Externalities and Public Goods Chapter 18 Externalities and Public Goods

Topics to be Discussed Externalities Ways of Correcting Market Failure Externalities and Property Rights Common Property Resources Public Goods Private Preferences for Public Goods ©2005 Pearson Education, Inc. Chapter 18 2

Externalities Externalities arise between producers, between consumers, or between producers and consumers Externalities are the effects of production and consumption activities not directly reflected in the market They can be negative or positive ©2005 Pearson Education, Inc. Chapter 18 4

Externalities Negative Action by one party imposes a cost on another party Plant dumps waste in a river, affecting those downstream The firm has no incentive to account for the external costs that it imposes on those downstream ©2005 Pearson Education, Inc. Chapter 18

Externalities Positive Action by one party benefits another party Homeowner plants a beautiful garden where all the neighbors benefit from it Homeowner did not take their benefits into account when deciding to plant ©2005 Pearson Education, Inc. Chapter 18

Negative Externalities and Inefficiency Scenario – plant dumping waste Marginal External Cost (MEC) is the increase in cost imposed on fishermen downstream for each level of production Marginal Social Cost (MSC) is MC plus MEC We can show the competitive market firm decision and the market demand and supply curves ©2005 Pearson Education, Inc. Chapter 18 6

Negative Externalities and Inefficiency Assume the firm has a fixed proportions production function and cannot alter its input combinations The only way to reduce waste is to reduce output Price of steel and quantity of steel initially produced given by the intersection of supply and demand ©2005 Pearson Education, Inc. Chapter 18

Negative Externalities and Inefficiency The MC curve for the firm is the marginal cost of production Firm maximizes profit by producing where MC equals price in a competitive firm As firm output increases, external costs on fishermen also increase, measured by the marginal external cost curve From a social point of view, the firm produces too much output ©2005 Pearson Education, Inc. Chapter 18

The profit maximizing firm efficient output level is q*. External Costs There is MEC of production from the waste released. The MSC is true cost of production. The profit maximizing firm produces at q1 while the efficient output level is q*. Firm will produce q1 at P1. MSC Price Price MC MSCI D S = MCI P* Q* P1 P1 Q1 q* q1 MECI MEC Firm output Industry output ©2005 Pearson Education, Inc. Chapter 18

External Costs MC S = MCI D P1 q1 Q1 MSC MSCI MEC MECI q* P* Q* Price By not producing at the efficient level, there is a social cost on society. MC S = MCI D P1 q1 Q1 MSC MSCI Firm output Price Industry output MEC MECI q* P* Q* Aggregate social cost of negative externality ©2005 Pearson Education, Inc. Chapter 18

External Cost Negative externalities encourage inefficient firms to remain in the industry and create excessive production in the long run ©2005 Pearson Education, Inc. Chapter 18 17

Positive Externalities and Inefficiency Externalities can also result in too little production, as can be shown in an example of home repair and landscaping Repairs generate external benefits to the neighbors Shown by the Marginal External Benefit curve (MEB) Marginal Social Benefit (MSB) curve adds MEB +D ©2005 Pearson Education, Inc. Chapter 18

External Benefits Value MSB D P1 MC P* MEB Repair Level q1 q* When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits (MSB) are higher than marginal benefits (D). D MC P1 q* P* q1 A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair. MEB Repair Level ©2005 Pearson Education, Inc. Chapter 18 25

Ways of Correcting Market Failure Assumption: The market failure is pollution Output decision and emissions decision are independent Firm has chosen its profit-maximizing output level MSC is marginal social cost of emissions Equivalent to MEC from before Upward sloping because of substantially increasing harm as pollution increases ©2005 Pearson Education, Inc. Chapter 18 26

Ways of Correcting Market Failure MCA is marginal cost of abating emissions Additional cost to firm of controlling pollution Downward sloping because when emissions are high, there is little cost to controlling them Large reductions require costly changes in production process ©2005 Pearson Education, Inc. Chapter 18

Ways of Correcting Market Failure If the firm does not consider abatement, their profit maximizing level is 26 units of emissions Level where MCA is zero The socially efficient level of emissions is 12 where the MSC equals the MCA ©2005 Pearson Education, Inc. Chapter 18

The Efficient Level of Emissions Dollars/ Unit of Emissions MSC MCA E0 6 At Eo the marginal cost of abating emissions is greater than the marginal social cost. 4 At E1 the marginal social cost is greater than the marginal benefit. E1 The efficient level of emissions is where MCA = MSC. E* 2 Level of Emissions 2 4 6 8 10 12 14 16 18 20 22 24 26 ©2005 Pearson Education, Inc. Chapter 18 34

Ways of Correcting Market Failure Firms can be encouraged to reduce emissions to the efficient level in three ways: Emissions standards Emissions fees Transferable emissions permits ©2005 Pearson Education, Inc. Chapter 18

Ways of Correcting Market Failure Options for Reducing Emissions to E* Emissions 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 Emissions Fee Charge levied on each unit of emission ©2005 Pearson Education, Inc. Chapter 18 35

Standards and Fees MSC 3 MCA E* 12 Standard Fee Dollars/ Unit of Emissions MSC MCA 3 12 E* Standard Fee Level of Emissions ©2005 Pearson Education, Inc. Chapter 18 38

Standards and Fees MSC E* 3 MCA 12 Cost is less than the Dollars/ Unit of Emissions MSC MCA Cost is less than the fee if emissions were not reduced. E* Fee 3 Total Fee of Abatement Total Abatement Cost 12 Level of Emissions ©2005 Pearson Education, Inc. Chapter 18 42

Ways of Correcting Market Failure Standards Versus Fees Assumptions Policymakers have asymmetric information Administrative costs require the same fee or standard for all firms ©2005 Pearson Education, Inc. Chapter 18 43

The Case for Fees Assume two firms Same marginal social cost curve Different marginal abatement cost curves MCA1 and MCA2 Emissions fees are preferable to standards in this case We want to reduce total emissions by 14 units The cheapest way to do that is for Firm 1 to reduce by 6 and Firm 2 by 8 units ©2005 Pearson Education, Inc. Chapter 18

The Case for Fees MCA1 MCA2 2 4 6 Fee per Unit of Emissions 1 3 5 The cost minimizing solution would be an abatement of 6 for Firm 1 and 8 for Firm 2 and MCA1= MCA2 = $3. Level of Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 ©2005 Pearson Education, Inc. Chapter 18 48

The Case for Fines What if the regulatory agency forces each firm to cut emissions by 7 units? MAC for Firm 1 increases to $3.75 MAC for Firm 2 decreases to $2.50 This is not cost minimizing because one firm can reduce emissions at a lower cost than the other firm Marginal cost of abatement must be equal between firms for reductions to occur at minimum cost ©2005 Pearson Education, Inc. Chapter 18

The impact of a standard of abatement of 7 for both firms The Case for Fees 2 4 6 Fee per Unit of Emissions 1 3 5 MCA1 MCA2 The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA2 < MCA1. 3.75 2.50 Firm 1’s Increased Abatement Costs Firm 2’s Reduced Abatement Costs Level of Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 ©2005 Pearson Education, Inc. Chapter 18 48

Ways of Correcting Market Failure Advantages of Fees When equal standards must be used, fees achieve the same emission abatement at a lower cost Fees create an incentive to install equipment that would reduce emissions further ©2005 Pearson Education, Inc. Chapter 18 50

The Case for Standards Assume we have Steep marginal social cost curve Flat marginal cost of abatement An emissions fee of $8 would be efficient but because of limited information, fee is set at $7 Firms’ emissions increase and with steep MSC, this will lead to significant additional social costs ©2005 Pearson Education, Inc. Chapter 18

The Case for Standards What if standard is used instead and has the same percentage mistake? Standard set at 9 instead of 8 Increase in social costs and decrease in abatement costs Net increase in social costs is smaller than with fees ©2005 Pearson Education, Inc. Chapter 18

information, fee is $7 (12.5% decrease). information, standard is 9 The Case for Standards Fee per Unit of Emissions 2 4 6 8 10 12 14 16 B C Based on incomplete information, fee is $7 (12.5% decrease). Emission increases to 11. Marginal Social Cost ABC is the increase in social cost less the decrease in abatement cost. E D A Based on incomplete information, standard is 9 (12.5% decrease). ADE < ABC Marginal Cost of Abatement Level of Emissions 2 4 6 8 10 12 14 16 ©2005 Pearson Education, Inc. Chapter 18 56

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 emissions levels and less certainty on the cost of abatement ©2005 Pearson Education, Inc. Chapter 18 57

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 ©2005 Pearson Education, Inc. Chapter 18 58

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 ©2005 Pearson Education, Inc. Chapter 18 59

Ways of Correcting Market Failure The market for externalities is appealing since it combines the system of standards with the system of fees The agency who administers the system determines the total number of permits and therefore the total amount of emissions Marketability of the permits allows pollution abatement to be achieved at minimum cost ©2005 Pearson Education, Inc. Chapter 18 60

The Costs and Benefits of Reduced Sulfur Dioxide Emissions Costs of Reducing Emissions Conversion to natural gas from coal and oil Emission control equipment Benefits of Reducing Emissions Health Reduction in corrosion Aesthetic ©2005 Pearson Education, Inc. Chapter 18 61

The Costs and Benefits of Reduced Sulfur Dioxide Emissions The efficient sulfur dioxide concentration equates the marginal abatement cost to the marginal social cost Can show the marginal abatement cost curve in a series of steps, each representing a different abatement technology ©2005 Pearson Education, Inc. Chapter 18 62

Sulfur Dioxide Emissions Reductions Dollars per unit of reduction 60 Marginal Abatement Cost Observations MAC = MSC @ .0275 .0275 is slightly below actual emission level Economic efficiency improved 40 Marginal Social Cost 20 Sulfur dioxide concentration (ppm) 0.02 0.04 0.06 0.08 ©2005 Pearson Education, Inc. Chapter 18 65

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 ©2005 Pearson Education, Inc. Chapter 18 67

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 = $105.7 million) 85% reduction at each plant with internal trading (total cost = $42.6 million) 85% reduction at all plants with internal and external trading (total cost = $14.6 million) ©2005 Pearson Education, Inc. Chapter 18 68

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 ©2005 Pearson Education, Inc. Chapter 18 69

Price of Tradable Emissions Permits ©2005 Pearson Education, Inc. Chapter 18

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 ©2005 Pearson Education, Inc. Chapter 18 70

Recycling Marginal private cost likely constant for fixed amount of garbage Social cost of disposal includes the harm to environment from littering and injuries caused by litter Without market intervention, the level of scrap will be at m and m1 > m* With refundable deposit, MC increases and MC = MSC = MCR ©2005 Pearson Education, Inc. Chapter 18

The Efficient Amount of Recycling ©2005 Pearson Education, Inc. Chapter 18 75

Refundable Deposits Deposit is paid when bottle is purchased and then refunded when bottle returned Can choose the deposit to give household incentive to recycle more Deposit increases private cost of disposal Supply of glass comes from new glass and recycled glass Increasing deposit increases supply of recycled glass and lowers price of glass ©2005 Pearson Education, Inc. Chapter 18

Refundable Deposits Sr $ S’r Sv D S S’ P P’ M1 M* Amount of Glass The supply of glass is the sum of the supply of virgin glass (SV) and the supply of recycled glass (Sr). Sr Without refunds the price of glass is P and Sr is M1. $ S’r Sv With refunds Sr increases to S’r and S increases to S’. D S Price falls to P’ and the amount of recycled glass increases to M*. S’ P P’ ©2005 Pearson Education, Inc. M1 M* Chapter 18 Amount of Glass 80

Externalities and 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 would control upstream emissions ©2005 Pearson Education, Inc. Chapter 18 81

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 ©2005 Pearson Education, Inc. Chapter 18 82

Profits Under Alternative Emissions Choices (Daily) ©2005 Pearson Education, Inc. Chapter 18 84

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 ©2005 Pearson Education, Inc. Chapter 18 85

Bargaining with Alternative Property Rights ©2005 Pearson Education, Inc. Chapter 18 87

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 ©2005 Pearson Education, Inc. Chapter 18 88

Costly Bargaining – The Role of Strategic Behavior Bargaining requires clearly defined rules and property rights If property rights were not clear, the other party might not be willing to pay as much and the bargaining process would break down One party might incorrectly assume the other party will eventually break down and accept less Problems also arise when there are many parties affected ©2005 Pearson Education, Inc. Chapter 18 89

A Legal Solution – Suing for Damages In many situations involving externalities, one party is harmed (victim) They can recover monetary damages equal to harm suffered A suit for damages is different than effluent fee since the victim, not the government, is paid ©2005 Pearson Education, Inc. Chapter 18

A Legal Solution – Suing for Damages – Example 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) ©2005 Pearson Education, Inc. Chapter 18 90

A Legal Solution – Suing for Damages – Example 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 A suit for damages results in an efficient outcome ©2005 Pearson Education, Inc. Chapter 18 91

The Coase Theorem at Work Negotiating an Efficient Solution 1987 – New York garbage spill (200 tons) littered New Jersey beaches The potential cost of litigation resulted in a solution that was mutually beneficial to both parties ©2005 Pearson Education, Inc. Chapter 18 93

Common Property Resources Characteristics Everyone has free access Likely to be overutilized Examples Air and water Fish and animal populations Minerals ©2005 Pearson Education, Inc. Chapter 18 94

Common Property Resources Consider a lake where people fish Each fisherperson takes fish up to the point where the marginal benefit to them equals the marginal cost There is no reason that any one fisherperson take into account how their taking fish affects others’ experience ©2005 Pearson Education, Inc. Chapter 18

Common Property Resources Private cost underestimates the true cost to society More fishing reduces the stock of fish Less is available to others and too low of a stock will completely deplete the fish Too many fish are caught ©2005 Pearson Education, Inc. Chapter 18

Common Property Resources Benefits, Costs ($ per fish) Without control, the number of fish/month is FC where PC = MB. Marginal Social Cost However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D). Private Cost Demand (MB) F* FC Fish per Month ©2005 Pearson Education, Inc. Chapter 18 98

Common Property Resources Solution Private ownership Owner will set fee for use of resource equal to the marginal cost of depleting the stock Fishermen will no longer find it profitable to catch more than the efficient amount of fish It is often the case that when private ownership is not possible, the government steps in ©2005 Pearson Education, Inc. Chapter 18 99

Crawfish Fishing in Louisiana Crawfish has become very popular in restaurants As a common property resource, too many crawfish have been trapped, causing the population to fall below efficient level Finding the Efficient Crawfish Catch F = crawfish catch in millions of pounds/yr C = cost in dollars/pound ©2005 Pearson Education, Inc. Chapter 18

Crawfish Fishing in Louisiana Demand C = 0.401 = 0.0064F MSC C = -5.645 + 0.6509F PC C = -0.357 + 0.0573F Efficient Catch D = MSC 9.2 million pounds ©2005 Pearson Education, Inc. Chapter 18

Crawfish as a Common Property Resource Cost ($/pound) Marginal Social Cost Private Cost 11.9 2.10 9.2 0.325 Demand Crawfish Catch (millions of pounds) ©2005 Pearson Education, Inc. Chapter 18 98

Public Goods Characteristics Nonrival Nonexclusive 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 Example – use of lighthouse by a ship ©2005 Pearson Education, Inc. Chapter 18 101

Public Goods Nonexclusive goods Goods that people cannot be excluded from consuming, so that it is difficult or impossible to charge for their use Example: fireworks, national defense ©2005 Pearson Education, Inc. Chapter 18 102

Efficiency and Public Goods Efficient level of private good is where marginal benefit equals marginal cost For a public good, the value of each person must be considered Can add demand of all those who value good Must equate the sum of these marginal benefits to the marginal cost of production ©2005 Pearson Education, Inc. Chapter 18

Efficient Public Good Provision Benefits (dollars) D1 is demand for consumer 1. D2 is demand for consumer 2. D is total demand for all consumers. D $7.00 $5.50 MC D2 $4.00 Efficient output occurs where MC = total MB 2 units of output. MB is $1.50 + $4.00 or $5.50. D1 $1.50 Output ©2005 Pearson Education, Inc. 1 2 3 Chapter 18 4 5 6 7 8 9 10 105

Public Goods and Market Failure 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 ©2005 Pearson Education, Inc. Chapter 18 107

Public Goods and Market Failure Establishing a mosquito abatement company How do you measure output? Who do you charge? A mosquito meter? ©2005 Pearson Education, Inc. Chapter 18 108

The Demand for Clean Air Clean Air is a public good Nonexclusive and nonrival No market and no observable price at which people are willing to trade clean air for other goods ©2005 Pearson Education, Inc. Chapter 18 109

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 ©2005 Pearson Education, Inc. Chapter 18 110

The Demand for Clean Air Dollars Low Income Middle Income High Income 3000 2500 2000 1500 1000 500 Nitrogen Oxides (pphm) 1 2 3 4 5 6 7 8 9 10 ©2005 Pearson Education, Inc. Chapter 18 112

The Demand for Clean Air Findings The amount of people who 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 ©2005 Pearson Education, Inc. Chapter 18 113

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 ©2005 Pearson Education, Inc. Chapter 18 114

Private Preferences for Public Goods Can represent different citizens’ willingness to pay for education minus any required tax payments In general, benefit from increased spending on education increases as spending increases Tax payments to provide more education increase as well ©2005 Pearson Education, Inc. Chapter 18

Determining the Level of Educational Spending Willingness to pay $ 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. The efficient level of educational spending is determined by summing the willingness to pay for education for each of three citizens. AW W3 W2 W1 Educational spending per pupil $0 ©2005 Pearson Education, Inc. $600 Chapter 18 $1200 $1800 $2400 117

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 over-investment If two of the three preferred $600, there would be under-investment ©2005 Pearson Education, Inc. Chapter 18 119

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 ©2005 Pearson Education, Inc. Chapter 18 120