Topic 4: Externalities

Question 1

Externality

Answer 1

Externalities arise whenever the actions of one economic agent directly affect another economic agent outside the market mechanism

Question 2

Production externality

Answer 2

effect of externality on a profit relationship (supply side)

Question 3

Consumption externality

Answer 3

effect of externality is on the utility level (demand side)

Question 4

Private marginal cost (PMC)

Answer 4

the direct cost to producers of producing an additional unit of a good

Question 5

Marginal damage (MD)

Answer 5

any additional costs associated with the production of the goods that are imposed on others but that producers do not pay

Question 6

Social Marginal Cost (SMC)

Answer 6

the private marginal cost to producers plus marginal damage (SMC=PMC+MD)

Question 7

How to obtain pareto efficient allocations in the presence of externalities?

Answer 7

Maximise the total utility of the society (sum of utilities of all consumers) subject to the production possibilities in the economy

Question 8

Policy interventions to correct externalities

Answer 8

1. Establish property rights (Coasian solution)
2. Emission taxes or Pigouvian corrective taxation
3. Regulation (Command and Control)
4. Permits (cap-and-trade)

Question 9

Coase theorem

Answer 9

1. When there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and party affected by the externality can bring about the socially optimal market quantity
2. The efficient quantity for a good producing an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights

Question 10

Assumptions of Coase theorem

Answer 10

1. Complete information
2. Zero transaction costs

Question 11

Problems with the Coasian solution

Answer 11

1. The assignment problem
2. The holdout problem
3. Transaction costs and negotiating problems (hard to negotiate when lots of people on both sides of negotiation)

Question 12

The assignment problem

Answer 12

In cases where externalities affect many agents, assigning property rights is difficult

Question 13

The holdout problem

Answer 13

Shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution)

Question 14

Pigouvian taxation

Answer 14

Sets tax equal to the wedge between MSC and MPC to restore production efficiency (i.e. set tax equal to the marginal damage)

Question 15

Advantages of regulation

Answer 15

1. Easier to enforce/administer than taxation
2. Useful to quickly reduce pollution levels if you want to meet a certain salient target (immediate effect)

Question 16

Disadvantages of regulation

Answer 16

1. Discourages innovation (no monetary incentives to discover new technologies to reduce pollution further)
2. Inefficient allocation when there is heterogeneity in costs of pollution abatement across firms

Question 17

When the MD curve is relatively flatter than the MC curve and there is uncertainty about the MC of reducing pollution is tax or quantity regulation better?

Answer 17

Price regulation better as generates a lower DWL

Question 18

What affects the relative steepness of the MD/MB curve for pollution abatement?

Answer 18

Flat curve = delayed benefit (e.g. global warming)
Steep curve = immediate benefit (e.g. nuclear leakage)

Question 19

Challenges to reducing CO2 emissions (Wagner-Weitzman, 2015)

Answer 19

1. Global (emissions in one country affect the full world)
2. Irreversible (atmospheric CO2 has long life)
3. Long-term (costs of global warming are decades/centuries away)
4. Uncertain (about costs of global warming)

Question 20

Difference between Kyoto Protocol and Paris Agreement

Answer 20

Both emission reduction commitments but:
1. Kyoto Protocol (1997) only included developed countries (despite developed reducing emissions, overall emissions rose)
2. Paris agreement (2015) included developing countries