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Economics 2

Lecture 27 - Externalities

policies for externalities

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Policies for Externalities

• regulation: allow the externality to the point where MSC = MSB
• taxes or subsidies: levied on polluting activities to make MPC = MSC; set the tax equal to the marginal external cost
• assign property rights: the Coase theorem says that costless bargaining leads to the efficient level of the externality. Suppose a brewery uses lake water to make beer while a fertilizer manufacturer disposes wastes in the lake. If the fertilizer company owns the lake the brewery can pay it to reduce emissions. The brewery will be willing to pay up to the amount of damage the emissions create while the fertilizer company will be willing to accept payments equal to their costs of reducing emissions. Bargaining will result in the efficient outcome. If the brewery owns the lake emissions would be zero. The fertilizer company would be willing to pay to be permitted to dump wastes in the lake and the brewery will be willing to receive payments equal to the damage the wastes do to them. Bargaining will result in an efficient outcome. No matter who was initially given ownership of the lake we will get the same level of emissions.
• pollution permits: firms are required to possess permits for each unit of pollution emitted and these permits can be bought and sold
  
  

  Suppose we run a power plant that currently emits 8000 tons of SO₂ a year and that the EPA wants to reduce sulfur emissions by 25%. Our firm might receive 6000 permits. We then have 3 options:

  1. reduce emissions to 6000 tons
  2. buy additional permits and emit at a higher level, say we buy 1500 permits and emit 7500 tons of SO₂
  3. reduce emissions below 6000 tons, to say 3500 tons, and sell the excess 2500 permits

  What do we do? It depends on the costs of reducing sulfur emissions and the price of a permit. We will do whatever is the least expensive. Those firms that can cheaply reduce emissions will end up selling permits to those firms that find it expensive to reduce sulfur emissions. In this way, the 25% reduction in SO₂ emissions is achieved in the least costly way.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31