Externalities and Public Goods Lecture 7 – academic year 2013/14 Introduction to Economics Fabio Landini

Where we are… Lecture 1 : Demand and supply model Lecture 2: Elasticity and its application Lecture 4: Demand, Supply and economic policy Lecture 5: Demand, Supply and economic efficiency Lecture 5: Surplus of consumers and producer

What do we do today? The “external” effects of economic activities How do we internalize externalities? The different typologies of economic goods: private goods, public goods, common resources and natural monopolies

The KYOTO Protocol – since 1997 The Kyoto Protocol, signed in December 1997 at the UNFCCC COP3 (Conference Of Parties), represents the executive instruments of the Framework Convention The countries that are subject to the emission constraint are 39 and they include the European countries (including the East countries), Japan, Russia, United States, Canada, Australia and New Zealand

The KYOTO Protocol – since 1997 The European Directive 2003/87/CE “Emissions Trading” regulate the exchange of quotas for the emission of greenhouse gas. The final aim is to establish an European market for the emission quotas. During the first three years (2005-2007), the emissions of large combustion plants, such as oil refineries, plants for the production of ferrous metal, mineral goods (concrete, lime, etc.) and the plants for the production of paper and cartboard

Market efficiency: A brief recap In a perfectly competitive market with no externalities the total welfare of the economic system is measured as the sum of consumer surplus and producer surplus. “The invisible hand” (of the market) maximize the total benefit of society Markets are usually good instruments to organize the economic activity Sometimes, however: “markets fail”

Externalities: definition and effects When the transaction between a buyer and a seller has an effect on a third party, the effect on the latter is called externality. Whenever they do not take into account the “third party”, the equilibrium prices and quantities are not efficient. Therefore the externalities cause an inefficient allocation of resources, i.e. market failure.

The effects of externalities on society In the presence of externalities: Social welfare is not measured only by the welfare of consumers and producers, but also by the welfare of the third party (involuntary participant to the market). The externalities can be negative or positive However, ALL externalities are sources of market inefficiencies in the sense that the quantity exchanged ≠ optimal quantity.

Negative externalities Costs on other individuals (consumers or producers) that are not directly involved in the market exchange. Example: smoke of cigarettes, cars’ exhaust gas

Positive externalities Direct benefits obtained by individuals (consumers or producers) not directly involved in the market exchange. Example: Vaccines, restoration of a piece of Art, investment in new technologies.

Externalities and market inefficiency Negative externalities in production Qmarket > Qoptimum (socially desirable quantity) social costs > private costs Positive externalities in production Qmarket < Qoptimum social costs < private costs

Externalities and market inefficiency Negative externalities in consumption Qmarket > Qoptimum (socially desirable quantity) Social benefit < private benefit Positive externalities in consumption Qmarket < Qoptimum Social benefit > private benefit

Negative externalities in production Social cost Cost of pollution Price of aluminium Supply (private cost) QOPTIMUM Optimum Equilibrium Demand (private value) Quantity of aluminium QMARKET

Positive externalities in production Price of Robot Supply (private cost) Value of technological diffusion Social cost Optimum Equilibrium QOPTIMUM Demand (private value) QMARKET Quantity of Robot

Negative externalities in consumption Price of alcoholic drinks Supply (private cost) QOPTIMUM Optimum Social value Equilibrium Demand (private value) QMARKET Quantity of alcoholic drinks

Positive externalities in consumption Price of education QOPTIMUM Optimum Social value Supply (private cost) Equilibrium Demand (private value) QMARKET Quantity of education

How to obtain Qoptimum? 1. Government intervention Government can internalize the externalities by taxing the goods that causes negative externalities and by subsidizing those with positive externalities. “To internalize an externality” means to alter market incentive with subsidies and taxes, so as to induce individuals to take adequately into account the external effects of their actions.

Obtaining optimal production If the externality is negative: internalization through a tax – the tax reduces the quantity that is exchanged in equilibrium until the social optimum obtains If the externality is positive: internalization through a subsidy – the subsidy increase the quantity that is exchanged in equilibrium until the social optimum obtains

How to obtain Qoptimum? 2. Private solution Public intervention is not always either necessary or efficacious to deal with externalities. Example of private solutions: Ethical codes and social sanctions. NGOs (in the “no-profit” sector). Integration of different types of activities. System of contracts (Coase’s theorem).

Externalities and public goods A case in which externalities are of particular relevance is when we deal with specific types of economic goods, called public goods and common resources Example: knowledge (technological spillover), environment (pollution) What are public goods and common resources?

Typologies of economic goods The goods available in our economy can be distinguished along two dimensions: Excludability and Rivalry

Typologies of economic goods Excludability An individual can be prevented from using a good (e.g. laws usually recognize the private property of a good)

Typologies of economic goods Rivalry The consumption of a good by an individual prevents the simultaneous consumption of the same good by other individuals

Example of a public good: A bridge A bridge connects two shores of a river Given a certain dimension of the bridge, if the n. of people using the bridge increases (congestion): consumption rivalry If there is a fee for the bridge (those who don’t pay cannot use it): consumption excludability

Rivalrous Non-rivalrous Example of the bridge Free access Rivalrous Non-rivalrous Many N. people Few

Non-excludable Excludable Example of the bridge Fee yes No Given number of people

Example of the bridge: two-ways table Fee Yes No Excludable Rivalrous Non-excludable Non-rivalrous Many N. people Few

Example of the bridge: two-ways table Fee Yes No Excludable Rivalrous (PRIVATE GOODS) Non-excludable (COMMONS) Excludabe Non-rivalrous (NATURAL MONOPOLY) (PUBLIC GOODS) Many N. people Few

Four types of economic goods (1) Private goods Both excludable and rivalrous Example: ice-cream, CDs, etc. Public goods Neither excludable nor rivalrous Example: national defence, scientific knowledge

Four types of economic goods (1) Commons Rivalrous, but non-excludable Example: sea fishes Natural monopoly Excludable, but non-rivalrous Example: drinkable water

Public goods and externalities Non-excludable goods  all can benefit without paying the price, p = 0 Access to the good cannot be limited; private value = 0, social value > 0 But: production costs > 0 (scarce resources) Who is it going to produce the good, if not paid? Therefore: positive externalities of a public good (autonomously, market produces too few).

The problem of free riding A free rider is a person who can enjoy the benefit of a good without paying the price

It is convenient for me NOT to pay!!! In order to build the bridge, a voluntary contribution equal to 10 is requested….. The bridge is built The bridge is not built I contribute (I pay 10) 90 - 10 I do not contribute (I don’t pay) 100 It is convenient for me NOT to pay!!!

The problem of free riding Since public goods are non-excludable, each individual can refuse to pay the good, hoping that other people will pay in his/her place. If everybody reasons the same, the good is not produced. IMPORTANT: the presence of free riding makes it impossible to rely on the market to supply public goods.

Solution of the free riding problem If the benefits > costs (social value > 0), public authorities can produce the good by relying on taxes. Example: fireworks by Moena’s Municipality 500 inhabitants; value for each inhabitant =10 €; cost of fireworks = 1000 €. Fireworks tax for each inhabitant = 2€, it covers the costs. Consumer surplus = 8€ (= 10€ - 2€).

The need for a State to produces public goods, whose cost is financed via taxes, represents the main economic justification for the existence of taxation (and thus for the fight against tax evasion): that is the “minimum State”.

Common resources Common resources are non-excludable They are freely available for anybody to exploit But they are rival: the consumption of the good by one individual reduces the possibility for other individual to consume

Examples of common resources Air and clean water Congested streets Fishes, whale and other wild species

The tragedy of the commons When an individual, by using a resource, diminishes the availability of the resource for others we encounter the tragedy of the commons. Common resources tend to be over-exploited This generates a negative externality.

The tragedy of the commons The public administration can: Impose a tax on usage; Regulate the use of the resource; Transform the common resource in a private good (by defining and enforcing individual property rights on the resource.

The importance of property rights When the absence of property rights is the cause of market failures, public intervention can potentially solve the problem in 3 ways By defining property rights, which enable the market to operate efficiently; By regulating individual behaviour; By producing a good that the market does not supply.

Conclusion When the transaction between consumer and producer has effects on a third party, there is an externality. Negative (positive) externalities imply that the quantity exchanged in the market equilibrium is superior (inferior) to the social optimum. The solution to the problem of externalities can be pursued both by private parties and public intervention

Conclusion Economic goods differ in terms of excludability and rivalry. The market can function when goods are private i.e. both excludable and rivalrous. Public goods are neither excludable nor rivalrous, hence the market does not function well. In because of free riding, it is the public sector who is responsible to supply public goods.

Conclusion Collective resources are rivalrous but not excludable. Since individuals do not pay for the use of the resource, there is a tendency toward over- exploitation. Public administration may limit the use of common resources via access regulation and taxes