may respond by reducing the quantity of goods they produce, especially if they are unable to pass the full tax burden to consumers.
Long run
a) Shifts in market (firms that produce NE exit the market) - In the long run, the imposition of the Pigouvian tax creates a stronger incentive for firms that produce goods causing negative externalities to either innovate or exit the market. As firms experience the financial burden of the tax, less efficient firms that are unable to adapt may exit the market altogether. Or new firms with cleaner technologies move into the market.
b) incentive for innvoation - The Pigouvian tax encourages firms to innovate in order to reduce the external costs associated with their production. Firms that can find ways to reduce pollution or increase efficiency in their production processes can reduce their tax burden, thereby increasing profitability.
Indirect (pigovian) taxes neg prod stake holder consumer+producer
1) Government
Short Run
a) Immediate revenue - The government collects revenue from the tax imposed on the good. This provides a direct financial benefit to the government, which can be used to fund public services such as healthcare, education, or environmental initiatives.
b) Administration costs - Implementing, monitoring, and enforcing a tax requires administrative resources. Governments need systems to ensure compliance, monitor tax collection, and deal with evasion or illegal activities like smuggling.
Long run
a) Price variability - The tax-induced price increase can create fluctuations in the market. For example:
Producers may pass the cost to consumers, leading to price hikes.
Over time, market dynamics, such as reduced demand or shifts in supply (due to innovation), can lead to price stabilization or even reduction.
b) Enhanced public welfare - By discouraging harmful activities (like smoking, pollution, etc.), the tax helps reduce negative externalities, such as pollution or health risks. (better health and public resources)
c) Black markets
Tax Payers
1) When the government incurs costs such as administration and implementation, they use funds that have been acquired from tax payers and hence tax payers are in loss. Rather then using the money for other alternatives to benefit them, it is being lost to eradicate externalities
What are tradable permits?
1) Tradable permits are government-issued allowances that grant the holder the right to emit a certain amount of a pollutant (e.g., carbon dioxide). The total number of permits is capped (hence the term “cap-and-trade”) to limit overall emissions.
2) Firms can trade these permits in a market, buying or selling them depending on their needs.
3) They can be distributed directly from the government, or some countries choose to auction it. It ensures that the permits are allocated efficiently and helps the government generate revenue.
4) It offers an incentive to switch to cleaner technologies
Tradable Permit curve
1) Supply is perfectly inelastic as the government determines the amount that is distributed in the economy.
2) The demand curve will determine the price of the permits.
3) If the firm decreases its pollution after purchase of the permit, they are able to sell it to another firm who requires more, they are able to choose the price.
Stake holder impact of tradable permits - consumer and producer
- Consumers
Short-term Impacts:
a) Higher Prices for Goods and Services - Firms that need to purchase permits may pass on the increased costs to consumers in the form of higher prices, especially for goods or services produced by emissions-intensive industries (e.g., electricity, transportation).
b) Increased Awareness - Consumers may become more aware of the environmental impacts of their consumption choices, leading to shifts in preferences toward eco-friendly products and services.
3) Less availability of goods
Long-term Impacts:
a) Improved Quality of Life - As emissions decrease due to the cap, the long-term benefits include cleaner air, reduced health issues related to pollution, and a healthier environment.
This improvement contributes to lower healthcare costs for consumers and enhances public well-being.
2) Producers
Short-term Impacts:
a) Higher Production Costs: Firms that rely heavily on emissions will incur higher costs to purchase permits or invest in cleaner technologies.
b) This may reduce their profit margins, particularly for firms unable to pass on costs to consumers.
Competitive Pressure:
c) Firms that cannot adapt to the new costs may face difficulties competing with more efficient or cleaner competitors.
Market Uncertainty - Price fluctuations in the permit market can create uncertainties, making it harder for firms to plan their finances and investments.
Long-term Impacts:
a) Incentive for Innovation - Firms are encouraged to innovate and develop cleaner production methods to reduce their dependency on permits, lowering long-term costs and gaining a competitive edge.
Market Restructuring:
b) Inefficient or highly polluting firms may exit the market, while cleaner, innovative firms thrive, reshaping the industry.
c) Corporate Reputation - Firms that successfully transition to greener operations may enhance their reputation among environmentally conscious consumers and investors.
Stake holder impact of tradable permits -
- Government
Short-term Impacts:
Revenue Generation:
1) If permits are auctioned, the government generates significant revenue, which can be reinvested into environmental projects, green infrastructure, or compensating vulnerable groups affected by higher prices.
Administrative Costs:
2) Setting up and managing a tradable permit system requires substantial resources, including monitoring emissions, ensuring compliance, and managing the trading platform.
Long-term Impacts:
3) Achievement of Environmental Goals:
The fixed cap on emissions ensures that the government meets its environmental targets, contributing to sustainable development and meeting international commitments (e.g., Paris Agreement).
Economic Growth in Green Sectors:
4) Revenue from permits can be invested in promoting green technology and renewable energy, fostering innovation and growth in these sectors.
Evaluation of market based policies
Pros
1) Make producers pay for the externality-internalize it.
2) Greater efficiency (reduced cost) in decreasing pollution , compared to government based.
3) When emissions are reduced, producers pay less and are able to generate money by selling their permit.
4) Taxes and permits create incentives to switch to cleaner technologies. The switch causes MSC to shift right and decrease externality.,
5) Reduced welfare loss.
Cons
1) For both policies it’s difficult to attach a monetary value to the extent of externality.
2)In the case of tax, difficulties in identifying the value of tax that will be equal to the value of harm.
3)For tradable permit it’s difficult to calculate the permissible amount (the cap). Then difficult to determine how to distrubte them.
4) Difficulty in ensuring compliance and enforcement.
5) Large firms ussually are the biggest contirbutors to these externalities and are also the ones with the most profit. Hence, it is much cheaper for them to just pay of the tax rather then cut down on production or switch to better technologies. Making the tax or permit insignificant.
Education and awareness creation
It is using approaches such as educating the public about the harmful effects of these externalities to attempt to influence the behavior.
Pros - It is often effective, as producers want to keep their reputation up as well as keep their customers happy to keep their revenue generation. Specifically, if the problem is local.
Cons - Does not make a signifcant difference if the problem is more global. For negative production externalities, especially those that affect the global environment (like climate change or global pollution), the scale of the problem is immense. Local or even national education and awareness campaigns cannot directly mitigate the externality on a global scale.
International Agreements
These are policies that are created in co-peration with governments and international agencies in order to mitgate externalities.
To what extent are govt policies simpler to implement ?
