Regulation of Externalities

Market Efficiency & Market Failure

• Efficiency– All goods worth more than they cost to produce get

produced (No DWL)– No goods worth less than they cost to produce get

produced (No DWL)– Aggregate well-being is maximized

• Why do we like free markets?– In general, free markets produce efficient outcomes– Interventions such as price controls, quantity limits,

minimum wages, cause DWL

• But – Under some circumstances, unfettered markets fail to produce “best” outcomes– Market Failures

Externalities

• Negative: Production or consumption of a product harms others– Pollution– Loud Noise– Blocked view

• Positive: Production or consumption of a product benefit others– Planting flowers– Painting house

• Analytical Representation– Why do externalities create DWL?

What’s the Inefficiency?

• With Negative Externalities, market quantity is higher than social optimum and price is too low

$

S=MC

S’=SMC

Q (Gallons of Gasoline)

Demand

QMarketQEfficient

PMarket

PEfficient

Negative Externalities

DWL

Solutions to Externality ProblemTraditional Economics Approach

• Negative externalities should be taxed

• Positive externalities should be subsidized

• Goal -Make market demand & supply match “real” demand & supply

• Examples: Oil refinery, House Painting

Solutions to Externality ProblemsTraditional Approach

• Taxes shift the supply curve. A per-unit tax equal to the negative externality will align the market and social marginal cost curves.

• Why is it hard to “correct” externalities with taxes?• How can we measure the effect of externalities?

– Planting Trees, Oil Refinery, Logging?

$

STax = S’

Q (Gallons of Gasoline)

Demand

QTax

PTax

Negative Externalities with Taxes

S

New View of ExternalitiesReciprocity & the Coase Theorem

• Ronald Coase, “The Problem of Social Cost”, Journal of Law & Economics, 1960

• Suppose a candy maker works next to a doctor– Candy maker produces a negative externality (noise)– Noise harms doctors business

• Old view: Noise is bad, factory must be restrained with rules or taxes

• Coase view: Allowing noise harms doctor, but stopping noise harms factory

• Key insight -- may be more efficient to stop doctor than to stop noise

Examples

• Case 1: – Candy maker earns $40/hr from operating– Doctor loses $60/hr when candy maker operates

• Case 2: – Candy maker earns $60/hr from operating– Doctor loses $40/hr when candy maker operates

• What is the efficient outcome in each case?• What outcomes do markets produce?

– Liability for Noise Damage– No Liability for Noise Damage

Examples, Continued

• Now suppose that the candy maker can install soundproofing at a cost of $20.00– What is the efficient outcome?– What does the market produce in each case?

• Liability for Noise Damage• No Liability for Noise Damage

The Coase Theorem

• When parties affected by externalities can negotiate costlessly with each other and property rights are clear, the efficient outcome occurs regardless of who has property rights.

New Solutions to Externality Problems• When does the free market work best?

– Clear Property Rights– Easy Bargaining

• How should we assign property rights?– Cost of Compliance: Eg: Soundproofing– Zoning

• Examples:– Airspace Rights – CO2 Emissions– Second-Hand Smoke– Chernobyl Reactors

• When are taxes & subsidies still the best option?

Transferable Air Rights• Japan

– Construction boom in 1960’s caused disputes between builders & homeowners

– Local law assigned rights specifying minimum sunlight a builder had to provide to neighbors

– To construct a building that would block sunlight, builder needed unanimous consent from neighbors.

– Sunshine rights were exclusive and divestible

• New York– Early 1900’s skyscraper boom affects neighboring property– Building Codes: 1916 -- setbacks, 1962 -- FAR’s– NYC proposes transferable air rights in 1980’s– Incentive for historic preservation (Trump Tower & Tiffany & Co.)

• Questions– How does assignment of rights differ in NY & Japan?– How do outcomes differ?– LA & DC have height limits. How do outcomes compare?