Chapter 18
Externalities and Public Goods
Chapter 1
Topics to be Discussed
Externalities
Ways of Correcting Market Failure
Externalities and Property Rights
Common Property Resources
Chapter 1
Topics to be Discussed
Public Goods
Private Preferences for Public Goods
Chapter 1
Externalities
Negative
Action by one party imposes a cost on another party
Positive
Action by one party benefits another party
Chapter 1
External Cost
Scenario
Steel plant dumping waste in a river
The entire steel market effluent can be reduced by lowering output (fixed proportions production function)
Chapter 1
External Cost
Scenario
Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production.
Marginal Social Cost (MSC) is MC plus MEC.
Chapter 1
External Costs
MC
S = MCI
D
P1
Aggregate
social cost of
negative
externality
P1
q1
Q1
MSC
MSCI
When there are negative
externalities, the marginal
social cost MSC is higher
than the marginal cost.
Firm output
Price
Industry output
Price
MEC
MECI
The differences is
the marginal external
cost MEC.
q*
P*
Q*
The industry competitive
output is Q1 while the efficient
level is Q*.
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
Chapter 1
External Cost
Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.
Chapter 1
Externalities
Positive Externalities and Inefficiency
Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.
Chapter 1
External Benefits
MC
P1
Repair Level
Value
D
Is research and development
discouraged by positive
externalities?
q1
MSB
MEB
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
q*
P*
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
Chapter 1
Ways of Correcting Market Failure
Assumption: The market failure is pollution
Fixed-proportion production technology
Must reduce output to reduce emissions
Use an output tax to reduce output
Input substitution possible by altering technology
Chapter 1
The Efficient Level of Emissions
Level of Emissions
2
4
6
Dollars
per unit
of Emissions
0
2
4
6
8
10
12
14
16
18
20
22
24
26
MSC
MCA
E*
The efficient level of
emissions is 12 (E*) where
MCA = MSC.
Assume:
1) Competitive market
2) Output and emissions decisions are independent
3) Profit maximizing output chosen
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost.
E0
At E1 the marginal
social cost is greater
than the marginal benefit.
E1
Why is this more efficient
than zero emissions?
Chapter 1
Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emission Standard
Set a legal limit on emissions at E* (12)
Enforced by monetary and criminal penalties
Increases the cost of production and the threshold price to enter the industry
Chapter 1
Standards and Fees
Level of Emissions
Dollars
per unit
of Emissions
MSC
MCA
3
12
E*
Standard
Fee
Chapter 1
Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emissions Fee
Charge levied on each unit of emission
Chapter 1
Standards and Fees
Total
Abatement Cost
Cost is less than the
fee if emissions were
not reduced.
Total Fee
of Abatement
Level of Emissions
Dollars
per unit
of Emissions
MSC
MCA
3
12
E*
Fee
Chapter 1
Ways of Correcting Market Failure
Standards Versus Fees
Assumptions
Policymakers have asymmetric information
Administrative costs require the same fee or standard for all firms
Chapter 1
The Case for Fees
Firm 2’s Reduced
Abatement
Costs
Firm 1’s Increased
Abatement Costs
MCA1
MCA2
Level of
Emissions
2
4
6
Fee per
Unit of
Emissions
0
1
2
3
4
5
6
7
8
9
10
11
12
13
1
3
5
14
The cost minimizing solution
would be an abatement of 6
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
If a fee of $3 was imposed
Firm 1 emissions would fall
by 6 to 8. Firm 2 emissions
would fall by 8 to 6.
MCA1 = MCA2: efficient solution.
Chapter 1
Ways of Correcting Market Failure
Advantages of Fees
When equal standards must be used, fees achieve the same emission abatement at lower cost.
Fees create an incentive to install equipment that would reduce emissions further.
Chapter 1
The Case for Standards
ABC is the increase
in social cost less the
decrease in abatement
cost.
Marginal
Social
Cost
Marginal Cost
of Abatement
Level of Emissions
Fee per
Unit of
Emissions
0
2
4
6
8
10
12
14
16
2
4
6
8
10
12
14
16
E
Based on incomplete
information standard is 9
(% decrease).
ADE < ABC
D
A
B
C
Based on incomplete
information fee is $7
(% reduction).
Emission increases to 11.
Chapter 1
Ways of Correcting Market Failure
Summary: Fees vs. Standards
Standards are preferred when MSC is steep and MCA is flat.
Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement.
Chapter 1
Ways of Correcting Market Failure
Summary: Fees vs. Standards
Fees have certainty on cost and uncertainty on emissions.
Preferred policy depends on the nature of uncertainty and the slopes of the cost curves.
Chapter 1
Ways of Correcting Market Failure
Transferable Emissions Permits
Permits help develop a competitive market for externalities.
Agency determines the level of emissions and number of permits
Permits are marketable
High cost firm will purchase permits from low cost firms
Chapter 1
Ways of Correcting Market Failure
Question
What factors could limit the efficiency of this approach?
Chapter 1
The Costs and Benefits
of Reduced Sulfur Dioxide Emissions
Cost of Reducing Emissions
Conversion to natural gas from coal and oil
Emission control equipment
Chapter 1
The Costs and Benefits
of Reduced Sulfur Dioxide Emissions
Benefits of Reducing Emissions
Health
Reduction in corrosion
Aesthetic
Chapter 1
Sulfur Dioxide Emissions Reductions
Sulfur dioxide
concentration (ppm)
20
40
60
0
Dollars
per
unit of
reduction
Marginal Social Cost
Marginal Abatement Cost
Observations
MAC = MSC @ .0275
.0275 is slightly below actual emission level
Economic efficiency improved
Chapter 1
Emissions Trading and Clean Air
Bubbles
Firm can adjust pollution controls for individual sources of pollutants as long as a total pollutant limit is not exceeded.
Offsets
New emissions must be offset by reducing existing emissions
2000 offsets since 1979
Chapter 1
Emissions Trading and Clean Air
Cost of achieving an 85% reduction in hydrocarbon emissions for DuPont
Three Options
85% reduction at each source plant (total cost = $ million)
85% reduction at each plant with internal trading (total cost = $ million)
85% reduction at all plants with internal and external trading (total cost = $ million)
Chapter 1
Emissions Trading and Clean Air
1990 Clean Air Act
Since 1990, the cost of the permits has fallen from an expected $300 to below $100.
Causes of the drop in permit prices
More efficient abatement techniques
Price of low sulfur coal has fallen
Chapter 1
Ways of Correcting Market Failure
Recycling
Households can dispose of glass and other garbage at very low cost.
The low cost of disposal creates a divergence between the private and the social cost of disposal.
Chapter 1
The Efficient Amount of Recycling
Scrap
Cost
0
4
8
12
MCR
MSC
m*
With a refundable deposit,
MC increases and
MC = MSC = MCR.
MC + per unit refund
MC
m1
Without market intervention
the level of scrap will be at m1
and m1 > m*.
Chapter 1
Refundable Deposits
Amount of Glass
$
D
Price falls to P’ and
the amount of
recycled glass
increases to M*.
Sv
Sr
S
The supply of glass is
the sum of the supply
of virgin glass (Sr) and
the supply of recycled
glass (Sr).
M1
P
Without refunds the
price of glass is P and
Sr is M1.
S’r
S’
P’
M*
With refunds Sr increases
to S’r and S increases to S’.
Chapter 1
Externalities and Property Rights
Property Rights
Legal rules describing what people or firms may do with their property
For example
If residents downstream owned the river (clean water) they control upstream emissions.
Chapter 1
Externalities and Property Rights
Bargaining and Economic Efficiency
Economic efficiency can be achieved without government intervention when the externality affects relatively few parties and when property rights are well specified.
Chapter 1
Profits Under Alternative
Emissions Choices (Daily)
No filter, not treatment plant 500 100 600
Filter, no treatment plant 300 500 800
No filter, treatment plant 500 200 700
Filter, treatment plant 300 300 600
Factory’s Fishermen’s Total
Profit Profit Profit
Chapter 1
Externalities and Property Rights
Assumptions
Factory pays for the filter
Fishermen pay for the treatment plant
Efficient Solution
Buy the filter and do not build the plant
Chapter 1
Bargaining with
Alternative Property Rights
No Cooperation
Profit of factory $500 $300
Profit of fishermen $200 $500
Cooperation
Profit of factory $550 $300
Profit of fishermen $250 $500
Right to Dump Right to Clean Water
Chapter 1
Externalities and Property Rights
Conclusion: Coase Theorem
When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified.
Chapter 1
Externalities and Property Rights
Costly Bargaining --- The Role of Strategic Behavior
Bargaining requires clearly defined rules and property rights.
Chapter 1
Externalities and Property Rights
A Legal Solution --- Suing for Damages
Fishermen have the right to clean water
Factory has two options
No filter, pay damages
Profit = $100 ($500 - $400)
Filter, no damages
Profit = $300 ($500 - $200)
Chapter 1
Externalities and Property Rights
A Legal Solution --- Suing for Damages
Factory has the right to emit effluent
Fishermen have three options
Put in treatment plant
Profit = $200
Filter and pay damages
Profit = $300 ($500 - $200)
No plant, no filter
Profit = $100
Chapter 1
Externalities and Property Rights
Conclusion
A suit for damages results in an efficient outcome.
Question
How would imperfect information impact the outcome?
Chapter 1
The Coase Theorem at Work
Negotiating an Efficient Solution
1987 --- New York garbage spill (200 tons) littered the New Jersey beaches
The potential cost of litigation resulted in a solution that was mutually beneficial to both parties.
Chapter 1
Common Property Resources
Common Property Resource
Everyone has free access.
Likely to be overutilized
Examples
Air and water
Fish and animal populations
Minerals
Chapter 1
Common Property Resources
Fish per Month
Benefits,
Costs
($ per
fish)
Demand
However, private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Marginal Social Cost
F*
Private Cost
FC
Without control the number
of fish/month is FC where
PC = MB.
Chapter 1
Common Property Resources
Solution
Private ownership
Question
When would private ownership be impractical?
Chapter 1
Crawfish Fishing in Lousiana
Finding the Efficient Crawfish Catch
F = crawfish catch in millions of pounds/yr
C = cost in dollars/pound
Chapter 1
Crawfish Fishing in Lousiana
Demand
C = =
MSC
C = +
PC
C = +
Chapter 1
Crawfish Fishing in Lousiana
Efficient Catch
million pounds
D = MSC
Chapter 1
Crawfish as a Common
Property Resource
Crawfish Catch
(millions of pounds)
C
Cost
(dollars/pound)
Demand
Marginal Social Cost
Private Cost
Chapter 1
Public Goods
Question
When should government replace firms as the producer of goods and services?
Chapter 1
Public Goods
Public Good Characteristics
Nonrival
For any given level of production the marginal cost of providing it to an additional consumer is zero.
Nonexclusive
People cannot be excluded from consuming the good.
Chapter 1
Public Goods
Not all government produced goods are public goods
Some are rival and nonexclusive
Education
Parks
Chapter 1
Efficient Public Good Provision
D1
D2
D
When a good is nonrival, the social marginal
benefit of consumption (D) , is determined by
vertically summing the individual demand
curves for the good.
Output
0
Benefits
(dollars)
1
2
3
4
5
6
7
8
10
9
$
$
$
Marginal Cost
$
Efficient output occurs
where MC = MB at 2
units of output. MB is
$ + $ or $.
Chapter 1
Public Goods
Public Goods and Market Failure
How much national defense did you consume last week?
Chapter 1
Public Goods
Free Riders
There is no way to provide some goods and services without benefiting everyone.
Households do not have the incentive to pay what the item is worth to them.
Free riders understate the value of a good or service so that they can enjoy its benefit without paying for it.
Chapter 1
Public Goods
Establishing a mosquito abatement company
How do you measure output?
Who do you charge?
A mosquito meter?
Chapter 1
The Demand for Clean Air
Clean Air is a public good
Nonexclusive and nonrival
What is the price of clean air?
Chapter 1
The Demand for Clean Air
Choosing where to live
Study in Boston correlates housing prices with the quality of air and other characteristics of the houses and their neighborhoods.
Chapter 1
The Demand for Clean Air
Nitrogen Oxides
(pphm)
0
Dollars
1
2
3
4
5
6
7
8
10
9
2000
2500
3000
500
1500
1000
Low Income
Middle Income
High Income
Chapter 1
The Demand for Clean Air
Findings
Amount people are willing to pay for clean air increases substantially as pollution increases.
Higher income earners are willing to pay more (the gap between the demand curves widen)
National Academy of Sciences found that a 10% reduction in auto emissions yielded a benefit of $2 billion---somewhat greater than the cost.
Chapter 1
Private Preferences for Public Goods
Government production of a public good is advantageous because the government can assess taxes or fees to pay for it.
Determining how much of a public good to provide when free riders exist is difficult.
Chapter 1
Determining the Level
of Educational Spending
Educational spending
per pupil
$0
Willingness
to pay
$
$1200
$600
$1800
$2400
W1
W2
W3
AW
The efficient level of educational
spending is determined by summing the
willingness to pay for education for each
of three citizens.
Chapter 1
Determining the Level
of Educational Spending
Educational spending
per pupil
$0
Willingness
to pay
$
$1200
$600
$1800
$2400
W1
W2
W3
AW
Will majority rule yield an efficient outcome?
W1 will vote for $600
W2 and W3 will vote for $1200
The median vote will always win in a majority
rule election.
Chapter 1
Private Preferences for Public Goods
Question
Will the median voter selection always be efficient?
Answer
If two of the three preferred $1200 there would be overinvestment.
If two of the three preferred $600 there would be underinvestment.
Chapter 1
Private Preferences for Public Goods
Majority rule is inefficient because it weighs each citizen’s preference equally---the efficient outcome weighs each citizen’s vote by his or her strength of preference.
Chapter 1
Summary
There is an externality when a producer or a consumer affects the production or consumption activities of others in a manner that is not directly reflected in the market.
Pollution can be corrected by emission standards, emissions fees, marketable emissions permits, or by encouraging recycling.
Chapter 1
Summary
Inefficiencies due to market failure may be eliminated through private bargaining among the affected parties.
Common property resources are not controlled by a single person and can be used without a price being paid.
Chapter 1
Summary
Goods that private markets are not likely to produce efficiently are either nonrival or nonexclusive. Public goods are both.
A public good is provided efficiently when the vertical sum of the individual demands for the public good is equal to the marginal cost of producing it.
Chapter 1
Summary
Under majority rule voting, the level of spending provided will be that preferred by the median voter---this need not be the efficient outcome.
Chapter 1
End of Chapter 18
Externalities and Public Goods
Chapter 1
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