Week 3: Externalities - Public Solutions

Question 1

Government responses to externalities include…

Answer 1

1. Indirect (Pigouvian) tax
2. Subsidies
3. Marketable permits
4. Regulation

Question 2

Define indirect (Pigouvian tax)

Answer 2

Corrective measures used in order to reduce or eliminate the external costs (negative externalities) associated with the production of certain products.

Question 3

Main purpose of indirect tax

Answer 3

Make the price of the product equal to D = MPB = MSB, thereby creating a more socially efficient allocation of resources.

Question 4

Graph explanation of indirect tax

Answer 4

1. Point A shows the free market equilibrium, whereas point B shows the socially optimal level of output (where MSC = MSB).
2. The indirect tax raises costs for the producer, thereby causing the S = MPC curve (or the supply curve of the private firm) to shift leftwards towards the S2 = MSC curve.
3. The lower supply
   causes the price to rise from Pe (the market equilibrium price) to Popt (the socially optimal price level)
4. AND The quantity demanded to fall from Qe (the market equilibrium quantity) to Qopt (the socially optimal quantity).

Question 5

What are the differences between Coasian and Pigouvian approaches?

Answer 5

1. Pigouvian analysis holds producers of negative externalities responsible vs Coasian analysis shows this assumption is untenable: (e.g. if you prevent me from smoking you are imposing an externality on me) – the concept of externality cannot be used on its own to decide who should pay for the externality
2. Coase restricts scope of application of the concept:

a) If costs (transaction costs or production costs) are higher than the benefits of internalising the externality then externality will not be fixed.

b) How do we reduce transation costs? This requires a comparative institutional analysis of what is best - states vs market in reducing transaction costs

Question 6

What is the similarity between Coasian and Pigouvian approaches?

Answer 6

Both extend the scope of markets to solve inefficiency (is this morally ok tho? – can we put a price on all things?)

Question 7

Advantages of income tax

Answer 7

1. It increases the price of the product and therefore should decrease the quantity demanded.
2. It creates tax revenue for the government (shown by the shaded green area in Figure 11.14) which can be used to raise public funds to deal with the external costs of negative externalities or to fund other interventionist measures, such as providing subsidies for firms to adopt green technologies or to fund government provision of merit and public goods and services.

Question 8

Disadvantages of income tax

Answer 8

1. the demand for many of these products (such as cigarettes, alcohol, gambling and petrol) tend to be price inelastic, so the tax may have little impact on the level of consumption and, hence, production
2. the tax on many of these products is regressive so has a greater impact on low-income earners than high- income earners
3. it can encourage smuggling and unofficial market activities, creating a parallel market for demerit goods.
4. Information problem
5. Monitoring and enforcement costs
6. Taxing inputs reduces incentives to reduce pollution in the future
7. Blunt instrument, may need exceptions
8. Political feasibility, “tax hurts ____sector”

Question 9

Subsidies

Answer 9

a sum of money given to a producer to reduce the costs of production (thereby encouraging higher levels of output) or to consumers to reduce the price of consumption (e.g some governments subsidize public transport to discourage people from using private cars)

Question 10

Limitations of subsidies

Answer 10

1. Just as with indirection taxation imposed on negative production and consumption externalities, it is difficult to set a precise subsidy that ensures an optimal allocation of resources (merit goods, for example).
2. The social return on the production and consumption of merit goods (such as education or the provision of public libraries, sports facilities and museums) is difficult, if not subjective, to measure.
3. If PED for a good/service is inelastic, the lower price due to the subsidy has little impact on q. demanded
4. Always an opp cost to the provision of subsidies as the money could have been used for other gov projects that may reap greater social gains

Question 11

What are marketable permits or the cap and trade system?

Answer 11

A limit, or cap, is placed on the total amount of a pollutant that may be emitted, and this limit is either allocated or sold to firms in the form of emissions permits.

These limit the amount of pollution that any single firm may emit.

Question 12

Explain how marketable/tradable permits work.

Answer 12

1. Each firm may be allowed to emit 90 percent of the amount it emitted the previous year. (e.g)
2. Thus, a firm is granted a permit to emit so many units of pollutants.
3. Because what the government cares about is the total amount of emission reduction, it allows firms to trade permits.

Question 13

Under this system…

Answer 13

Firms will be willing to sell permits as long as the market price of the permit is greater than the marginal cost of reducing pollution, and firms will be willing to buy permits as long as the marginal cost of reducing pollution is greater than the market price of the permit.

Question 14

Thus, in equilbirum, each firm will reduce pollution to…

Answer 14

A level such that the marginal cost of pollution reduction is equal to the market price of the permit.

Question 15

Tradable permit schemes mean that the largest polluters…

Answer 15

Have to purchase more permits, which increases their costs of production, so makes them less competitive and less profitable.

Question 16

Limitations of tradable permits

Answer 16

1. anti-competitive (against smaller firms) and they can cause job losses (due to higher costs of production).
2. multinational
   companies can shift production to other countries to avoid the constraints of pollution permits and CATS.
3. Environmentalists have also argued that higher prices of tradable permits have proved ineffective in reducing carbon dioxide emissions to levels necessary to stop global warming and climate change, especially as the demand for pollution permits is highly price inelastic as gov revenue also increases because of the permits
4. Even though the system of assigning firms a fraction of their current levels of pollution might at first glance seem reasonable, it causes a major equity problem: marketable permits are an asset that can be traded, so giving pollution permits is equivalent to giving away money. Why should firms that have been polluters in the past be entitled to receive a bigger gift from the government?

Question 17

What have governments traditionally relied on to curb environmental externalities?

Answer 17

Direct regulation

Question 18

Examples of gov direct regulation in dealing w environmental externalities

Answer 18

1. Setting emission standards for automobiles
2. Put forth detailed regulations relating to the disposal of toxic chemicals
3. Outlawed smoking on domestic airline flights
4. Imposed laws requiring oil companies with wells in the same oil pool to unitize their prod.
5. Imposed restrictions on fishing + hunting to reduce the inefficiencies associated with excessive utilisation of these common resources

Question 19

What are the 2 types of regulations?

Answer 19

1. Performance-based Regulations
2. Input regulations

Question 20

What is performance-based regulation?

Answer 20

Concerned with the final outcome/amount of pollution produced by firms (s)

e.g. emission of standards for automotive

Question 21

Benefits of performance-based regulation

Answer 21

1. Directly address the level of pollution
2. They may induce innovations, such as new ways of producing that generate less pollution or new techniques for reducing pollution at lower costs
3. advances in tech have improved the ability t monitor some kinds of pollution - ongoing innovations should enhance this further

Question 22

Implicitly many economists believe…

Answer 22

The benefits of the innovation would outweigh the costs

Question 23

What is input regulation?

Answer 23

Focused on general practices and inputs of production e.g standards for smoke-stacks, prohibition on certain kinds of production methods

Question 24

What is innovation?

Answer 24

The advances in production methods for cheaper abatement, monitoring equipment etc.

Question 25

Innovation is generally induced by…

Answer 25

More policies focussing on performance rather than specific secondary aspects

Question 26

What is the argument over innovation simulation?

Answer 26

Market-based solution sceptics (innovation benefits>costs, but industry too reticent to innovate unless forced because price system insufficient incentive -> stringent product standards (in practice sometimes cheaper to overturn standard as unreasonable in court rather than comply, non-enforcement gamble, sometimes trailblazer firms), gap between best cost-effective practice & actual behaviour -> Gov Intervention in coordination & information problems
-> norm diffusion) vs slow and indirect changes of market-based intervention

Question 27

What is information disclosure?

Answer 27

1. In some areas, governments have been experimenting with another
   approach, focusing on public pressure rather than the heavy hand of government
2. The government’s role would be limited to requiring firms to
   disclose, for instance, the potentially cancer-inducing chemicals that they
   discharge into the water or emit into the air.
3. The government would not even
   comment on the extent of scientific evidence concerning the impact of
   the chemicals on humans.

Question 28

Informative provision - when is it effective?

Answer 28

Effective in encouraging desired consumption even without pointing out science

Question 29

Information provision - what are the critics saying?

Answer 29

1. High disclosure costs
2. Potential scare campaign/misconceptions instead of cost-benefits - Most people
   would simply assume that if a chemical is listed as dangerous, it must be dangerous—or, in any case, why risk it?
3. One study by the
   Environmental Protection Agency (EPA) that showed the magnitude of popular misconceptions about environmental risks. Among the risks rated most highly by the nonscientists were several that were ranked at the bottom by the scientists, and vice versa.

Question 30

Much of the debate regarding the environment is focused on?

Answer 30

The distribution of consequences of env hazards (who bears the cost)

Question 31

Why will subsidies for pollution abatement equipment result in less efficient resource allocation?

Answer 31

• Ideally, it has been believed by economists that the industry must be forced to innovate
• By imposing extremely stringent standards e.g cars get at least 40 miles per gallon: THIS WILL FORCE THE INDUSTRY TO DEVELOP A PRODUCT MEETING THESE STANDARDS
• However, in reality, rather than encouraging innovation, stringent regulations have led to litigation: it may appear cheaper to a firm to try to persuade the court that the regulation = unreasonable than to spend the money to meet the standards imposed by the regulation
• In some cases, firms have played a game of chicken, gambling that if they fail to meet the standards, the gov will not shut them down for fear of political backlash from workers who are pt out of the job