Externalities, Pollution and Global Warming

Markets are usually a good way to organize economic activity In the absence of market failures, the market outcome is efficient, maximizes total surplus One major type of market failure: externalities Externality: the uncompensated impact of one person’s actions on the well-being of a bystander 2 Externalities and Efficiency

In the presence of externality, market equilibrium is no longer efficient Individual’s estimates of resources value (or cost) are not correct (from the society’s point of view) Traditional belief: Government to step in to ensure efficient resource allocation And to protect the interest of bystanders as well 3 Negative Externality Negative Externality: the effect on bystanders is adverse Example: the neighbor’s barking dog talking on cell phone while driving makes the roads less safe for others health risk to others from second-hand smoke noise pollution from construction projects 4 Pollution: A Negative Externality

Firms burn huge quantities of fossil fuels (coal, natural gas, oil) that cause acid rain and global warming Firms dump toxic waste into rivers, lakes, and oceans These environmental issues are simultaneously everybody’s problem and nobody’s problem 5 Pollution: A Negative Externality Example of negative externality: Air pollution from factory Firm does not bear the full cost of its production, so will produce more than the socially efficient quantity How govt may improve the market outcome: Impose a corrective tax on the firm equal to the external cost of the pollution it generates 6 Recap of Welfare Economics

P $5 4 3 $2. 50 2 1 0 The market for gasoline The market eqm maximizes consumer + producer surplus. Supply curve shows private cost, the costs directly incurred by sellers Demand curve shows private value, the value to buyers (the prices they are willing to pay) 0 10 20 25 30 Q (gallons) 7 Analysis of a Negative Externality Key: distinguish private and social costs Private costs and social costs diverge in the presence of externality Producer concerns private cost, which neglect the external cost (pollution cost) Social cost represents the resource cost to a society social cost = private cost + external cost 8

Analysis of a Negative Externality P $5 4 3 2 1 0 The market for gasoline Social cost =private+ external cost external cost 0 External cost = value of the negative impact on bystanders = $1 per gallon (value of harm Supply (private cost) from smog, greenhouse gases) 10 20 30 Q (gallons) 9 Analysis of a Negative Externality P $5 4 3 2 D 1 0 The market for gasoline Social cost S The socially The socially optimal quantity optimal quantity is 20 gallons. is 20 gallons.

At any Q < 20, At any Q < 20, value of additional gas value of additional gas exceeds social cost exceeds social cost At any Q > 20, At any Q > 20, social cost of the social cost of the last gallon is last gallon is greater than its value greater than its value 10 0 10 20 25 30 Q (gallons) Analysis of a Negative Externality P $5 4 3 2 D 1 0 The market for gasoline Mkt eqm (Q = 25) Social cost is greater than social optimum S (Q = 20) overproduction resulted in DWL (red triangle) One solution: impose a corrective tax of $1/gallon on sellers, shift supply curve up $1 11 0 10 20 25 30 Q (gallons) Internalizing the Externality

Internalizing the externality: altering incentives so that people take account of the external effects of their actions previous example: $1/gallon tax on sellers makes sellers’ costs equal to social costs When market participants must pay social costs, the market eqm matches the social optimum. Imposing the tax on buyers would achieve the same outcome: market Q will equal optimal Q 12 Summary For Pollution: A Negative Externality With negative externality, QMarket >QSocial Optium firms over-produce (DWL exist) Remedy: The government can internalize the externality by imposing corrective tax Price tax S’ S

Q = Qmarket = initial eqm Q’ = QSocial Optium = eqm after tax D Q’ Q Quantity 13 Externality in Consumption Consumption of alcohol, tobacco, and gasoline (private driving) all create negative externality to the society Got impose a heavy corrective tax on these goods to alter the incentives of customers, in order to mitigate of negative externality 14 Corrective Tax Rate (Levy / Charges) in HK Alcohol: 100% tax rate for alcohol with strength of more than 30% by volume Cigarettes: $1. 7 / each cigarette, tax for a pack of 20-stick cigarettes = $34 70% of the selling price of $50 / pack Leaded petrol: $6. 823/ litre, unleaded petrol: $6. 6/ litre About 40% of the selling price of each litre of gasoline 15 Example: Gasoline Tax Targets 3 Negative Externalities Congestion: the more you drive, the more you contribute to congestion Accidents: larger vehicles cause more damage in an accident Pollution: burning fossil fuels produces greenhouse gases 16 Case Study: Environmental Levy on Plastic Shopping Bags in HK Survey indicates that some 8 billion (8,000,000,000) plastic shopping bags are disposed of at landfills every year in HK This translates into more than 3 plastic shopping bags per person per day, which apparently go beyond our needs 7 Case Study: Environmental Levy on Plastic Shopping Bags in HK Address the problem of abuse, gov introduced an levy of $0. 5 HKD on each plastic shopping bag at the retail level Estimated negative externality of each plastic bag = ? 18 Positive Externality Positive Externality: the effect on bystanders is beneficial Example: When you get a flu vaccination, everyone you come into contact with benefits Research and Development (R&D) creates knowledge others can use Renovating your house increases neighboring property values Restores of historical building 19 Positive Externalities from Education

A more educated population benefits society: lower crime rates: educated people have more opportunities, so less likely to rob and steal better government: educated people make better-informed voters People do not consider these external benefits when deciding how much education to “purchase” 20 Positive Externalities from Education Result: market eqm Q of education too low How govt may improve the market outcome: subsidize cost of education In the presence of a positive externality, the social value of a good includes private value: the direct value to buyers external benefit: the value of the positive impact on bystanders 21

Analysis of a positive externality P The market for flu shots $50 40 30 20 10 0 0 10 20 30 S D External benefit = $10/shot Draw the social value curve. Find the socially optimal Q. What policy would internalize this externality? Q 22 Analysis of a positive externality P The market for flu shots $50 40 30 20 10 0 0 10 20 25 30 external benefit S Mkt eqm Q = 20 Social optimal Q = 25 underproduction resulted in DWL (red triangle) Social value = private value + external benefit D To internalize the externality, use Q subsidy = $10/shot. 23

Case Study: Innovation and Technology Policy in HK Should government subsidize high tech companies? Pros: Spillover effects International competitiveness Cons: Potential misallocation of public resource Potential problems of unfairness & corruption 24 Case Study: Innovation and Technology Policy in HK Eg: Cyberport IT project? 25 Summary: Corrective Tax and Subsidy to Deal With Externalities If negative externality market produces a larger quantity than is socially desirable If positive externality market produces a smaller quantity than is socially desirable 6 Summary: Corrective Tax and Subsidy to Deal With Externalities remedy the problem: “internalize the externality” tax goods with negative externalities ideal corrective tax = external cost subsidize goods with positive externalities ideal corrective subsidy = external benefit 27 Private Solutions to Externalities? Government intervention is always controversial Major concerns of government intervention include fairness and efficiency The market does develop some possible solutions to externality over time 28 Private Solutions to Externalities?

Social norms / moral codes Eg: littering Mergers Eg: MTR as a property developer Contracts between market participants and the affected bystanders However: If an externality affects many people, contract negotiation is virtually impossible 29 Public Policies Toward Negative Externalities Market-based policies provide incentives so that private decisionmakers will choose to solve the problem on their own Corrective Tax Tradable Pollution Permits 30 Public Policies Toward Negative Externalities Command-and-control policies: Regulation regulate behavior directly.

Examples: limits on quantity of pollution emitted requirements that firms adopt a particular technology to reduce emissions 31 Policy Option: Example “Ace Electric” and “Billy Power” both are running coal-burning power plants Each emits 40 tons of sulfur dioxide per month SO2 causes acid rain & other health issues Policy goal: reducing SO2 emissions 25% to 60 tons/month 32 Policy Option: Regulation Vs Corrective Tax Policy options 1. regulation: require each plant to cut emissions by 25% 2. corrective tax: make each plant pay a tax on each ton of SO2 emissions. Set tax at level that achieves goal. 33

Policy Option: Regulation Vs Corrective Tax Under Policy option 1, regulation, firms have no incentive to reduce emissions beyond the 25% target Suppose cost of reducing emissions is lower for “Ace Electric” than for “Billy Power” Socially efficient outcome: “Ace Electric” reduces emissions more than “Billy Power” 34 Policy Option: Regulation Vs Corrective Tax Corrective tax is a price on the right to pollute Under policy option 2, tax on emissions gives firms incentive to continue reducing emissions as long as cost of doing so is less than the tax If a cleaner technology available, tax gives firms incentive to adopt it Tax payment is money!

So, corrective taxes enhance efficiency by aligning private with social incentives 35 Policy Option: Tradable Pollution Permits Recall: “Ace Electric” and “Billy Power” each emit 40 tons SO2, total of 80 tons. Goal: reduce 25% emissions to 60 tons/month Policy option 3: Tradable Pollution Permits issue 60 permits, each allows its holder to emit one ton of SO2 give 30 permits to each firm establish market for trading permits 36 Policy Option: Tradable Pollution Permits

Each firm can choose among these options: emit 30 tons of SO2, using all its permits emit < 30 tons, sell unused permits buy additional permits so it can emit > 30 tons 37 Policy Option: Tradable Pollution Permits A system of tradable pollution permits achieves goal at lower cost than regulation Firms with low cost of reducing pollution (Ace Electric) sell whatever permits they can Firms with high cost of reducing pollution (Billy Power) buy permits Result: incentive to reduce pollution: permit = money 38

Tradable Pollution Permits in the Real World Emission of greenhouse gases causes the global warming The primary greenhouse gas in the atmosphere is the emission of carbon dioxide Carbon emissions trading is a form of emissions trading that specifically targets carbon dioxide 39 Tradable Pollution Permits in the Real World Carbon emissions permits traded in Europe since January 1, 2005 Recall: permit = money Firms will have strong incentive to reduce carbon emissions 40