THE ECONOMICS OF THE PUBLIC SECTOR 4 THE ECONOMICS OF THE PUBLIC SECTOR

10 Externalities

But market failures can still happen. The Main Idea… Recall: Adam Smith’s “invisible hand” Markets allocate scarce resources with forces of S & D; equilibrium typically maximizes market welfare But market failures can still happen. Outcome of free market differs from socially optimal outcome Gov’t policies can sometimes improve things Video Clip: “Episode 31: Market Failures”

EXTERNALITIES Externality = the uncompensated impact of one person’s actions on the well-being of a bystander For example, I played a terrible song at the start of class. You were innocent bystanders – you weren’t involved in me buying the song off of iTunes, but you still suffered the noise pollution.

EXTERNALITIES When the impact on the bystander is adverse, the externality is called a negative externality Exhaust from cars Your neighbor’s barking dog Rebecca Black’s, “Friday” When the impact on the bystander is beneficial, the externality is called a positive externality Me getting a flu shot Education

EXTERNALITIES CAUSE MARKET INEFFICIENCY In either case, decision maker fails to take into account the external effect of his or her behavior This causes markets to be inefficient, and thus fail to maximize total surplus Negative externalities lead markets to produce a larger quantity than is socially desirable - overproduction Positive externalities lead markets to produce a smaller quantity than is socially desirable - underproduction

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Negative Externality Example: Aluminum The Market for Aluminum The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

Figure 1 The Market for Aluminum Price of Aluminum Supply (private cost) Demand (private value) QMARKET Equilibrium Quantity of Aluminum Copyright © 2004 South-Western

Negative Externality Example: Aluminum The Market for Aluminum For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

Figure 2 Pollution and the Social Optimum Price of Social cost Aluminum Cost of pollution Demand (private value) Supply (private cost) Optimum QOPTIMUM Equilibrium QMARKET Quantity of Aluminum Copyright © 2004 South-Western

Negative Externality Example: Aluminum Intersection of the demand curve and the social-cost curve determines optimal output level. Socially optimal output level is less than market equilibrium quantity The market produces a larger quantity than is socially desirable. The social cost of the good exceeds the private cost of the good.

Adjusting for Externalities Internalizing an externality involves altering incentives so that people take account of the external effects of their actions Negative externality can be internalized by a tax on producers for each unit of aluminum; this would reduce equilibrium quantity to socially optimal level

Quick Quiz 1: Are You Picking Up What Was Put Down? The government taxes goods like alcohol, tobacco, and gasoline – you may be familiar with the term sin tax. Why do you think many economists support these types of taxes? Provide a brief written explanation along with a graph to support your reasoning. For you graph, pick one market to represent – alcohol, tobacco, or gas.

Happy Friday  What are your plans for after graduating high school? For example, college? job? What are your reasons? Take out your class notes & the quick quiz handout. (extras are available in the “Absent” folder if you can’t find yours…)

Positive Externality Example: Education When an externality benefits the bystanders, a positive externality exists. The social value of the good exceeds the private value. For example, education yields positive externalities Better-educated voters lead to better government Crime rates drop as education level of population rises Countries with high levels of education enjoy higher standard of living

Figure 3 Education and the Social Optimum Price of Education Social value Supply (private cost) Demand (private value) QOPTIMUM QMARKET Quantity of Education Copyright © 2004 South-Western

Positive Externalities The intersection of the supply curve and the social-value curve determines the optimal output level. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good.

Positive Externalities Internalizing Positive Externalities: Subsidies Used as the primary method for attempting to internalize positive externalities Education is heavily subsidized through public schools and gov’t scholarships

Quick Quiz 2: Are You Picking Up What Was Put Down? Give an example of positive externality. Explain why market outcomes are inefficient in the presence of this externality. Provide a graphical representation and explain how the government can remedy such a market failure. DON’T PEAK AT YOUR NOTES.

Addressing Externalities: Two Types of Public Policy Command-and-Control Policies – regulate behavior directly Make certain behaviors illegal Environmental regulations – limit pollution

Addressing Externalities: Two Types of Public Policy Market-Based Policies – provide incentives so private decision makers choose to solve problem on their own Policy 1: Corrective Taxes: used to counter effects of negative externalities; ideal tax should equal external costs (a.k.a. Pigovian Taxes) Subsidies: used to counter effects of positive externalities; ideal subsidy should equal external benefit Policy 2: Tradable Pollution Permits: Firms allotted certain amount of pollution per year; a free market for pollution rights develops as firms can buy and sell unused “units” of pollution

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (a) Pigovian Tax Price of Pollution Demand for pollution rights P Pigovian tax Q 1. A Pigovian tax sets the price of pollution . . . Quantity of 2. . . . which, together with the demand curve, determines the quantity of pollution. Pollution Copyright © 2004 South-Western

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits (b) Pollution Permits Price of Q Supply of pollution permits Pollution Demand for pollution rights P 2. . . . which, together with the demand curve, determines the price of pollution. Quantity of 1. Pollution permits set the quantity of pollution . . . Pollution Copyright © 2004 South-Western

Quick Quiz #3 A glue factory and a steel mill emit smoke containing a chemical that is harmful if inhaled in large amounts. Describe three ways the town government may respond to this externality. What are the pros and cons of each solution? Hint: Creating a chart would make this really easy for Mrs. K to grade… 

PRIVATE SOLUTIONS TO EXTERNALITIES Government action is not always needed to solve the problem of externalities. Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties

The Coase Theorem The Coase Theorem is a proposition that private parties can solve the problem of externalities on their own by bargaining without cost over the allocation of resources Example: Mrs. K’s barking dog

Private Solutions Don’t Always Work  Transaction costs can be so high that private agreement is not possible The costs parties incur in the process of agreeing to and following through on a bargain

In Summary… Sometimes the “invisible hand” fails to take into account the well-being of third parties – when a transaction impacts a third party, it’s called an externality Externalities can be positive or negative Those affected by externalities can sometimes solve the problem privately (Coase Theorem) When private parties cannot adequately deal with externalities, then the government steps in.

Quick Quiz #4 Come up with your own externality story. Apply the Coase Theorem and provide a private solution. Give a specific scenario where the transaction costs may get in the way of the private solution.