101+Class+16+W2009 - Principles of Economics I Economics...

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Unformatted text preview: Principles of Economics I Economics 101 Announcements Readings: Chapter 5 this week Discussion Sections this week New assignment available on Ctools Exam 2 Tuesday, March 24th Practice Exam available this evening No class Monday 23rd Example: Market for electricity from coal generators $/kW/h MCsoc = MC + MD Supply (MC) MCsoc = MVsoc P* Deadweight Loss Marginal Damage from Pollution (MD) Demand (MV) Qeff Q* Q (kW/h) How can we solve this problem? Need to make transacting parties consider the external costs/benefits Reflect the external costs/benefits in the sellers' costs; or Reflect the external costs/benefits in the buyers' valuations Call this "internalizing the externality" Privately Derived Solutions The Coase Theorem Imposed Solutions Regulation Taxation/Subsidization The Importance of Property Rights Imagine we could... Assign property rights to the air Enforce those property rights To polluters; or To the public Allow trade in these rights Polluters may only pollute air that they own Others may only prevent polluters from polluting air that they own Price at which rights to the air will trade reflects the damages produced by a unit of pollution It is the absence of this market that leads to inefficiency Example: Pollution Assign the right to clean air to the general public In order to produce a unit of output, the producer/polluter must pay for two things: i.e. not the polluters Production costs (reflected in MCprod) Cost of purchasing rights to the air from the public The external cost is "internalized" To buy the pollution right, must pay a price at least as high as the damage imposed by the pollution The producer now faces costs that include the full social cost of producing the output Otherwise owners of that right will not sell Production costs + payments that cover the external cost Example: Pollution $/unit MCprod + P MCprod + MCpollutionpollution right = MCsoc MCproduction MCsoc = MVsoc P* Ppollution right MCpollution MVsoc Q* Qeff Q Example: Pollution Observation: outcome would not have been any different if we had assigned the right to the clean air to the producer Producer still sees two costs Production costs (reflected in MCprod) Opportunity cost of using the pollution right Could have sold it to somebody who valued the clean air Negotiated price will not be above the damage imposed by pollution The external cost is "internalized" The producer now faces the full social cost of producing the output Production costs plus external costs Private Solutions to Externality Problems Pollution example illustrates that the efficient outcome may still obtain in markets with externalities if Property rights are defined and enforced over the right to benefit from or impose an externality Agents are free to trade these rights The efficiency of the outcome is independent of initial allocation of rights Allocation of rights will affect distribution of wealth though The Coase Theorem Private arrangements will be freely negotiated to ensure that externalities are internalized E.g. if your production imposes an economic cost on me, we can negotiate to find a mutually beneficial arrangement that is mutually beneficial If there is social surplus available, private parties will find a way to secure it Efficient allocation of resources achieved in the free market The Coase Theorem Barriers to efficiency improving negotiations: Poorly assigned or enforced property rights Transactions and bargaining costs Example: When a producer pollutes the local water supply, a great many people suffer damage People could pay the polluter not to pollute But, this group is: It is unlikely that the group will raise funds to reflect the damage that the pollution generates Large and dispersed Costly to organize Poorly informed Tempted to "free ride" Private Solutions to Externality Problems Two questions: 1. Do we ever see private solutions successfully implemented? 1. If these private solutions aren't successful, are there solutions that can be imposed by the state? Are Private Solutions Ever Successful? Markets for Tradable Emissions Permits SO2, CO2 and NOx permits are currently traded Clear Skies Act (2003) authorizes new tradable permit markets (mercury, NOx etc) Referred to as "cap and trade" programs Assigns rights to a limited quantity of the air, and allows trade in those rights Cap the total amount of pollution Allocate permits to pollute amongst polluters Allow them to trade these permits How does "cap and trade" work? Example: coal burning electricity generators produce pollution Permit grants a producer to generate an amount of pollution Producing pollution (i.e. using a permit) means either SO2, CO2, NOx The cost of polluting now rises Buying the permit Forgoing the opportunity to sell it Internalizing an externality How does "cap and trade" work? There is a fixed quantity of permits allocated Amount of pollution is predetermined Cannot lower the level of pollution Achieve the target pollution level at the lowest abatement cost Abatement Costs Pollution abatement can be tackled on two margins: Reducing output of the good is costly to society: Reduce output of the good with which the pollution is associated Reduce the amount of pollution produced with each unit of the good Deprive consumers of the good the benefits of consuming it May be less costly to achieve the reduction in pollution by working on the other margin Minimizing abatement costs Using pollution permits, polluters have the incentive to find the cheapest methods of pollution abatement Polluters with high MCabatement buy permits from those with low MCabatement, and need not reduce pollution Polluters with low MCabatement sell their permits and reduce pollution Encourages adoption of newer, cleaner technology only when the costs of that new technology are sufficiently low Encourage reduction in output of the good only when that's the cheapest way to abate pollution Does "cap and trade" yield the efficient amount of pollution? Efficient amount of pollution has marginal damage = marginal abatement cost EPA determines the number of pollution permits available Limits the total pollution Those harmed by pollution could themselves purchase permits and "retire" them Does cap and trade express marginal damage information? If damage from the marginal unit of pollution is greater than the price of the permit Not much activity on this level: benefits of retirement accrue widely, and coordination between those who benefit is costly Alternatives to private solutions: The pollution example Regulation of pollution by command Legislate technology to be used Legislate caps on output of products No way to ensure that the "cheap" method of abatement is used Alternatives to private solutions: The pollution example Taxation of polluting firms We want to "internalize" the external costs of pollution Impose a tax equal to the marginal damage from pollution Parties to the transaction observe both production costs AND taxation costs Equal to the production cost PLUS MARGINAL DAMAGE Pigouvian Tax $/unit MCsoc MCproduction MCsoc = MVsoc Pc t* P* Pp MVsoc Qeff Q* Q Pigouvian Taxation vs. Coasian Solutions Pigouvian taxation: Coasian Solutions: Need to know information about private costs and benefits If we cannot measure pollution directly, can only manipulate output of the good (not necessarily the low cost approach to abatement) No need to know information about private costs and benefits Potentially provides incentives on all relevant margins Requires well defined and enforcable property rights Requires bargaining and transactions costs are low ...
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This note was uploaded on 05/16/2010 for the course ECON Section 40 taught by Professor Hogan during the Winter '09 term at University of Michigan.

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