Externalities

#### Externalities

##### Garrett Olson Stanford

##### January 10, 2025

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### Today's Plan

- Quick review of market efficiency

- Define externalities

- Walk through an example

- Consider solutions

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class: 
name: markets_1

### Economists and Markets: A Love Story

What are the benefits for society when a marketplace is <gold>**working well**</gold>?
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class: 
name: markets_2
### Economists and Markets: A Love Story

What are the benefits for society when a marketplace is <gold>**working well**</gold>?

- No long-term shortages or surpluses.

- Goods and services are allocated to individuals who most value them.

- Society's resources are used efficiently (Total Surplus is maximized)
  
- Flexible and responsive

- No need for central planning or regulation

- Innovation is incentivized

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class: 
name: markets_3
### Economists and Markets: A Love Story

What are the benefits for society when a marketplace is <gold>**working well**</gold>?

- No long-term shortages or surpluses.

- Goods and services are allocated to individuals who most value them.

- <pink> Society's resources are used efficiently (Total Surplus is maximized) </pink>
 
- Flexible and responsive

- No need for central planning or regulation

- Innovation is incentivized

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class:
name: markets_plot_1

### Markets *can* maximize social welfare
- Supply slopes up to reflect the increasing marginal cost of production
- Demand slopes down to reflect the diminishing marginal benefit of consumption

<img src="figs/plots/plot_1.png" width="85%" />
 
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class:
name: markets_plot_2

### Markets *can* maximize social welfare

In market equilibrium, marginal cost = marginal benefit at (P\*, Q\*)

<img src="figs/plots/plot_2.png" width="85%" />
 
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### Markets *can* maximize social welfare

Market equilibrium is **efficient** because it maximizes Total Surplus (Consumer Surplus + Producer Surplus)

<img src="figs/plots/plot_3.png" width="85%" />
 
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class:
name: assumptions

### Markets *can* maximize social welfare

Key assumption in our market:<gold> Producers and consumers internalize all the costs and benefits of their actions </gold>

In other words, market prices reflect:

- all of the <pink>costs of production</pink> (including both <pink>private</pink> and <pink>social costs</pink>)

- all of the <green>benefits to society</green> (including both <green>private</green> and <green>social benefits</green>).

What happens when this assumption isn't accurate?

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class:
name: externalities_1

### Externalities

One common reason that markets fail is the presence of an externality.

Externality: A cost or benefit of a market activity that affects a third party

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class:
name: externalities_2

### Externalities

One common reason that markets fail is the presence of an externality.

Externality: A cost or benefit of a market activity that affects a third party

Example: when my neighbor uses their leaf blower at 11:00 PM Sunday night.

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class:
name: externalities_3

### Externalities

Question: Can you think of a situation where economic activity causes some third party to be impacted?

- Shipping & transport of consumer goods leads to pollution.

- Secondhand smoke can cause lung cancer.

- Pet cats are quite detrimental to song bird populations.

- When everyone drives a car at once it creates congestion.
]

.pull-right[
<blue>Positive</blue>
- The individual pursuit of education improves community well-being.

- The hives of local beekeepers can pollinate plants and farms.

- Driving safely protects your fellow drivers.

- Shopping locally can increase the overall economic welfare of your community 
]

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name: scc_1

Carbon dioxide ( `$CO_2$` ) emissions are likely **the** externality of our time: 
 
 
 
`$CO_2$` emissions are a byproduct of so many of humanity's activities (e.g., energy, transportation, industrial production, AI) 
 
 
 
Increasing `$CO_2$` levels in the atmosphere is a primary driver for <green>climate change.</green>
]

.pull-right-image[
<img src="figs/cumulative-co-emissions.png" width="80%" style="display: block; margin: auto 0 auto auto;" /><img src="figs/temperature-anomaly.png" width="80%" style="display: block; margin: auto 0 auto auto;" />
]

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class:
name: scc_2

### Who really pays?

If I use gas to heat my home on a cold day, then I have to pay the price that Georgia Power is charging.

`$\rightarrow$` In a very competitive market, we think that the price of a good will reflect marginal cost of producing that good.

This is a central reason why market trading is usually efficient:

`$\rightarrow$` Price reflects the cost to society of producing something.

`$\rightarrow$` I will only buy a good if my marginal benefit exceeds the price I am charged.

The trades that happen in a (functional) marketplace lead to a net benefit for society.

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class:
name: scc_3

### Who really pays?

.pull-left[
But, the `$CO_2$` generated when I turn on my furnace means that others also pay a price when I buy gas from Georgia Power:

- gas use `$\rightarrow$` `$CO_2$` `$\rightarrow$` climate change

<green>Climate change</green> impacts everyone on earth (including other organisms and future generations):
- More "billion dollar disasters"

- Agricultural loss

- Economic productivity

- Etc.!
]

.pull-right[
Climate change even affects test scores:
<img src="figs/heat and learning.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
*Goodman et al. (2020)*
]

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class:
name: scc_3

### Who really pays?

When I buy gas to heat my home, I don't see all the other costs.

<green>Internal (Private) Cost:</green> The costs of a market activity paid only by the active participants.

<pink>External Cost:</pink> The costs of a market activity imposed on those who are not participants in that activity.

<orange>Social Cost:</orange> Sum of internal and external costs of a market activity.

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class:
name: scc_4

### The Social Cost of Carbon

The external cost of carbon emissions is so critical that it has its own name.

<orange>The **Social Cost of Carbon (SCC)**:</orange> an estimate, in dollars, of the economic damages that would result from emitting one additional ton of carbon dioxide into the atmosphere. *(Resources For the Future)*

The SCC is difficult to measure and estimates are constantly updated.

However, an accurate value is essential for policymakers and lots of research has gone into estimating the SCC (e.g., *Stanford and Cameron, WP*).

SCC estimates have increased over time
 
 
*Tol (2023)* `$\rightarrow$`]

.pull-right-image[ 
<img src="figs/scc over time.png" width="70%" style="display: block; margin: auto 0 auto auto;" />
]
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class:
name: scc_5

### The Social Cost of Carbon

The external cost of carbon emissions is so critical that it has its own name.

The SCC is difficult to measure and estimates are constantly updated.

However, an accurate value is essential for policymakers and lots of research has gone into estimating the SCC (e.g., *Stanford and Cameron, WP*).

SCC has changed across administrations:
- Obama ~$43 a ton

- Trump ~$4 a ton

- Biden ~$195 a ton]

.pull-right-image[ 
<img src="figs/scc over time.png" width="70%" style="display: block; margin: auto 0 auto auto;" />
]

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name: ex_setup_1

### Modeling Externalities

Our standard supply and demand analysis is very useful in visualizing what externalities look like.

Let's visualize the market for Georgia Power's natural gas.

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name: ex_plot_1

But, these demand and supply lines only reflect the internal costs and benefits of gas.

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name: ex_plot_2

We will rename the Supply curve *S.private* to reflect it doesn't include external costs.

<img src="figs/plots/plot_4.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class: 
name: ex_setup_2

### Modeling Externalities

Let's say we put a price of $4 on the external costs of natural gas due to carbon emissions.
- For every cubic foot of gas sold, society experiences costs of $4.
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class: 
name: ex_plot_

In this example, let's imagine an external cost of $4 per cubic foot.

<img src="figs/plots/plot_5.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class: 
name: ex_setup_2

### Modeling Externalities

Let's say we put a price of $4 on the external costs of natural gas due to carbon emissions.
- For every cubic foot of gas sold, society experiences costs of $4.

If we want to show these external costs, we can add them to the supply line

`$\rightarrow$` The social supply curve shows the cost to produce gas, <orange>plus</orange> the cost that society pays when that gas is used.

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class: 
name: ex_plot_3

We can now draw our *S.social* curve which reflects the <pink>internal</pink> and <orange> external</orange> the costs.

<img src="figs/plots/plot_6.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class: 
name: ex_setup_3

### Modeling Externalities

The social supply curve lets us clearly see why externalities represent a market failure.

`$\rightarrow$` From society's POV, the marginal cost of the fourth cubic foot of gas exceeds the benefit.

<img src="figs/plots/plot_6.png" width="80%" style="display: block; margin: auto 0 auto auto;" />
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class: 
name: ex_setup_4

### Modeling Externalities

The social supply curve lets us clearly see why externalities represent a market failure.

`$\rightarrow$` From society's POV, the marginal cost of the fourth cubic foot of gas exceeds the benefit.

We can also put a dollar value on how much society is losing from these bad trades.
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class: 
name: ex_plot_4

The green area indicates where the cost of production/consumption is greater than the benefit.

<img src="figs/plots/plot_7.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class: 
name: ex_setup_3

### Modeling Externalities

The social supply curve lets us clearly see why externalities represent a market failure.

`$\rightarrow$` From society's POV, the marginal cost of the fourth cubic foot of gas exceeds the benefit.

We can also put a dollar value on how much society is losing from these bad trades.
- Referred to as deadweight loss.
- To find this value, we calculate the area of the shaded region.
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class: 
name: ex_plot_5
"Deadweight loss" caused by externality.

<img src="figs/plots/plot_8.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class:
name:social_optimum_1

### The social optimum 
Graphing an externality like this also lets us ask an important question:

How much natural gas should society use?
- More broadly, how much should we limit `$CO_2$` emissions?

Social Optimum: the equilibrium if there were no externalities (all costs and benefits are internalized).

`$\rightarrow$` the market equilibrium at which the set of socially beneficial trades happens.

Here, the social optimum happens where the social supply line meets the demand line.

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class:
name:ex_plot_6

We still find our optimal Q using the intersection of S and D, but we use S.social.

<img src="figs/plots/plot_9.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class:
name:ex_plot_7

We still find our optimal Q using the intersection of S and D, but we use S.social.

<img src="figs/plots/plot_10.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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Our optimal Q is smaller and the equilibrium P is higher, but Q `$\neq$` 0.

<img src="figs/plots/plot_11.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class:
name:social_optimum_1

### The social optimum 
How much natural gas should society use?

Notice that the social optimum still involves society using some leaded gas.

`$\rightarrow$` Society is willing to pay the cost of some pollution if the benefits are larger.

--
Using the social optimum as a reference point, we can see that an externality with an external cost leads to overproduction.

This is a common feature of goods associated with externalities:
- <pink>Negative externalities:</pink> the market tends to over produce and consume
- <green>Positive externalities:</green> the market tends to under produce and consume

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class:
name: solve_1

### Solving an externality problem

The market has failed us! What do we do?

If the social optimum involves some trading ( Q*social `$\neq$` 0 ), we'd really like to find a way to get the market to internalize the externality.

- Internalize: The act of taking into account the external costs (or benefits) of a given transaction.

Question: Can you think of a policy or mechanism to internalize an externality in a market?
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class:
name: solve_2

### Solving an externality problem

One way to solve a negative externality is through the use of an excise tax.
- Excise tax: A tax on the sale of a good or service.

In our previous example, the external cost of gas was $4.

`$\rightarrow$` By imposing a $4 excise tax, the government shifts the private supply line up to the social supply line

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We can shift our *S.private* to *S.social* using a tax = the external cost

<img src="figs/plots/plot_13.png" width="100%" style="display: block; margin: auto 0 auto auto;" />
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class:
name: solution_2

### Solving the Social Cost of Carbon

In the context of the <orange> Social Cost of Carbon </orange> a number of policies have been suggested, and to some degree tried:

- Carbon tax (drive price up to P*social)

- Cap-and-trade (cap at Q*social)

- Carbon offsets (increase production costs for firms)

- Sustainability nudges to consumers

- Environmental, Social, and Governance (make it profitable to be "Green")

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### Takeaways

What are our major takeaways from the analysis of an externality?
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1. Sometimes, market activity can affect non-participants

2. The presence of these externalities leads to a breakdown in the efficiency of a market.
 - Society is not using its resources optimally.

3. Policymakers can use tools like an excise tax to <pink> internalize</pink> an externality and restore efficiency a market.

--

<blue>For future consideration:</blue>

How would the presence of <gold>positive</gold> externality affect the market? What policies might restore efficiency in that marketplace?

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