chapter 20 Externalities and Public Goods Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-2 Learning Objectives Explain why competitive markets may not allocate resources efficiently when externalities are present. Discuss the nature and limitations of private negotiation as a remedy for market failures associated with externalities. Evaluate various public policies that are designed to address externalities. Understand why common property resources tend to be overused, and analyze ways that such problems can be corrected. Identify the characteristics of a good that can justify public provision. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-3 Overview Externalities: When our choices directly affect the well being of others not involved in the transaction, competitive markets may allocate resources inefficiently Private parties have strong incentives to identify inefficiencies and negotiate mutually beneficial solutions When the private sector fails to address externalities, appropriate government policies can potentially improve economic efficiency Common property resources tend to be overused, though that problem can be corrected The government provision of public goods is sometimes beneficial Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-4 Externalities Externality: when an action affects someone with whom the decision maker has not engaged in a related market transaction – Negative externality: when such an action harms someone else – Positive externality: when such an action benefits someone else External cost: the economic harm that a negative externality imposes on others External benefit: the economic gain that a positive externality provides to others Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-5 Inefficiency in Competitive Markets When an externality is present, the private costs and/or benefits of an activity to the party who performs it differ from the social costs and/or benefits of that activity When a consumption or production activity creates an externality, competitive markets will usually allocate resources inefficiently Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Competitive Equilibrium with a Negative Externality Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 20-6

20-7 Competitive Equilibrium with a Positive Externality Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Monopoly with a Negative Externality Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 20-8

20-9 Remedies for Externalities Private sector – Property rights and negotiation Public sector – Policies that support markets – Quantity controls – Taxes, fees, subsidies – Liability rules Hybrid market approaches – Tradable permits Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-10 Property Rights and Negotiation The outcome of any negotiation depends on the allocation of property rights – The party who holds the relevant property rights is in a stronger bargaining position Coase Theorem: if bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will remedy the market failures associated with externalities and restore economic efficiency Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Property Rights and Negotiation Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

20-12 Limitations of Bargaining Bargaining can be impractical, requiring substantial time and effort The assignment of property rights may be ambiguous Parties may have limited information about each others’ costs and benefits Efficient contracts may be difficult to monitor and enforce Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-13 Remedies for Externalities: The Public Sector Public sector – Policies that support markets – Quantity controls – Taxes, fees, subsidies – Liability rules Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-14 Policies That Support Markets When private negotiations fail to remedy the market failures associated with externalities, appropriate government policies can potentially improve economic efficiency In some situations, governments can address externalities by helping the private sector create the necessary markets – Establish clear property rights, pass laws that protect those rights, and enforce contracts – Governments can even create and operate a market Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Quantity Controls Emissions standard: legal limit on the amount of pollution that a person or company can produce when engaged in a particular activity Socially efficient Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Taxes, Fees, and Subsidies Pigouvian taxation: the use of taxes or fees to remedy negative externalities Pigouvian subsidization: the use of subsidies to remedy positive externalities Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Liability Rules Liability rule: a legal principle requiring a party who takes an action that harms others to compensate the affected parties for some or all of their losses Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Pitfall for Liability Rules and Pigouvian Taxes Efforts to correct private incentives can lead to high levels of inefficiency because they might lead the affected parties to engage in wasteful behaviors Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

20-19 Consequences of Policy Errors Government information and choices are frequently imperfect Errors in setting a tax and a standard may have different implications, depending on the slopes of the curves Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Consequences of Policy Errors for a Noise Standard and a Noise Tax Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Minimizing the Total Cost of Abatement With a tax on SO 2 emissions, each firm will pollute up to the point at which the marginal cost of abatement equals the tax rate – The firms will produce different amounts of pollution, yet they will share the same marginal cost of abatement Setting the same emissions standard for both firms would be highly inefficient Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

20-22 Flexibility A quantity standard sometimes offers greater flexibility than a tax – E.g., the government can ban smoking in the workplace while permitting it in bars, but would have difficulty taxing cigarettes differently according to where smokers consume them However, a tax also sometimes offers greater practical flexibility than a quantity standard – E.g., the government would have difficulty monitoring compliance with a limit on the number of cigarettes a person can smoke, but can easily vary the tax rate on cigarettes Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-23 Pigouvian Subsidy for College Tuition With Pigouvian subsidy Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-24 Economic Justification for Compulsory Schooling Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Tradable Permits Promote Low-Cost Abatement Tradable emissions permit: entitles a firm to generate a specified amount of a given pollutant. It is also transferrable; one firm can sell it to another. Total emissions are limited by the number of permits the government chooses to issue. Tradable permits achieve any given reduction in total emissions at the lowest possible abatement cost. Permits allocated to each firm Trade Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Common Property Resources and Overfishing Common property resource: a resource that more than one person is free to use without payment Lakes, rivers, parks, air People tend to overuse such resources, creating a negative externality Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

20-27 Public Good A good is nonrival if more than one person can consume it at the same time without affecting its value to others A good is nonexcludable if there is no way to prevent a person from consuming it Public good: a good that is nonrival and nonexcludable Private good: a good for which consumption involves perfect rivalry and that is completely excludable Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-28 Public Goods Private solution Socially efficient outcome Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-29 Public Goods and Market Failure If the provision of a public good is left entirely to the independent actions of private parties, the level of production will usually be inefficiently low A free rider contributes little or nothing to a public good while benefitting from others’ contributions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-30 Public Policy toward Public Goods Provide some public goods – Example: national defense Contribute to nonprofit organizations that provide other public goods – Example: public radio Subsidize private contributions to many public goods – Example: environmental protection Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Groves Mechanism Groves mechanism: a procedure for setting the level of the public good that induces everyone to report their preferences correctly, producing a socially efficient outcome All MB minus one individual Self-reported marginal benefits Optimal contribution of that individual Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

20-32 Public Decision Making To determine whether public intervention is justified, we must weigh the consequences of a market failure against the likely consequence of a government failure Political economy: examines the economic consequences of public sector decision making Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-33 Majority Rule and the Level of a Public Good Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Maximum total social benefitMedian voter: with majority rule, his ideal policy will be chosen

20-34 Majority Rule and the Level of a Public Good 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, and declines thereafter The median voter is the voter who has the median ideal policy among all voters The median voter theorem states that, if voters have single-peaked preferences, a majority of them prefer the median ideal policy to all other policies Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-35 Review When an activity creates an externality, competitive markets will allocate resources inefficiently. Externalities result from missing markets. Negotiations can substitute for those markets. If bargaining is frictionless, then regardless of how property rights are assigned, voluntary agreements between private parties will lead to an efficient outcome. Governments can remedy some externalities through policies that help the private sector create the necessary markets, or by creating and operating those markets, or by regulating the level of activities, or by correcting private incentives through taxes, fees, subsidies, or liability rules. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-36 Review People tend to overuse common property resources, thereby creating negative externalities. To determine whether public intervention is justified, we must weigh the consequences of market failure against the likely consequence of government failure. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20-37 Looking Forward Next, we will switch our attention to situations where one party to a transaction has more information than the other. Among other phenomena, we will study the effect of adverse selection and moral hazard on economic behavior and efficiency. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.