Econ. 611 - Advanced Microeconomic Analysis

Semester Paper: (Econ. 611: Advanced Microeconomic Aanalysis)

MICROECONOMIC SOLUTIONS FOR EXTERNALITIES

 

Semester Paper Submitted as Requirement for the Internal Examination of the

M. Phil. in Economics

 

 

Submitted to:

Tribhuvan University

Central Department of Economics

M. Phil. Programme

 

 

Submitted by:

Yogendra Dahal

Roll No.: 14

 

February, 2017

1.  Introduction

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. Some terms that encompass phases of economic efficiency include allocation efficiency, production efficiency and Pareto efficiency.

The situation in which it is impossible to generate a larger welfare from the available resources or the situation where some people cannot be made better-off by reallocating the resources or goods, without making others worse-off is Pareto efficiency. It indicates that a balance between benefit and loss has been achieved, called allocative efficiency. For example, initially 1000 megawatt of electricity and 100 tons of paddies were being produced in an economy. If by reshuffling the existing resources we can produce 1002 megawatt of electricity and same amount of paddies. Then, obviously the original allocation of resources can be considered inefficient. In Pareto sense (after Vilfredo Pareto, an Italian economist), any reallocation of resources cannot make some people better off without reducing the welfare of someone else. It can be termed as Pareto efficiency or economic efficiency

However, under some circumstances the market mechanism cannot lead to this situation of economic efficiency (i.e. the state of maximum social welfare). The circumstance under which the market mechanism fails to achieve economic efficiency is called market failure. Market failure is often associated with the existence of market power of a firm to raise and maintain price above the level, natural monopoly having high fixed or start-up costs of operating a business, information asymmetry (buyer and seller possess different information), externalities (i.e. external economies and dis-economies in production and consumption), and public goods (i.e. non excludability in consumption of certain goods).

The present study deals with the problems of externalities due to which market mechanism fails to achieve economic efficiency in an economy. Furthermore, the study examines the microeconomic policies suggested by Pigou and Coase and other public policies that can be used to deal with the problem of externalities.

2.  Subject Matter

An externality exists whenever the welfare of some agent, either a firm of a household, depends directly, not only on his or her activities, but also on activities under the control of some other agent as well.

A cost or benefit that is not shown in the actual price of something and is incurred by a party who did not agree to the action causing the cost or benefit.

Externality is a situation in which an individual or firm takes an action but does not bear all the costs (negative externality) and does not receive all the benefits that (positive externality). Some costs and benefits that fall on third parties (spill over).

Due to the high transaction costs injured parties find difficulties to use legal or other means to cause polluters to internalize the damage they cause, poorly defined property rights and difficulty in tracing the causal connections between activities that resulting damages and often involve long time periods are the basic reasons for externalities.

Producers of externalities do not have an incentive to take into account the effect of their action on others, the outcome is inefficient. So, market produces or individual consumes larger quantity than is socially desirable in case of negative externality and similarly, in case of positive externality, market produces or individual consumes smaller quantity than is socially desirable.

2.1 Negative Production Externalities

Side effects of production activities or negative production externality arises when a firm's production reduces the well-being of others who are not compensated by the firm or does not have to pay the full cost of decision. In an unregulated market, producer don’t take responsibility for the damage, it passes on to society.

For example, manufacturing cause air and water pollution, congestion, housing development on green belt areas, destruction of hedgerows and wildlife, noise, pollution, anti-social behaviour, crime are negative production externalities. Where, MSC = MPB – MPC. (⸪MPB=MSB)

Thus producer have lower marginal costs and the supply cure is effectively shifted down (to the right) of the supply curve that society faces. More of the product is bought and sold than the socially desirable efficient amount. Since MB is not equal to MC, a dead-weight loss arises.

2.2 Positive Production Externalities

A positive production externality occurs when a third party gains as a result of production. However, those third parties who benefit cannot be charged, so there is only an incentive to supply to those who can be charged. On For example, an apple orchard next to a beekeeper and research into new technologies, human resource development, research, development in industry, technology developed alongside the internet, such as the HTML language and construction and operation of infrastructure projects, such as a new airport, or motorway are the positive production externalities. Where, MSC < MPC.

Thus producer have higher marginal costs and the supply cure is effectively shifted up (to the left) of the supply curve that society faces. Less of the product is bought and sold than the socially desirable efficient amount. Since MB is not equal to MC, a dead-weight loss arises.

2.3 Negative Consumption Externalities

When the consumption (demerit goods)of a person reduces the well-being of others who are not compensated by the individual or creates detrimental effect on others, it is negative externality in consumption. For example, neighbor playing loud music at 3 in the morning, passive smoking, discarding garbage in public places, gambling addiction, littering and not recycling, noise, anti-social behaviour, barking dogs, driving cars (traffic, pollution, accident etc.) are the example of negative consumption externalities. Where MSB < MPB.

Thus consumer have higher marginal benefit and the demand cure is effectively shifted up (to the right) of the demand curve that society faces. More of the product is consume than the socially desirable efficient amount. Since MB is not equal to MC, a dead-weight loss arises.

2.4 Positive Consumption Externalities

When an individual's consumption (merit goods) increases the well-being of others but the individual is not compensated by those others or creates beneficial effects on others, it is positive consumption externalities. For example, fire proofing of an individual's home improves the fire safety of neighbors, people going to college raise the population's education level, which reduces crime and improves government, pleasure from observing neighbor's flower garden, preventative health care – vaccinations, public transport, attractive gardens and bathing regularly. These all are positive consumption externalities. Where MSB > MPB. 

Without considering externalities, quantity consume at Q* by an individual. But individual consumption bring more benefit to the society. Because of external benefit, MSB is over the MPB with social quantity demand Q1. Thus consumer have lower marginal benefit and the demand cure is effectively shifted down (to the left) of the demand curve that society faces. Since MB is not equal to MC, a dead-weight loss arises.

3.  Analysis

There are differences between private returns or costs and the costs or returns to society as a whole. Consumption, production, and investment decisions of individuals, households, and firms often affect people not directly involved in the transactions. Sometimes these indirect effects are tiny. But when they are large they can become problematic—what economists call externalities. Externalities are among the main reasons governments intervene in the economic sphere.

Most externalities fall into the category of so-called technical externalities; that is, the indirect effects have an impact on the consumption and production opportunities of others, but the price of the product does not take those externalities into account. As a result, there are differences between private returns or costs and the returns or costs to society as a whole. However, there are other social institutions such as the legal system or government intervention that can mimic the market mechanism to some degree and thereby achieve Pareto efficiency. There are several general types of solutions to the problem of externalities:

3.1 Correcting Measure to Negative Production Externalities

a) Command and Control Policies (Legislation and regulations)

The government can antidote an externality by making definite performances whichever needed for prohibition. It help to reduce the production to a certain level that socially desirable. Normally governments pass laws and regulations to address pollution and other types of environmental harm by setting standards, targets or forcing production units to adopt a particular technology to reduce damage.

b) Tradable permits

A cost efficient and market driven approach to reducing the quantity of goods produced so that it equal to socially optimal level. Tradable permits are instruments aimed at reducing pollution. A maximum permissible emission rate is determined by government and permits that allow for the production of a maximum emission are issued to industry players. These permits can subsequently be traded to firms that require more permits in order to continue their activities.

For Example: Himal Cement Factory (HCF) and Udayapur Cement Factory (UCF) run coal power plants. Each emits 40 tons of sulfur dioxide per month. The objective is to reduce sulpher dioxide emissions by 25 % and the cost of reducing emissions is Rs 100/ton for HCF and Rs. 200/ton for UCF. Below tables shows the total cost of achieving goal with regulation and tradable permits policies.

Policy 1 (Regulation): Every firm must cut its emission 25% (10 tons)

Factory	Total Emission	Reduced Emission	Permitted Emission	Total Permitted Emission	Cost of reduction/ton	Net cost	Total Cost of reduction
HCF	40 tons	10 tons	30 tons	60 tons	Rs. 100	Rs. 1000	Rs. 3000
UCF	40 tons	10 tons	30 tons		Rs. 2000	Rs. 2000

Policy 2 (Tradable Permits): Each firm may use all its permits to emit 30 tons, may emit< 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons. Suppose HCF uses 20 permits and sells 10 permits to UCF for Rs. 150 each.

Firm	Total Emission	Reduced Emission	Permitted Emission	Total Used Emission	Cost of reduction/ ton	Cost of reduction of 25% of total emission	Selling or buying Price/ ton	Selling/ buying amount	Net Cost
HCF	40 tons	20 tons	30 tons	20 tons	Rs. 100	Rs. 2000	Rs. 150	10 tons	Rs. 2000- Rs. 1500 = Rs. 500
UCF	40 tons		30 tons	40 tons			Rs. 150	10 tons	Rs.1500
Total Permitted Emission				60 tons		Total Cost of reduction			Rs. 2000

Using tradable permits, goal is achieved at lower total cost and lower cost to each firm than using regulation.

c) Corrective tax

A tax designed to induce private decision-makers to take account of the social cost that arise from a negative externality is also known as Pigouvian taxes. Putting distortionary taxes either on per unit of production or per unit of damage caused by production reduce output and bring closer to the socially optimal level of production.  

The size of the negative externality, or external cost, is the difference between the marginal social cost curve and the marginal private cost curve. If the government can correctly assess the true external cost then it can set the tax at exactly that level, so that the marginal private cost curve shifts until it superimposes itself on to the marginal social cost curve. This would mean that the equilibrium price and quantity reached by consumers and producers would now be the same as the socially optimal equilibrium.

As the government imposes taxes, the MPC curve will slowly shift. This makes the welfare loss shrink, and it is totally eliminated once the MPC line shifts to the same position as the MSC line.

3.2 Correcting Measure to Positive Production Externalities

Pigouvian subsidies are also an option. Firm will produce more of the positive externality since they are receiving a beneficial Pigouvian subsidy.  A subsidy that reduces the marginal cost which coincides with the social marginal cost then production increases to socially optimal level.

3.3  Correcting Measure to Negative Consumption Externalities

a) Negative advertising and moral codes

Raise awareness about the harms of a good's consumption could help reduce demand and moral codes guide individuals' behavior. Individuals know that certain actions are simply not "the right thing to do" or would elicit disapproving reactions from others. This is illustrated in the case of littering. The likelihood of being fined may be small, but moral codes provide an incentive to refrain from littering.

b) Corrective taxes

Increases the MPC to reduce the supply and raise the price lead to smaller quantity demand at socially optimum level.

c) Legislations and regulations (fines)

Government can regulate, limit or ban the consumption of a harmful good.

d) Legal limits or bans: Age restriction (legal drinking age)

e) Mediation or negotiation

Contracts between those affected by externalities and those causing them can costlessly bargain over the allocation of resources, they can solve the externalities on their own is known as Coase Theorem. If property rights are fully assigned and if people can negotiate (act rationally) at low transaction costs or zero with one another they will arrive at efficient solutions to problems caused by externalities without the need for explicit government intervention in the form of regulation and/or taxation.

For Example: Spot's (dog) barking disturbs Jane (person II), Dicks' (person I) neighbor. The socially efficient outcome maximizes Dicks's and Jane's well-being. If Dick values having Spot more than Jane values peace and quiet, the dog should stay otherwise not.

Case	Right	Benefit to Dick of Having Spot (dog)	Cost to Jane of Spot's barking	Socially Efficient Outcome	Private Outcome
I	Dick has the right to keep Spot	Rs. 500	Rs. 800	Spot goes bye-bye	Jane pays Dick Rs. 600 to get rid of Spot. Both Jane and Dick are better off.
II	Dick has the right to keep Spot	Rs. 1000	Rs. 800	See Spot stay	Jane not willing to pay more than Rs. 800 and Dick not willing to accept less than Rs. 1000. So, Spot stays.
III	Jane has the legal right to peace and quiet	Rs. 800	Rs. 500	Dick keeps Spot	Dick pays Jane Rs. 600 to put up with Spot's barking.

The private market achieves the efficient outcome regardless of the initial distribution of rights.

3.4 Correcting Measure to Positive Consumption Externalities

Pigouvian subsidies are also an option to produce more of the positive externality from the consumption of merit goods since they are receiving a beneficial Pigouvian subsidy. A subsidy that increases the marginal private benefit which coincides with the social marginal benefit then consumption increases to socially optimal level.

Increasing supply

Government grants and subsidies to producers of goods and services that generate external benefits will reduce costs of production, and encourage more supply. This is a common remedy to encourage the supply of merit goods such as healthcare, education, and social housing. Such merit goods can be funded out of central and local government taxation. Public goods, such as roads, bridges and airports, also generate considerable positive externalities, and can be built, maintained and fully, or part, funded out of tax revenue.

Increasing demand

Demand for goods, which generate positive externalities, can be encouraged by reducing the price paid by consumers. For example, subsidizing the tuition fees of university students will encourage more young people to go to university, which will generate a positive externality for future generations.

4. Conclusion

The welfare economics shows that a free, competitive market will provide an efficient outcome in the absence of externalities. However, if externalities are present, the outcome of a competitive market is unlikely to be Pareto efficient. However, in this case the state can sometime 'mimic' the role of the market by using prices to provide correct signals about the social cost of individual actions. More importantly, the legal system can ensure that property rights are well defined, so that efficiency-enhancing trades can be made.

Sometimes, bargain without cost people can solve externalities on their own states by the Coase theorem can reach the socially optimal allocation of resources. But in practice, bargaining is often costly or difficult, and then government can attempt to remedy the problem. It can internalize the externality using corrective Pigouvian taxes. It can issue permits to polluters and establish a market where permits can be traded.

More specifically, for the positive production and consumption externalities subsidy is the basic measure to internalize the externalities. To eliminate negative production externalities Command and Control Policies (Legislation and regulations), tradable permits, corrective tax are the basic measure. Similarly, negative advertising and moral codes, corrective taxes, legislations and regulations (fines), legal limits or bans, age restriction (legal drinking age), mediation or negotiation are the  correcting measure for negative consumption externalities. 

References

Atilla, A. (2011). Internalizing Externality in the case of Joint and Separate Productions: Property Rights Regulation as the Public Economy Solution. International Journal of Business and Social Science, 2(10).

Baumol, W. J. (2014). Economic Theory and Operations Analysis (4^th ed.). New Jersey: Pearson Education.

Locke, R. (nd). Externalites: The Coase and Pigouvian Theorems and Their Implications. Retrieved from: http://slideplayer.com/slide/5952892/

Mankiw, G. N. (2010). Externalities. Retrieved from

http://mankiw.swlearning.com/mankiw3e/ppt_lecture/externalities.ppt

Saez, E. (nd). Externalities: Problems and solution. Retrieved from:

http://eml.berkeley.edu/~saez/course131/externalities1_ch05.pdf

Sharma, Sarad K. "Class Notes on Semester Paper Outline." Presentation at the M. Phil. Class, T.U., Kirtipur, December 09, 2016.

Varian, H.R. (2010). Intermediate Microeconomics (8 ed.). US: W.W. Norton & Company.

Websites:

http://economics.fundamentalfinance.com/positive-externality.php

https://en.wikipedia.org/wiki/Externality

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/market

http://www.citeman.com/13480-private-solutions-to-externalities.html

http://www.econclassroom.com/?p=2859

http://www.economicsonline.co.uk/Market_failures/Externalities.html

http://www.economicsonline.co.uk/Market_failures/Positive_externalities.html

http://www.imf.org/external/pubs/ft/fandd/basics/external.html

https://www.safeopedia.com/definition/3058/tradable-permitsfailure-externalities-7/private-solutions-60/types-of-private-solutions-227-12318/