Lecture 4 - Externalities

Question 1

Consumption externality - definition and example

Answer 1

Where the utility of one agent is affected directly by the actions of another, eg. factory emitting pollutants that affect my health

Question 2

Production externality - definition and example

Answer 2

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)

Question 3

Distribution externality - Meade’s definition (4pts)

Answer 3

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.

Question 4

Starrett’s definition of an externality

Answer 4

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.

Question 5

Efficient level of pollution abatement

Answer 5

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

Question 6

Condition for MAC to be monotonically increasing

Answer 6

Least-costly abatement measures (cost per tonne) implemented first and gradually towards more costly measures.

Question 7

Pigouvian tax

Answer 7

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

Question 8

Tradeable permits - properties (3)

Answer 8

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’)

Question 9

Pigouvian taxes vs. emissions trading - key issues

Answer 9

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

Question 10

Coase Theorem

Answer 10

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

Question 11

Coase theorem - 2 theses

Answer 11

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

Question 12

Coasean bargaining - two situations

Answer 12

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

Question 13

Conditions for the Coase Theorem to hold (3)

Answer 13

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

Question 14

Bargaining w/ asymmetric info - result

Answer 14

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

Question 15

Invariance thesis will not hold when…

Answer 15

income/wealth effects affect either the MAC or MDC

Question 16

Wealth effects when the parties bargaining are firms?

Answer 16

No: effects of pollution on profits are unaffected by the wealth of the firm. It just reduces its profits by the amount spend or the damage suffered

Question 17

Wealth effects for individuals?

Answer 17

• > Polluter: MAC may include behavioural changes, eg. turning down loud music at night. A wealthy individual would be willing to pay more to avoid this.
• > Victim: MDC may include utility losses, eg. health effects from pollution. Wealthier people would also be willing to pay more to avoid these utility losses.