Topics Externalities. The Inefficiency of Competition with Externalities. Regulating Externalities. Market Structure and Externalities. Allocating Property Rights to Reduce Externalities. Rivalry and Exclusion.

Externalities Externality – the direct effect of the actions of a person or firm on another person’s wellbeing or a firm’s production capability rather than an indirect effect through changes in prices. Negative externality – an externality that harms someone. Positive externality – an externality that benefits other.

The Inefficiency of Competition with Externalities Firms produce paper and by-products of the production process—such as air and water pollution—that harm people who live near paper mills. We’ll call the pollution gunk. Each ton of paper that is produced increases the amount of gunk by one unit, The only way to decrease the volume of gunk is to reduce the amount of paper manufactured. No less-polluting technologies are available, It is not possible to locate plants where the gunk bothers no one.

The Inefficiency of Competition with Externalities (cont.) Private cost - the cost of production only, not including externalities. Social cost - the private cost plus the cost of the harms from externalities.

The Inefficiency of Competition with Externalities (cont.) Social marginal cost (MCs) - is the cost of manufacturing one more ton of paper to the paper firms plus the additional externality damage to people in the community from producing this last ton of paper.

Figure 18.1 Welfare Effects of Pollution in a Competitive Market 450 Demand , $ per ton of paper MC s = p + g p A MC p e s p s = 282 E B C D c p = 240 e c H 198 MC g G F 84 30 = Q s 84 Q c = 105 225 Q , T ons of paper per da y

Figure 18.1 Welfare Effects of Pollution in a Competitive Market (cont.)

The Inefficiency of Competition with Externalities (cont.) A deadweight loss results because the competitive market equates price with private marginal cost instead of with social marginal cost.

The Inefficiency of Competition with Externalities (cont.) A competitive market produces excessive negative externalities. The optimal amount of pollution is greater than zero.

Regulating Externalities The government: might control pollution directly by restricting the amount of pollution that firms may produce emissions standard by taxing them for pollution they create. A governmental limit on the amount of air or water pollution emissions fee – tax on air pollution effluent charge - tax on discharges into the air or waterways

Table 18.1 Industrial CO2 Emissions, 2010

Emissions Fee The government may impose costs on polluters by taxing their output or the amount of pollution produced. Internalize the externality - to bear the cost of the harm that one inflicts on others (or to capture the benefit that one provides to others)

Figure 18.2 Taxes to Control Pollution Placing a tax on the firms equal to the harm from the gunk. 450 Demand MC s = p + T ( Q ) , $ per ton of paper Applying a specific tax of t = 84 per ton of paper results in the social optimum as well. MC p + t e s MC p p s = 282 p t = 84 MC p = 198 MC g MC g = 84 Q s = 84 225 Q , T ons of paper per da y

Solved Problem 18.1 For the market with pollution in Figure 18.1, what constant, specific tax, t, on output could the government set to maximize welfare? Answer: Set the specific tax equal to the marginal harm of pollution at the socially optimal quantity.

Monopoly and Externalities The monopoly outcome may be less than the social optimum even with an externality.

Figure 18.3 Monopoly, Competition, and Social Optimum with Pollution

Monopoly and Externalities (cont.) The reason that a monopoly may produce too little or too much is that it faces two offsetting effects: The monopoly tends to produce too little output because it sets its price above its marginal cost, but the monopoly tends to produce too much output because its decisions depend on its private marginal cost instead of the social marginal cost.

Solved Problem 18.2 In Figure 18.3, what is the effect on output, price, and welfare of taxing the monopoly an amount equal to the marginal harm of the externality? Answer: Show how the monopoly equilibrium shifts if the firm is taxed. Determine how this shift affects the deadweight loss of monopoly.

Coase Theorem Property right - the exclusive privilege to use an asset. Coase Theorem - the optimal levels of pollution and output can result from bargaining between polluters and their victims if property rights are clearly defined.

Table 18.2 Daily Profits Vary with Production and Noise

Key Results from Coase Theorem The three results from the Coase Theorem: If property rights are not clearly assigned, one firm pollutes excessively and joint profit is not maximized. Clearly assigning property rights results in the social optimum, maximizing joint profit, regardless of who gets the rights. However, who gets the property rights affects how they split the joint profit. Because the property rights are valuable, the party with the property rights is compensated by the other party.

Markets for Pollution Cap-and-trade system - the government gives firms permits, each of which confers the right to create a certain amount of pollution. Each firm may use its permits or sell them to other firms.

Markets for Pollution (cont.) Suppose that the cost in terms of forgone output from eliminating each ton of pollution is $200 at one firm and $300 at another. If the government tells each firm to reduce pollution by 1 ton, TC = $500. With tradable permits, the first plant can reduce its pollution by 2 tons and sell its allowance to the second plant, so the total social cost is only $400.

Rivalry and Exclusion Rival good - good that is used up as it is consumed. Exclusion - others can be prevented from consuming a good.

Table 18.3 Rivalry and Exclusion

Open-Access Common Property and Club Goods Open-access common property - a resource that is nonexclusive and rival. Club good - a good that is nonrival but is subject to exclusion.

Public Goods Public good - nonrival and nonexclusive. A public good is a special type of externality. If a firm reduces the amount of pollution it produces, thereby cleaning the air, it provides a nonpriced benefit to its neighbors: a positive externality.

Free Riding Free riding - benefiting from the actions of others without paying. Free riders want to benefit from a positive externality. It is very difficult for firms to profitably provide a public good because few people want to pay for the good no matter how valuable it is to them.

Free Riding (cont.) Because a public good lacks rivalry, many people can get pleasure from the same unit of output. As a consequence, the social demand curve or willingness-to-pay curve for a public good is the vertical sum of the demand curves of each individual.

Free Riding (cont.) Guards patrolling the mall provide a service without rivalry: All the stores in the mall are simultaneously protected. Each store’s demand for guards reflects its marginal benefit from a reduction in thefts due to the guards.

Figure 18.4 Inadequate Provision of a Public Good vice 50 D , $ per hour of guard ser 36 D 1 26 p p e e s 20 Supply , MC 16 14 D 2 6 4 4 5 7 9 Guards per hour

Solved Problem 18.3 In a different mall, a stereo store and a television store each decide whether to hire one guard or none—extra guards provide no extra protection. A guard costs 20 per hour. The benefit to each store is 16 per hour. The stores play a game in which they act independently. The table shows their payoffs. What is the outcome of this game? What is the socially optimal solution?

Solved Problem 18.3: Answer

Reducing Free Riding social pressure mergers privatization compulsion Methods that may be used include social pressure mergers privatization compulsion

Valuing Public Goods surveys voting results The government may try to determine the value that consumers place on the public good through: surveys voting results

Table 18.4 Voting on $300 Traffic Signals

Challenge Solution: Trade and Pollution