Chapter 18 Externalities and Public Goods

Chapter 18Slide 2 Topics to be Discussed Externalities Ways of Correcting Market Failure Externalities and Property Rights Common Property Resources

Chapter 18Slide 3 Topics to be Discussed Public Goods Private Preferences for Public Goods

Chapter 18Slide 4 Externalities Negative Action by one party imposes a cost on another party Positive Action by one party benefits another party

Chapter 18Slide 5 External Cost Scenario Steel plant dumping waste in a river The entire steel market effluent can be reduced by lowering output (fixed proportions production function)

Chapter 18Slide 6 External Cost Scenario Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. Marginal Social Cost (MSC) is MC plus MEC.

MC S = MC I D P1P1 Aggregate social cost of negative externality P1P1 q1q1 Q1Q1 MSC MSC I When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. External Costs Firm output Price Industry output Price MEC MEC I The differences is the marginal external cost MEC. q* P* Q* The industry competitive output is Q 1 while the efficient level is Q*. The profit maximizing firm produces at q1 while the efficient output level is q*.

Chapter 18Slide 8 External Cost Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

Chapter 18Slide 9 Externalities Positive Externalities and Inefficiency Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.

Chapter 18Slide 10 MC P1P1 External Benefits Repair Level Value D Is research and development discouraged by positive externalities? q1q1 MSB MEB When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. q*q* P* A self-interested home owner invests q 1 in repairs. The efficient level of repairs q* is higher. The higher price P 1 discourages repair.

Chapter 18Slide 11 Ways of Correcting Market Failure Assumption: The market failure is pollution Fixed-proportion production technology  Must reduce output to reduce emissions  Use an output tax to reduce output Input substitution possible by altering technology

Chapter 18Slide 12 The Efficient Level of Emissions Level of Emissions Dollars per unit of Emissions MSC MCA E* The efficient level of emissions is 12 (E*) where MCA = MSC. Assume: 1) Competitive market 2) Output and emissions decisions are independent 3) Profit maximizing output chosen At E o the marginal cost of abating emissions is greater than the marginal social cost. E0E0 At E 1 the marginal social cost is greater than the marginal benefit. E1E1 Why is this more efficient than zero emissions?

Chapter 18Slide 13 Ways of Correcting Market Failure Options for Reducing Emissions to E* Emission 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

Chapter 18Slide 14 Standards and Fees Level of Emissions Dollars per unit of Emissions MSC MCA 3 12 E* Standard Fee

Chapter 18Slide 15 Options for Reducing Emissions to E* Emissions Fee  Charge levied on each unit of emission Ways of Correcting Market Failure

Chapter 18Slide 16 Total Abatement Cost Cost is less than the fee if emissions were not reduced. Total Fee of Abatement Standards and Fees Level of Emissions Dollars per unit of Emissions MSC MCA 3 12 E* Fee

Chapter 18Slide 17 Standards Versus Fees Assumptions  Policymakers have asymmetric information  Administrative costs require the same fee or standard for all firms Ways of Correcting Market Failure

Chapter 18Slide 18 Firm 2 ’ s Reduced Abatement Costs Firm 1 ’ s Increased Abatement Costs MCA 1 MCA 2 The Case for Fees Level of Emissions Fee per Unit of Emissions The cost minimizing solution would be an abatement of 6 for firm 1 and 8 for firm 2 and MCA 1 = MCA 2 = $ The impact of a standard of abatement of 7 for both firms is illustrated. Not efficient because MCA 2 < MCA 1. If a fee of $3 was imposed Firm 1 emissions would fall by 6 to 8. Firm 2 emissions would fall by 8 to 6. MCA 1 = MCA 2 : efficient solution.

Chapter 18Slide 19 Advantages of Fees When equal standards must be used, fees achieve the same emission abatement at lower cost. Fees create an incentive to install equipment that would reduce emissions further. Ways of Correcting Market Failure

Chapter 18Slide 20 ABC is the increase in social cost less the decrease in abatement cost. Marginal Social Cost Marginal Cost of Abatement The Case for Standards Level of Emissions Fee per Unit of Emissions E Based on incomplete information standard is 9 (12.5% decrease). ADE < ABC D A B C Based on incomplete information fee is $7 (12.5% reduction). Emission increases to 11.

Chapter 18Slide 21 Summary: Fees vs. Standards Standards are preferred when MSC is steep and MCA is flat. Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement. Ways of Correcting Market Failure

Chapter 18Slide 22 Summary: 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. Ways of Correcting Market Failure

Chapter 18Slide 23 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 Ways of Correcting Market Failure

Chapter 18Slide 24 Question What factors could limit the efficiency of this approach? Ways of Correcting Market Failure

Chapter 18Slide 25 The Costs and Benefits of Reduced Sulfur Dioxide Emissions Cost of Reducing Emissions Conversion to natural gas from coal and oil Emission control equipment

Chapter 18Slide 26 Benefits of Reducing Emissions Health Reduction in corrosion Aesthetic The Costs and Benefits of Reduced Sulfur Dioxide Emissions

Chapter 18Slide 27 Sulfur Dioxide Emissions Reductions Sulfur dioxide concentration (ppm) Dollars per unit of reduction Marginal Social Cost Marginal Abatement Cost Observations MAC = = is slightly below actual emission level.0275 is slightly below actual emission level Economic efficiency improvedEconomic efficiency improved

Chapter 18Slide 28 Emissions Trading and Clean Air Bubbles Firm can adjust pollution controls for individual sources of pollutants as long as a total pollutant limit is not exceeded. Offsets New emissions must be offset by reducing existing emissions  2000 offsets since 1979

Chapter 18Slide 29 Cost of achieving an 85% reduction in hydrocarbon emissions for DuPont Three Options  85% reduction at each source plant (total cost = $105.7 million)  85% reduction at each plant with internal trading (total cost = $42.6 million)  85% reduction at all plants with internal and external trading (total cost = $14.6 million) Emissions Trading and Clean Air

Chapter 18Slide Clean Air Act Since 1990, the cost of the permits has fallen from an expected $300 to below $100. Causes of the drop in permit prices More efficient abatement techniques Price of low sulfur coal has fallen Emissions Trading and Clean Air

Chapter 18Slide 31 Recycling Households can dispose of glass and other garbage at very low cost. The low cost of disposal creates a divergence between the private and the social cost of disposal. Ways of Correcting Market Failure

Chapter 18Slide 32 The Efficient Amount of Recycling Scrap Cost MCR MSC m* With a refundable deposit, MC increases and MC = MSC = MCR. MC + per unit refund MC m1m1 Without market intervention the level of scrap will be at m 1 and m 1 > m*.

Chapter 18Slide 33 Refundable Deposits Amount of Glass $ D Price falls to P ’ and the amount of recycled glass increases to M*. SvSv SrSr S The supply of glass is the sum of the supply of virgin glass (S r ) and the supply of recycled glass (S r ). M1M1 P Without refunds the price of glass is P and S r is M 1. S’rS’r S’S’ P’P’ M* With refunds S r increases to S ’ r and S increases to S ’.

Chapter 18Slide 34 Externalities and Property Rights Property Rights Legal rules describing what people or firms may do with their property For example  If residents downstream owned the river (clean water) they control upstream emissions.

Chapter 18Slide 35 Bargaining and Economic Efficiency Economic efficiency can be achieved without government intervention when the externality affects relatively few parties and when property rights are well specified. Externalities and Property Rights

Chapter 18Slide 36 Profits Under Alternative Emissions Choices (Daily) No filter, not treatment plant Filter, no treatment plant No filter, treatment plant Filter, treatment plant Factory ’ sFishermen ’ sTotal ProfitProfitProfit

Chapter 18Slide 37 Assumptions Factory pays for the filter Fishermen pay for the treatment plant Efficient Solution Buy the filter and do not build the plant Externalities and Property Rights

Chapter 18Slide 38 Bargaining with Alternative Property Rights No Cooperation Profit of factory$500$300 Profit of fishermen$200$500 Cooperation Profit of factory$550$300 Profit of fishermen$250$500 Right to DumpRight to Clean Water

Chapter 18Slide 39 Conclusion: Coase Theorem When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified. Externalities and Property Rights

Chapter 18Slide 40 Costly Bargaining --- The Role of Strategic Behavior Bargaining requires clearly defined rules and property rights. Externalities and Property Rights

Chapter 18Slide 41 A Legal Solution --- Suing for Damages Fishermen have the right to clean water Factory has two options  No filter, pay damages Profit = $100 ($500 - $400)  Filter, no damages Profit = $300 ($500 - $200) Externalities and Property Rights

Chapter 18Slide 42 A Legal Solution --- Suing for Damages Factory has the right to emit effluent Fishermen have three options  Put in treatment plant Profit = $200  Filter and pay damages Profit = $300 ($500 - $200)  No plant, no filter Profit = $100 Externalities and Property Rights

Chapter 18Slide 43 Conclusion A suit for damages results in an efficient outcome. Question How would imperfect information impact the outcome? Externalities and Property Rights

Chapter 18Slide 44 The Coase Theorem at Work Negotiating an Efficient Solution New York garbage spill (200 tons) littered the New Jersey beaches  The potential cost of litigation resulted in a solution that was mutually beneficial to both parties.

Chapter 18Slide 45 Common Property Resources Common Property Resource Everyone has free access. Likely to be overutilized Examples  Air and water  Fish and animal populations  Minerals

Chapter 18Slide 46 Common Property Resources Fish per Month Benefits, Costs ($ per fish) Demand However, private costs underestimate true cost. The efficient level of fish/month is F* where MSC = MB (D) Marginal Social Cost F* Private Cost FCFC Without control the number of fish/month is F C where PC = MB.

Chapter 18Slide 47 Common Property Resources Solution Private ownership Question When would private ownership be impractical?

Chapter 18Slide 48 Crawfish Fishing in Lousiana Finding the Efficient Crawfish Catch F = crawfish catch in millions of pounds/yr C = cost in dollars/pound

Chapter 18Slide 49 Crawfish Fishing in Lousiana Demand C = = F MSC C = F PC C = F

Chapter 18Slide 50 Crawfish Fishing in Lousiana Efficient Catch 9.2 million pounds D = MSC

Chapter 18Slide 51 Crawfish Catch (millions of pounds) C Cost (dollars/pound) Demand Marginal Social Cost Private Cost Crawfish as a Common Property Resource

Chapter 18Slide 52 Public Goods Question When should government replace firms as the producer of goods and services?

Chapter 18Slide 53 Public Goods Public Good Characteristics Nonrival  For any given level of production the marginal cost of providing it to an additional consumer is zero. Nonexclusive  People cannot be excluded from consuming the good.

Chapter 18Slide 54 Public Goods Not all government produced goods are public goods Some are rival and nonexclusive  Education  Parks

Chapter 18Slide 55 D1D1 D2D2 D When a good is nonrival, the social marginal benefit of consumption (D), is determined by vertically summing the individual demand curves for the good. Efficient Public Good Provision Output 0 Benefits (dollars) $4.00 $5.50 $7.00 Marginal Cost $1.50 Efficient output occurs where MC = MB at 2 units of output. MB is $ $4.00 or $5.50.

Chapter 18Slide 56 Public Goods Public Goods and Market Failure How much national defense did you consume last week?

Chapter 18Slide 57 Public Goods 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.

Chapter 18Slide 58 Public Goods Establishing a mosquito abatement company How do you measure output? Who do you charge? A mosquito meter?

Chapter 18Slide 59 The Demand for Clean Air Clean Air is a public good Nonexclusive and nonrival What is the price of clean air?

Chapter 18Slide 60 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.

Chapter 18Slide 61 The Demand for Clean Air Nitrogen Oxides (pphm) 0 Dollars Low Income Middle Income High Income

Chapter 18Slide 62 The Demand for Clean Air Findings Amount people 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.

Chapter 18Slide 63 Private Preferences for Public Goods Government production of a public good is advantageous because the government can assess taxes or fees to pay for it. Determining how much of a public good to provide when free riders exist is difficult.

Chapter 18Slide 64 Determining the Level of Educational Spending Educational spending per pupil $0 Willingness to pay $ $1200 $600 $1800$2400 W1W1 W2W2 W3W3 AW The efficient level of educational spending is determined by summing the willingness to pay for education for each of three citizens.

Chapter 18Slide 65 Determining the Level of Educational Spending Educational spending per pupil $0 Willingness to pay $ $1200 $600 $1800$2400 W1W1 W2W2 W3W3 AW Will majority rule yield an efficient outcome? W 1 will vote for $600 W 2 and W 3 will vote for $1200 The median vote will always win in a majority rule election.

Chapter 18Slide 66 Question Will the median voter selection always be efficient? Answer If two of the three preferred $1200 there would be overinvestment. If two of the three preferred $600 there would be underinvestment. Private Preferences for Public Goods

Chapter 18Slide 67 Majority rule is inefficient because it weighs each citizen ’ s preference equally---the efficient outcome weighs each citizen ’ s vote by his or her strength of preference. Private Preferences for Public Goods

Chapter 18Slide 68 Summary There is an externality when a producer or a consumer affects the production or consumption activities of others in a manner that is not directly reflected in the market. Pollution can be corrected by emission standards, emissions fees, marketable emissions permits, or by encouraging recycling.

Chapter 18Slide 69 Summary Inefficiencies due to market failure may be eliminated through private bargaining among the affected parties. Common property resources are not controlled by a single person and can be used without a price being paid.

Chapter 18Slide 70 Summary Goods that private markets are not likely to produce efficiently are either nonrival or nonexclusive. Public goods are both. A public good is provided efficiently when the vertical sum of the individual demands for the public good is equal to the marginal cost of producing it.

Chapter 18Slide 71 Summary Under majority rule voting, the level of spending provided will be that preferred by the median voter---this need not be the efficient outcome.

End of Chapter 18 Externalities and Public Goods