Market Failure (?): Externalities Dr. D. Foster Microeconomics

Economics Scarcity Choices (Opportunity) Costs A framework for understanding. . . Scarcity Choices (Opportunity) Costs Limited Resources Unlimited Wants Premise: Rational self-interest i.e., human action is not random; it is purposeful.

First choice – markets … Choices must be made What will be produced? How will it be produced? Who will get what is produced? Productive efficiency Allocative efficiency Distributive efficiency Efficiency - “measure” of how well we answer these questions. First choice – markets …

Putting Supply & Demand Together At P2 the market is in equilibrium. Price Supply At P1 a surplus will drive down prices. P1 Q1 Q3 P2 P3 At P3 a shortage will drive up prices. Demand Quantity Q2

What is “market failure”? When markets fail to achieve allocative and productive efficiency. When do markets fail? Asymmetric information Public goods Common property Positive externalities Negative externalities

Positive Externalities Some “consumers” benefit w/out paying. -- concert -- flower garden -- flu shot What to do? -- Nothing. -- Subsidize producer/consumer - there is a cost to this!

Positive Externalities Quantity Price Supply D = MPB P1 MSB Q2 $30 $5 Q1

Negative Externalities Third parties bear part of the cost without receiving any of the benefit. -- Pollution: the firm treats waste disposal as free. How do we deal with this problem? -- Tax the producer/consumer. -- Set standards/quotas for pollution. -- Allow parties to negotiate. -- Sell pollution rights.

Pollution - Tax & Standard MSC Q2 Tax raises costs;  production. Quota on production would (might?) serve the same purpose. Standards for pollution would also raise costs and  production. Quantity Price S = MPC D = MPB P1 $25 $15 Q1

Pollution & The Coase Theorem Assign property rights to the resource (!) And, it doesn’t matter who gets the rights!

Is zero the “right” level of pollution? $ MC NO !!! MB Quantity of pollution Qmin Q* Qmax Problems: Holdouts and Free Riders

The firm owns the rights The Free Rider Problem Quantity of pollution MC MB $ Q* Qm $1000 $400 The firm owns the rights

The downstream users own the rights The Holdout Problem Quantity of pollution MC MB $ Q* Qm $20,000 $2000 The downstream users own the rights

Selling Pollution Rights (!) Reduce Pollution by 3 Units Cost to reduce by: Firm X Firm Y Firm Z 1st unit $50 $70 $800 2nd unit $75 $130 $1000 3rd unit $100 $200 $2000 How? Cost? Price of permits? Issue 2 each.

Reduce Pollution by 3 Units Cut back equally (by 1 unit each): Cost = $50 + $70 + $800 = $920 Cut back most cheaply (by 3 units total): Cost = $50 (X) + $70 (Y) + $75 (X) = $195 Charge a price of . . . $90 per permit. Give out 2 each . . . Firm Z will buy 1 from X.

Limitations Transactions costs must be low. Assignment of rights will be contentious. What is optimal level of pollution? It is not a scientific question!! Who will set the tax? Who will be exempt? Coal & the Clean Air Act (1970, 1977, 1990) Choices: scrubbers, washing, use low-SO2 coal. Mandate on scrubbers benefits . . .

Buying & Selling the right to pollute. Class Exercise Buying & Selling the right to pollute.

Market Failure (?): Externalities Dr. D. Foster Microeconomics