Lecture 4 - Externalities Flashcards
Consumption externality - definition and example
Where the utility of one agent is affected directly by the actions of another, eg. factory emitting pollutants that affect my health
Production externality - definition and example
Where the production function of a firm is affected directly by the actions of another firm or individual, eg. a beekeeper benefits from a nearby apple orchard (positive ext)
Distribution externality - Meade’s definition (4pts)
When a change in demand leads to a change in prices and hence in the incomes of other people.
- > opposed to ‘real income externalities’
- > goods transferred to people who value them more (eg. painting goes to highest bidder, affects others but he values it more than them)
- > they are consistent with Pareto-efficiency as no output reduction occurs, only distribution.
Starrett’s definition of an externality
A situation where there is an insufficient incentive for a potential market to be created for some good, leading to a Pareto-inefficient equilibrium.
- > goods that matter in determining people’s living standards or the level of production
- > emphasises the role of transaction costs in preventing efficient outcomes.
Efficient level of pollution abatement
Balance b/n costs of abatement and benefits in terms of reduced environmental damage:
- > Marginal Abatement Cost schedule and Marginal Damage Cost schedule
- > if both assumed to be monotonically increasing and decreasing in abatement level, respectively, the optimal solution is at MAC=MDC
Condition for MAC to be monotonically increasing
Least-costly abatement measures (cost per tonne) implemented first and gradually towards more costly measures.
Pigouvian tax
Emissions tax that would lead a polluter to cut emissions up to the level at which it costs him more than the savings from lower taxes.
-> efficient allocation of abatement b/n polluters, those that can do it cheaply do it more than others
Tradeable permits - properties (3)
1) Quantity constraint on emissions: to have any environmental impact, the quantity of permits issued should set a cap below the ‘business-as-usual’ level of emissions
2) Trading in permits: provides flexibility
3) Issuance method: can be sold at a fixed price or auctions OR issued to existing polluters based on their historic emissions (‘grandfathered’)
Pigouvian taxes vs. emissions trading - key issues
Under conditions of certainty and w/ an efficient permit market, they have equivalent outcomes.
1) Efficiency of permit market: significance of transactions costs and/or market power -> poor choice when small # of firms
2) Issuance: grandfathering forgoes potential auction revenue
3) Permits guarantee an emissions level but an uncertain cost (MAC), taxes place an upper bound on MAC but impact on pollution is uncertain
Coase Theorem
Bargaining b/n polluter and victim may lead to the efficient level of pollution abatement, without the need for gov regulation.
- > argues that identifying who caused the problem is a waste of time
- > what matters is that rights are clearly assigned so bargaining can proceed
Coase theorem - 2 theses
1) Efficiency thesis: under required conditions, bargaining will lead to a Pareto-efficient outcome regardless of who was given the rights
2) Invariance thesis: same equilibrium in both cases
Coasean bargaining - two situations
1) Permissive assignment of rights (i.e. to the polluter): victim must pay the total abatement cost (c) to get to the efficient level + [0,d] where d is the net gain from reduced emissions
2) Restrictive assignment of rights: polluter must pay between the extra damage costs (b) and a+b, where a is the net gain from being allowed to pollute
NB: this assumes abatement and damage costs (MAC and MDC) are unaffected by the assignment of rights
Conditions for the Coase Theorem to hold (3)
1) Clear definition and enforcement of property rights
2) Zero transaction costs: hard to hold when many people involved + possibility of free-riding on deal
3) Full-info, non-strategic bargaining
Bargaining w/ asymmetric info - result
If seller knows there is a proba q that the buyer has high valuation (h), he sets price h if qh > j where j is the low-valuation
-> inefficient outcome when price is h as some Pareto-improving deals do not take place
Invariance thesis will not hold when…
income/wealth effects affect either the MAC or MDC
