Economics

Externalities
Dept. of Economics @ NCKU
Weng, Ming-Hung
 economic development vs.
environment protection
Formosa Oil refinery in
Mailiao

Whats the issue

about?

What has been

changed in these
decades?

Formosa Cogeneration, combined

heat and power factory in Changhua
 Outline
Externality and its impact
Government solution
Private solution
 Externalities
Externality:
a spillover from one persons action
(production/consumption) to a bystander.
Negative/positive externality ASE K7 plant and
residence along
Other examples? Houjing River

Beekeeping and
Vaccine and flu shots Pollination of fruit trees
 Impact from Externalities
Externality causes inefficiency in competitive
markets because private cost/benefit in
production/consumption does NOT reflect the
actual social cost/benefit.

Another Broken Invisible Hand

Negative externality
SMC
Social Marginal Cost
(SMC) of production
MC includes private MC
and the external cost
of $0.1 per unit of
production.
MB SMC can be
represented by a
parallel shift up of MC
by $0.1.
Negative externality*
The equilibrium
SMC
production of electricity
MC in the private markets is
____the socially
efficient level which
takes external cost of
$0.1 per unit into
MB account.
1. higher than
2. lower than
3. the same as
Negative externality
Without taking external
SMC
cost into account, the
MC private market induces
a deadweight loss
equal to the yellow
area as social benefit
derived from these
MB units of output is less
than social cost to
produce them
 Regulating PM 2.5
Would economists pursue efficient production or
complete prohibition of production that creates
pollution?
Why is the difference?
Implementation challenges?
 Externality from education
Social marginal benefit
Social marginal
benefit from
External Benefit receiving education
represents the sum
of private benefit (D)
and the external
MB benefit.
Externality from education
Social Marginal Benefit
Socially efficient level
of education with
positive externality is
____ the private market
equilibrium.
1. higher than
MB 2. lower than
3. the same as
Externality from education
 Externality:
A Broken Invisible Hand
Negative externality
Too much is produced
Causing deadweight loss

Positive externality
Too less is produced
Causing deadweight loss

Pecuniary externality
When a market exchange affects other traders through
market prices
Not an externality
 Solution to externality
Government solutions:
Command-and-controldirect regulation
Market-based policiesprovide incentives
Private Solutions
Under some circumstances, the agents involved
will solve the issue by themselves.
 Government solutions
Command-and-controldirect regulation
Quantity mandate (tons of pollution/production)
Standard enforcing (emission from motorcycles)
Government provision of goods/services
Market-based policiesincentives correction
Pigouvian tax (subsidy): reflecting external
cost/benefit
Negative externality
With external cost
SMC being $0.1 per unit, to
MC reach the efficient
production level, the
government should set
a maximum quantity of
production as
1. 200
2. 300
3. 400
4. 500
Negative externality *
With external cost
SMC being $0.1 per unit, to
MC reach the efficient
production level, the
government can go with
a tax equal to $___ per
unit.
1. 0.25
2. 0.20
3. 0.10
4. 0.05
Negative externality
MC+t Pigouvian tax
The tax necessary to
MC incentivize a firm to
produce the socially
optimal level of output
Cost internalization

Advantage?
Market-based policies
Per Bag Trash Collection
Fee or Pay as you
throw (PAYT) (also
called trash metering,
unit pricing, variable
rate pricing, or user-pay)
is a usage-pricing model
for disposing
of municipal solid waste
With or Without Per Bag Trash Fee
Garbage/waste generation KG/day per person
Keelung: 1.09
Taipei: 0.86
New Taipei: 0.64

Recycling rate
Keelung: 55.22%
Taipei: 67.02%
New Taipei: 63.49%
cigarette tax/duty
Justification for cigarette
duty
How much duty is
appropriate?
Environmental duty NTD 200 per
person for Orchid Island visitors?
Pigouvian subsidy*
Which of the following
examples in Taiwan is
considered as Pigouvian
subsidy?
1. pension
2. childbirth subsidy
3. death subsidy
4. disability subsidy
Babies
5. unemployment
compensation
 Pigouvian subsidy
Private benefit To achieve the
Social benefit efficient amount of
baby birth, the
government has to
subsidize each baby
___ thousands
1. 0
2. 10
3. 20
Babies
4. 50
 Private Solutions(*)

Profits Per Day

Without Filter With Filter
Fred (upstream) $130 $130
Anne (downstream) $90 $140
Can Fred and Anne come to an agreement if
it takes Fred another $30 to install the filter?
1. Yes
2. No
 Coase Theorem
Coase Theorem
The Doctor and the adjacent confectioner
private bargaining will result in an efficient
allocation of resources
provided that property rights are well-
defined
when transaction costs (bargaining and
negotiation) are not substantial
 Citizens in Pingtungs Sandimen where (suspension)
glass bridge is located complained no compensation to
their neighborhood from the government who collects
entrance fees to the facility.
 Private Solutions(*)

Profits Per Day

Without Filter With Filter
Fred (upstream) $130 $130
Anne (downstream) $90 $140

If installing the filter costs another $30, the

efficient outcome is to have the filter
1. installed
2. Not installed
 Private Solutions (*)
Profits Per Day
Without Filter With Filter
Fred $130 $130
Anne $90 $140

Suppose it costs another $30 to install the filter. If Fred

has the right of (polluting) the river
1. He will just pay to install the filter (F=100, A=140)
2. Anne may pay Fred $20 to install the filter (120, 120)
3. Anne may pay Fred $40 to install the filter (140, 100)
4. Anne may pay Fred $60 to install the filter (160, 80)
 Private Solutions
Profits Per Day
Without Filter With Filter
Fred $130 $130
Anne $90 $140

If Anne has the right of the clean river

1. Fred pays Anne $30 not to install the filter (100, 120)
2. Fred will pay to install the filter (100, 140)
3. Anne may pay Fred $40 to install the filter (140, 100)
4. Anne may pay Fred $60 to install the filter (160, 80)
 Private Solutions

Profits Per Day

Without Filter With Filter
Fred (upstream) $130 $130
Anne (downstream) $90 $140

If installing the filter costs another $60, the

efficient outcome is to have the filter
1. installed
2. Not installed
 Private Solutions
Profits Per Day
Without Filter With Filter
Fred $130 $130
Anne $90 $140

Suppose it costs another $60 to install the filter. If Fred

has the right of (polluting) the river
1. He will NOT install the filter (F=130, A=90)
2. Anne may pay Fred $20 to install the filter (90, 120)
3. Anne may pay Fred $40 to install the filter (110, 100)
4. Anne may pay Fred $60 to install the filter (130, 80)
 Private Solutions
Profits Per Day
Without Filter With Filter
Fred $130 $130
Anne $90 $140

Suppose it costs another $60 to install the filter and

Anne has the right of the clean river
1. Fred pays Anne $70 not to install the filter (60, 160)
2. Fred pays Anne $55 not to install the filter (75, 145)
3. Anne may pay Fred $40 to install the filter (110, 100)
4. Anne may pay Fred $60 to install the filter (130, 80)
 Mixed approach
Property right + market for emission quota
Market for emission
Carbon emission trading (Kyoto Protocol)
Zero Emission Vehicle (ZEV) credit (CARB)
$152 million in revenue in 2014 for Tesla.
Advantages?
Traffic control
Taiwan
High Occupancy Vehicle
Toll-free hours
Congestion charge in
Tainan?
World
Permit
Road space rationing or
driving restriction
Congestion charge
Congestion charge in Tainan?
Congestion pricing in UK
UKs sugar tax
 Traffic control*
A road between the suburbs and downtown is
congested at rush hour. If 100 people use the
road at rush hour, the trip takes 30 minutes. If the
101st person enters the road, everyone has to
slow down and the trip now takes 31 minutes.
People value their time at $0.10 per minute. For
simplicity, ignore all of the costs of using the road
other than the cost of time. The marginal private
cost of the 101st person
1. $3.1; 2. $6.1; 3. $10.1; 4. $13.1
 Traffic control*
A road between the suburbs and downtown is
congested at rush hour. If 100 people use the
road at rush hour, the trip takes 30 minutes. If the
101st person enters the road, everyone has to
slow down and the trip now takes 31 minutes.
People value their time at $0.10 per minute. For
simplicity, ignore all of the costs of using the road
other than the cost of time. The marginal social
cost of the 101st person
1. $3.1; 2. $6.1; 3. $10.1; 4. $13.1
 Traffic control
If 100 people use the road at rush hour, the trip
takes 30 minutes. If the 101st person enters the
road, the trip now takes 31 minutes. People value
their time at $0.10 per minute. The governor of
this state would like to institute a toll that would
equal the costs the last (101st) driver imposes on
the other drivers. How high should the toll be on
this 101st driver during rush hour?
1. $3.1; 2. $10; 3. $10.1; 4. $13.1
 Conclusion
Externality causes inefficiency
Pigouvian tax/subsidy restores efficiency while
preserving private incentive
Coase theorem