Externalities and Public Goods Chapter 20 Externalities and Public Goods McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics Externalities and inefficiency Remedies for externalities: the private sector Remedies for externalities: the public sector Common property resources Public goods 20-2

Externalities Competitive markets may not allocate resources efficiently when the assumptions of the model are violated Example: assumed that each consumer’s well-being depends only on her own consumption An action creates an externality if it affects someone with whom the decision-maker has not engaged in a related market transaction Negative externality if it harms someone else Polluting causes health problems in a community, neglecting a garden reduces neighbors’ home values Positive externality if it benefits someone else Pollution abatement reduces health effects on community, carefully tended garden raises the value of surrounding homes 20-3

Negative Externalities and Inefficiency Presence of a negative externality in a competitive market will usually allocate economic resources inefficiently An external cost is the economic harm that a negative externality imposes on others Each firm produces up to the point at which its marginal cost curve equals the market price But socially efficient level of production for any particular firm equates marginal social cost and marginal social benefit Marginal social cost = marginal cost to the producer + marginal external cost Therefore the firm’s equilibrium production level is socially excessive and inefficient 20-4

Negative Externalities and Inefficiency Similar result holds for the entire market When firms ignore external costs, they are willing to produce too much output at any given price The good is priced too cheaply in equilibrium Because output is priced incorrectly, consumers demand too much The externality creates deadweight loss Society’s loss equals the vertical distance between the demand curve and the marginal social cost curve 20-5

Figure 20.1: Negative Externality in a Competitive Market 20-6

Positive Externalities and Inefficiency Competitive equilibria are inefficient when either positive or negative externalities are present An external benefit is the economic gain that a positive externality provides to others Firm output will be inefficiently low from society’s perspective Like a negative externality, a positive externality creates deadweight loss 20-7

Figure 20.2: Positive Externality in a Competitive Market 20-8

Remedies for Externalities: Private Sector Whenever the allocation of resources is inefficient it is possible to arrange mutually beneficial trades Private parties thus have incentives to identify inefficiencies and negotiate solutions When private negotiations fail to address market failures associated with externalities, government policies can potentially improve economic efficiency Policies that support markets (e.g., establishing clear property rights) Quantity controls (e.g., emissions standards) Policies that correct private incentives (e.g., taxes, fees, subsidies) 20-9

Property Rights and Negotiation Outcome of a negotiation depends on the parties’ property rights Party who holds the relevant property rights is in a stronger bargaining position Usually emerges with a more favorable deal Assignment of property rights does not affect the level of pollution but does affect profits Coase theorem: regardless of how property rights are assigned, voluntary agreements will remedy externalities If bargaining is frictionless Sometimes used as a justification for laissez faire policies Coase did not believe that bargaining is frictionless 20-10

Limitations of Bargaining Every externality can be traced to missing markets Private negotiations lead to transactions that the parties would have made if the required markets weren’t missing Many factors that cause externalities also hinder bargaining Bargaining can be impractical Difficult logistics, substantial time and effort Property rights may be ambiguous Limited information can lead to an impasse Contracts may be difficult to enforce 20-11

Quantity Controls Government can attempt to address an externality by regulating the activity that produces it An emissions standard is a legal limit on the amount of pollution that a person or company can produce When engaged in a particular activity Example: Aircraft noise abatement Setting a socially efficient abatement standard requires information about abatement costs and benefits Private parties may have an incentive to exaggerate their costs (or benefits) Government may have trouble learning the truth Can lead to an inefficient standard and deadweight loss 20-12

Policies that Correct Private Incentives Some policies address externalities by forcing people to internalize external costs and benefits Impose taxes or fees, provide subsidies, expose decision-makers to legal liability Pigouvian taxation involves the use of taxes or fees to remedy negative externalities A Pigouvian tax forces a decision-maker to internalize the marginal external costs associated with her activity Weigh it against marginal benefit Make a socially efficient decision Ideal Pigouvian tax reproduces the price that the good in question would command in an efficient competitive equilibrium 20-13

Figure 20.5: Pigouvian Tax on Noise Airline produces noise up to the point where MCA equals the tax of $10,000 per decibel Socially efficient outcome is achieved, with noise at 80 decibels 20-14

Liability Rules Another mechanism for addressing negative externalities Under a liability rule a party who takes an action that harms others must compensate the affected parties for their losses Liability rules induce decision-makers to internalize all external costs Lead to efficient choices In some cases, the government needs less information to effectively use a liability rule than an emissions standard or Pigouvian tax Liability rules raise other difficulties because of their legal nature 20-15

Pitfalls for Policies that Correct Private Incentives Liability rules and Pigouvian taxes both force decision-makers to internalize harm caused to others But harms often have multiple causes In such cases efforts to correct private incentives can lead to inefficiency Typical liability rule holds one source of external cost accountable Inefficient if more than one group’s choices contribute to the external costs Ideal rule would force all parties contributing to the externality to bear a portion of the social costs 20-16

Consequences of Policy Errors Errors in setting a tax vs. a standard may have different implications for efficiency This consideration can provide a reason for preferring one approach over the other Which policy is better? Depends on the slopes of the marginal social cost (MSC) and marginal cost of abatement (MCA) curves Standard is superior when the MCA curve is relatively flat and the MSC curve is relatively steep Tax is superior when the MCA curve is relatively steep and the MSC curve is relatively flat 20-17

Figure 20.8: Consequences of Policy Errors 20-18

Minimizing Total Cost of Abatement External costs of pollution may depend on the total emission of many parties In so, an emissions tax guarantees that reduction in the overall level of pollution will be achieved at the lowest possible cost Emissions standard does not guarantee this Each firm will pollute up to the point at which the marginal cost of abatement equals the tax rate Firms produce different amounts of pollution but will share the same marginal cost of abatement Any change in firms’ emissions that leaves total pollution unchanged will increase overall abatement costs 20-19

Figure 20.9: Emissions Tax 20-20

Tradable Emissions Permits A tradable emissions permit entitles a firm to generate a specified amount of a given pollutant Transferable, one firm can sell it to another Total emissions are limited by the number of permits the government issues Enables the government to reduce the level of pollution to any desired target Can achieve any given reduction in total emissions at the lowest possible abatement cost Competitive market for permits may emerge Each firm will generate pollution up to the point at which marginal cost of abatement equals the market price of a permit Note that the market does not set the level of pollution 20-21

Sample Problem 1 (20.8): Inoculations create external benefits by reducing other people’s exposure to communicable diseases. Suppose the market demand curve for inoculations is Qd = 100 -10P, where Qd is millions of inoculations and P is the price per inoculation. Suppose also that the market for inoculations is competitive and that the market supply curve is Qd = 2P - 8. Finally, suppose that the marginal external benefit of inoculations is MEB = 8 + 1.5Q. Find thee socially efficient level of inoculations, the competitive equilibrium, the deadweight loss created by the externality, and the optimal Pigouvian subsidy.

Common Property Resources A common property resource is a resource that more than one person is free to use without payment Examples: Lakes, air, oceans Generally, each person’s use of a common property resource reduces its value to others Creates a negative externality Consider a large lake, the only source of fish for nearby towns, where anyone can become a fisherman free of charge The marginal social cost of fishing exceeds the marginal private cost Each fisherman fails to account for the fact that his decision to catch fish reduces the fish population and raises the cost of fishing for future fishermen Competitive level of fishing is socially excessive Remedies for market failures associated with common property resources are the same as for negative externalities 20-23

Figure 20.13: Common Property Resources and Overfishing Fish (pounds) Price per pound of fish ($) MSC MEC 2000 Dmarket Smarket 1500 Qefficient 1000 Qequilib 500 20-24

Public Goods: Basics A public good is nonrival and nonexcludable A good is nonrival if more than one person can consume it at the same time without affecting its value to others Marginal cost of providing it is zero A good is nonexcludable if there is no way to prevent a person from consuming it Examples of public goods: national defense, construction of lighthouses Governments often provide public goods Not all goods provided by a government are public goods 20-25

Efficient Provision of Public Goods Socially efficient level of production is where marginal social cost equals marginal social benefit Whether good is private or public To determine the marginal social benefit of a public good, add up the gains to all affected individuals Important difference from process for private good Sum individual curves vertically for a public good Example: security patrols on a city block Three stores would receive marginal benefit of $7.50, $45, and $40 from the first hour of patrolling Marginal social benefit is the vertical sum, $92.50, for a quantity of one hour 20-26

Figure 20.14: Provision of a Public Good 20-27

Public Goods and Market Failure If someone decides to contribute to a public good, other people will benefit The contribution creates a positive externality Competitive markets produce too little output when positive externalities are present If provision of a public good is left entirely to the independent actions of private parties, the level of production will be inefficiently low Market failure associated with public goods is due to free riding A free rider contributes little or nothing to a public good while benefiting from others’ contributions 20-28

Public Policy Toward Public Goods Governments address the market failures associated with public goods in a variety of ways: Provide some public goods (national defense) Contribute to non-profit organizations that provide them (public radio and television) Subsidize private contributions to many public goods (environmental protection) Subsidization often takes the form of tax deductibility for contributions to charitable causes that support public goods These are variants of the methods used to address externalities Efficient public provision of a public good need not entail public production Market failure of public goods related to demand, not production Governments often rely on the private sector to produce public goods Example: U.S. obtains military equipment from private defense contractors 20-29

Gathering Reliable Information To provide a public good efficiently, the government must have information about individual preferences Cannot simply ask; answers will depend on who consumers expect to foot the bill for the public good A Groves mechanism is a way to set the level of a public good that induces everyone to report their preferences correctly Produces a socially efficient outcome Ask each citizen to report the total benefit he would receive from the public good Calculate teach individual’s marginal benefit as though he told the truth Each consumer’s contribution toward the public good is based on the quantity of public good that would be optimal with and without his reported benefits Consumer will be worse off if he exaggerates or understates his benefits than if he tells the truth Groves mechanism gives consumers a strong incentive to tell the truth 20-30

Figure 20.15: The Groves Mechanism 20-31

Public Decision-Making The field of political economy examines the economic consequences of public sector decision-making Example: determine whether public intervention is justified Weigh the consequences of a market failure against the likely consequences of a government failure When markets fail, the public sector may be able to improve the allocation of resources, in principle Do democratic mechanisms promote socially efficient government decision-making? Assume a policy is overturned if more than 50% of voters prefer an alternative 20-32

Median Voter Theorem Median voter theorem: if voters have single-peaked preferences, a majority of them prefer the median ideal policy to all others A voter’s preferences are single-peaked if her net benefit from an activity increases with the activity’s level until her ideal is reached Declines thereafter Median voter is the voter who has the median ideal policy among all voters Majority rule leads to the selection of the median ideal policy 20-33

Figure 20.16: Majority Rule and the Level of a Public Good 20-34

Sample Problem 2 (20.13): Give three examples of public goods, other than the ones discussed in the text. Explain why they are nonrival and nonexcludable (or at least approximately so). From the text: national defense, lighthouses, pest control.