Externalities and Public Goods Chapter 18 Externalities and Public Goods

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 Immunizations another example Education…. ©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 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 immunizations Immunizations generate external benefits to the neighbors, community, etc. 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 Immunizations q1 q* When there are positive externalities (the benefits of immunizations to others), marginal social benefits (MSB) are higher than marginal private benefits (D). D MC P1 q* P* q1 A self-interested individual invests q1 in immunizations. The efficient level of immunizations q* is higher. The higher price P1 discourages them. MEB Immunizations ©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

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 cost of abatement. 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 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 cost of abatement. 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 Fees vs. Standards Standards 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 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 What if we don’t know costs and benefits AND if firms costs vary? ©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 (as well as its use of the market) 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 Don’t need to know firm’s individual costs --- those with high costs will buy permits from lower cost firms ©2005 Pearson Education, Inc. Chapter 18 60

In Sum The total cost of abatement for the industry is reduced Not every firm is subject to a standard The entire industry is subject to a standard Results in minimizing abatement costs from the point of view of the industry as a whole ©2005 Pearson Education, Inc. Chapter 18

Public Goods Characteristics Nonrival: fireworks display Nonexclusive For any given level of production, the marginal cost of providing it to an additional consumer is zero One person’s consumption of the good does not preclude another Nonexclusive People cannot be excluded from consuming the good – makes it difficult or impossible to charge for their use Example – lighthouse, national defense ©2005 Pearson Education, Inc. Chapter 18 101

Public Goods Non-rival but exclusive Nonexclusive but rival TV signal Bridge Concert Nonexclusive but rival Ocean in some respects like fishing National Forests & logging Don’t confuse positive externalities with public goods (education?) ©2005 Pearson Education, Inc. Chapter 18 102

Efficiency and Public Goods Efficient level of private good is where marginal benefit equals marginal cost: S = D Same principle applies to pubic goods – just measured differently For a public good, the value of each person must be considered Can add demand of all those who value good Calculated differently than for private goods Must equate the sum of these marginal benefits to the marginal cost of production Previously added quantities at each price: NOW – add prices at each quantity Vertical addition as opposed to horizontal addition ©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 Public goods thus provided by governments if to be produced efficiently ©2005 Pearson Education, Inc. Chapter 18 107

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