reduce pollution with the least cost are likely to do so (to avoid the tax) while firms that encounter high costs when reducing pollution will simply pay the tax Ø Thus, this tax allows firms that face the highest cost of reducing pollution to continue to pollute while encouraging less pollution over all Ø Unlike other taxes, corrective taxes do not cause a reduction in total surplus. In fact, they increase economic well-being by forcing decision-makers to take into account the cost of all of the resources being used when making decisions • Tradable pollution permits
Ø Example: EPA regulations restrict the amount of pollution that two firms can emit at 300 tons of glop per year. Firm A wants to increase its amount of pollution. Firm B agrees to decrease its pollution by the same amount if Firm A pays it $5 million Ø Social welfare is increased if the EPA allows this situation. Total pollution remains the same so there are no external effects. If both firms are doing this willingly, it must make them better off Ø If the EPA issued permits to pollute and then allowed firms to sell them, this would also increase social welfare. Firms that could control pollution most inexpensively would do so and sell their permits, while those who encounter high costs when reducing pollution would buy additional permits • Tradable pollution permits and corrective taxes are similar in effect. In both cases, firms must pay for the right to pollute Ø In the case of the tax, the government sets the price of pollution and firms then choose the quantity of pollution (given the tax) that maximizes their profit. Corrective taxes are used when the government knows the exact dollar amount that the externality is worth to society Ø If tradable pollution permits are used, the government chooses the quantity of pollution (in total, for all firms) and firms then decide what they are willing to pay for these permits. Pollution permits are used when the government knows the exact quantity of pollution that is optimal for society
The Coase Theorem • Definition of Coase theorem: the idea that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own • Example: Bob owns a dog named Spot who disturbs a neighbor (Jane) with its barking Ø One possible solution to this problem would be for Jane to pay Bob to get rid of the dog. The amount that she would be willing to pay would be equal to her valuation of the costs of the barking. Bob would only agree to this if Jane paid him an amount greater than the value he places on owning Spot Ø Even if Jane could legally force Bob to get rid of Spot, another solution could occur: Bob could pay Jane to let him keep the dog • Whatever the initial distribution of rights, the parties involved in an externality can potentially solve the problem themselves and reach an efficient outcome where both parties are better off • Why Private Solutions Do Not Always Work: Ø Definition of transaction costs: the costs that parties incur in the process of agreeing and following through on a bargain. (ex: lawyers, contracts, seeking advice from
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