Externalities1 EXTERNALITIES ECO 2023 Principles of Microeconomics Dr. McCaleb

Externalities2 TOPIC OUTLINE I.Basic Concepts II.Positive Externalities III.Negative Externalities IV.Property Rights V.Resource Conservation

Externalities3 Economic inefficiency results from i.taxes ii.subsidies iii.price ceilings iv.price floors 1.i and iii 2.ii and iv 3.i and ii 4.iii and iv 5.i, iii, and iv 6.i, ii, iii, and iv

Externalities4 True (T) or false (F): The efficient quantity of a good, service, or activity is the quantity at which MB=MC.

Externalities5 Basic Concepts

Externalities6  Externalities Definition A cost or benefit arising from production that falls on someone other than the producer, or a cost or benefit arising from consumption that falls on someone other than the consumer. BASIC CONCEPTS

Externalities7  Externalities Positive externality or external benefit A production or consumption activity that creates an external benefit. Negative externality or external cost A production or consumption activity that creates an external cost. BASIC CONCEPTS

Externalities8 Positive Externalities

Externalities9 POSITIVE EXTERNALITIES  Private Benefits and Social Benefits Marginal private benefit (MB) The benefit to the consumer of an additional unit of a good or service. Marginal external benefit (MEB) The benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.

Externalities10 POSITIVE EXTERNALITIES  Private Benefits and Social Benefits Marginal social benefit (MSB) The marginal benefit enjoyed by the entire society—by the consumers of a good or service and by everyone else who benefits from it. Marginal social benefit is the sum of marginal private benefit and marginal external benefit: MSB = MB + MEB

Externalities11 POSITIVE EXTERNALITIES When 15 million students attend college... marginal external benefit is $15,000 per student. marginal private benefit is $10,000 per student. marginal social benefit is $25,000 per student. Private Benefit and Social Benefit with an Externality An external benefit creates a wedge between social benefit and private benefit.

Externalities12 POSITIVE EXTERNALITIES The gray triangle shows the deadweight loss from underproduction. The efficient quantity is 15 million students, where MSB=MC. Inefficiency with an External Benefit With an external benefit, the equilibrium quantity is 7.5 million students where D=S. At equilibrium, MSB>MC. The equilibrium is inefficient because of underproduction.

Externalities13 POSITIVE EXTERNALITIES  Example: Education Internalizing the Positive Externalities from Education The problem is underproduction. The solution is to increase quantity. Possible policies to increase quantity Regulation Public provision Producer subsidies Vouchers (consumer subsidies)

Externalities14 POSITIVE EXTERNALITIES  Example: Education (1) Regulation Government decides on the quantity of education that each student should have and requires students to purchase that quantity of education in the market. For example, government requires that all children attend school until they are 16 years of age. With public education, government combines this regulatory policy with public provision of education.

Externalities15 POSITIVE EXTERNALITIES (2) Public Provision The agency sets tuition at $10,000 per student, equal to MB at the efficient quantity. Tax revenues cover the remaining $15,000 per student. At a price of $10,000, the efficient number of students, 15 million, seek an education. With public provision, a tax-funded public agency produces education-- the case of public schools and universities.

Externalities16 POSITIVE EXTERNALITIES At a price of $10,000, the efficient number of students, 15 million, seek an education. A $15,000 per student subsidy increases supply to S = MC – subsidy. With the subsidy, tuition is reduced to $10,000. (3) Producer Subsidies A subsidy is a payment from the government to private producers based on the level of output--in this case to private schools and universities.

Externalities17 POSITIVE EXTERNALITIES With a $15,000 voucher, the efficient number of students, 15 million, are willing to pay the full $25,000 per student cost of education. (4) Vouchers A $15,000 voucher increases demand from MB to MSB. A voucher is a subsidy to consumers for the purchase of specified goods or services--in this case, a subsidy paid to students.

Externalities18 With a positive externality or external benefit, marginal social benefit is _____ marginal private benefit and the good is _____. 1.Greater than; overproduced 2.Greater than; underproduced 3.Less than; overproduced 4.Less than; underproduced

Externalities19 True (T) or false (F): Correcting the inefficiency from a positive externality requires increasing the quantity of the good.

Externalities20 Negative Externalities

Externalities21 NEGATIVE EXTERNALITIES  Private Costs and Social Costs Marginal private cost (MC) The cost of producing an additional unit of a good or service that is borne by the producer of that good or service. Marginal external cost (MEC) The cost of producing an additional unit of a good or service that falls on people other than the producer.

Externalities22 NEGATIVE EXTERNALITIES  Private Costs and Social Costs Marginal social cost (MSC) The marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. Marginal social cost is the sum of marginal private cost and marginal external cost: MSC = MC + MEC

Externalities23 NEGATIVE EXTERNALITIES Private Cost and Social Cost with an Externality When output is 4,000 tons of chemicals per month... marginal private cost is $100 a ton. marginal external cost is $125 a ton. marginal social cost is $225 a ton. An external cost creates a wedge between social cost and private cost.

Externalities24 NEGATIVE EXTERNALITIES Inefficiency with an External Cost The gray triangle shows the deadweight loss from overproduction. The efficient quantity is 2,000 tons, where MB=MSC. With an external cost, the equilibrium quantity is 4,000 tons per month where D=S. At equilibrium, MB<MSC. The equilibrium is inefficient because of overproduction.

Externalities25 NEGATIVE EXTERNALITIES  Example: Pollution Economic efficiency with pollution Pollution imposes costs on society, but the production activities that generate pollution also confer benefits. Zero pollution is not efficient. As the amount of pollution is reduced, we reach a level where the marginal benefit from less pollution is less than the marginal cost of having less production and consumption. Efficiency requires balancing the costs of pollution against the benefits from the goods and services whose production generates pollution—in other words, finding the level at which MSB=MSC.

Externalities26 NEGATIVE EXTERNALITIES  Example: Pollution Correcting for the Negative Externalities from Pollution The problem is overproduction, so the solution is to decrease quantity. Possible policies to decrease quantity Regulation Marketable permits (or tradable emission rights) Pollution taxes and emission charges

Externalities27 NEGATIVE EXTERNALITIES  Example: Pollution (1) Regulation Government decides on the total amount of pollution allowed in a geographic area and assigns a quota to each pollution source so that the quotas add up to the total amount allowed. Alternatively, government may require each pollution source to use a certain technology that is intended to reduce the amount of pollution.

Externalities28 NEGATIVE EXTERNALITIES Example: Pollution (2) Marketable permits As with regulation, government decides the total allowed amount of pollution in a geographic area. Each polluter is given permits to pollute. The total number of permits equals the total allowed amount of pollution. Polluters are allowed to buy and sell their pollution permits at market prices determined by the demand for or marginal benefit of pollution rights.

Externalities29 NEGATIVE EXTERNALITIES The tax increases the cost of production and provides an incentive for the producer to reduce quantity. The equilibrium quantity with the tax is the efficient quantity, 2,000 tons a month. (3) Pollution Taxes Government imposes a pollution tax on each polluter equal to the MEC of pollution. With the tax, MSC=MC+Tax.

Externalities30 NEGATIVE EXTERNALITIES  Example: Pollution Advantages of permits and taxes over regulation Lower cost of pollution reduction with permits and taxes Greater incentives for substitution and development of less- polluting techniques with permits and taxes Permits and taxes less costly to administer than regulation

Externalities31 NEGATIVE EXTERNALITIES  Example: Pollution Lower cost of pollution reduction With permits, the target amount of pollution is is achieved at the lowest possible cost. Permits are more valuable to polluters for whom the cost of pollution reduction is higher and less valuable to polluters for whom the cost is lower. High cost polluters buy permits from low cost polluters. High cost polluters continue to pollute. Most of the pollution reduction is accomplished by those who can reduce pollution at the lowest cost.

Externalities32 NEGATIVE EXTERNALITIES  Example: Pollution Substitution and new technologies Permits have a market value so using permits or paying taxes represent an additional cost of production to the polluter. The additional cost is an incentive for polluters to substitute higher- cost but less-polluting production methods and to invest resources in developing new less-polluting methods. The additional cost is reflected in goods and services prices. The higher prices are an incentive for consumers to substitute less- pollution-generating goods for more-pollution-generating goods.

Externalities33 NEGATIVE EXTERNALITIES  Example: Pollution Costs of regulation Regulations typically imposes higher costs on polluters to comply with the regulations and on taxpayers for monitoring the performance of polluters and enforcing the regulations. Regulation shifts decision-making from consumers and producers who have better information about benefits and costs to bureaucrats and politicians who have less information about benefits and costs. Regulations are often adopted that protect and promote politically influential special interests rather than promoting low-cost pollution reduction and efficient production.

Externalities34 With a negative externality or external cost, marginal social cost is _____ marginal private cost and the good is _____. 1.Greater than; overproduced 2.Greater than; underproduced 3.Less than; overproduced 4.Less than; underproduced

Externalities35 True (T) or false (F): Correcting the inefficiency from a negative externality requires increasing the quantity of the good.

Externalities36 Why are passenger pigeons extinct, tigers almost so, and bald eagles, condors, and bison barely saved from extinction, but dogs, cats, horses, and even deer are plentiful? Why must we limit fishing of Atlantic cod and Gulf snapper but not catfish or shrimp? Why are sheep in the west being destroyed by marauding coyotes but not by marauding dogs even though dogs are more numerous and, given the opportunity, dogs will attack sheep?

Externalities37 With a negative externality or external cost, marginal social cost is _____ marginal private cost and the good is _____. 1.Greater than; overproduced 2.Greater than; underproduced 3.Less than; overproduced 4.Less than; underproduced

Externalities38 Property Rights

Externalities39 The incentives for maintaining a resource in good condition are greater with _____ property rights. The incentives for conserving a resource are greater with _____ property rights. 1.Common; private 2.Common; common 3.Private; common 4.Private; private

Externalities40  The Coase Theorem Private bargaining can correct for an externality If property rights are clearly defined and enforced, only a small number of individuals are involved, and transaction costs are low, then private negotiation among the affected individuals can correct the inefficiency that arises from an externality. Where the conditions of the Coase Theorem are met, government action to correct for an externality is unnecessary. The individuals who are affected by the externality have an incentive to negotiate an efficient solution. PROPERTY RIGHTS

Externalities41  The Coase Theorem Example: Property rights and pollution Polluters own the river Suppose polluting factories own a river and the homes along it. The more the factories pollute, the less rent people are willing to pay to live in the riverside homes. The factories pay for their pollution in the form of lower rental income. The effect of pollution on their rental income provides an incentive for factories to limit their pollution to the efficient level. PROPERTY RIGHTS

Externalities42  The Coase Theorem Residents own the river Suppose the residents own the river and the homes. Then, the factories must either cease polluting or compensate the homeowners for the decline in the value of the river due to pollution. The more the factories pollute, the more they pay. The compensation the factories pay for the decreased value of the river to the residents provides an incentive for the factories to limit their pollution to the efficient level. PROPERTY RIGHTS

Externalities43  The Coase Theorem Efficiency of private bargaining and market outcome It doesn’t matter who owns the river, so long as someone owns it. Whether the factories own it or the residents own it, the factories bear the full social cost of polluting the river. This provides incentives for them to limit pollution to the efficient level. When property rights are well-defined and enforced and transaction costs are low, market-style bargaining and market prices provide incentives for individuals to reach an efficient outcome. PROPERTY RIGHTS

Externalities44  Externalities and Property Rights Inefficiency without property rights If property rights in the river are not well-defined and enforced, the factories can pollute without bearing the cost. The costs of the pollution are externalized to the residents. Without well-defined and enforced property rights, the factories have no incentive to limit pollution. There is inefficiency from overproduction, too much pollution, and a deadweight loss. Externalities arise when property rights are not well-defined or not enforced. PROPERTY RIGHTS

Externalities45  Final Observation Not every externality problem is worth solving Externalities impose an opportunity cost on society. The opportunity cost is the deadweight loss that arises from overproduction with a negative externality or underproduction with a positive externality. But, there are also costs to correcting an externality. Sometimes the costs of correcting the externality are greater than the cost of the externality itself. Correcting the externality costs more than it is worth and the best course of action is no action—do nothing. PROPERTY RIGHTS

Externalities46 Use statements I and II to answer the question. (I) According to the Coase Theorem, one way to internalize externalities is to create well-defined and enforced private property rights. (II) Economic efficiency requires that every externality be internalized. 1.Both I and II are true. 2.Both I and II are false. 3.I is true; II is false. 4.I is false; II is true.

Externalities47 Resource Conservation

Externalities48  Common Property Resources Definition A resource for which rights are held in common by a group of individuals none of whom has exclusive ownership. With common property resources, property rights are not well-defined and are non- exclusive. An individual has the right to use the resource, but not to change its form or transfer it to other individuals even if transformation or transfer would increase the value of the resource. In particular, an individual has no guarantee of future use of the resource, no future interest in the resource. RESOURCE CONSERVATION

Externalities49  Common Property Resources Lack of incentives for conservation Many people mistakenly believe that resources are more likely to be conserved for the future and less likely to be depleted if they are owned in common than if they are private property. In fact, quite the opposite is true. If one person conserves on current use of a common property resource, that person bears the full cost of the conservation. But with common property rights, that person cannot exclude others from sharing in the increased future value of the resource that results from increased conservation. RESOURCE CONSERVATION

Externalities50  Common Property Resources Common property resources tend to be overused, poorly maintained, and depleted too rapidly Conservation of a common property resource generates external benefits so there is underproduction of conservation. There is too little conservation and too much current consumption of a common property resource. And because the only right a person has in a common property resource is a non-exclusive right to current use of the resource, the incentive is to maximize use of the resource. RESOURCE CONSERVATION

Externalities51  Property Rights and Conservation Private property encourages efficient conservation Unlike common property rights, private property rights provide incentives for efficient conservation of a resource and ensure against too rapid depletion of a resource. RESOURCE CONSERVATION

Externalities52  Property Rights and Conservation MB and MC of conservation MB of conservation: Value of having one more unit of a resource available for use in the future. MC of conservation: Loss in value from not using that unit of the resource today. RESOURCE CONSERVATION

Externalities53  Property Rights and Conservation Efficient conservation If MB of conservation>MC of conservation, having one more unit in the future is worth more than having it today  more conservation. If MB of conservation<MC of conservation, having one more unit in the future is worth less than having it today  less conservation. Efficient conservation: The amount where MB of conservation=MC of conservation. RESOURCE CONSERVATION

Externalities54  Property Rights and Conservation Market prices reflect benefits and costs of conservation In a competitive market, the expected future price of a resource equals the value of having one more unit of the resource in the future, the MB of conservation: P F =MB of conservation The current price of the resource equals the value of having one more unit of the resource today, the MC of conservation: P C =MC of conservation RESOURCE CONSERVATION

Externalities55  Property Rights and Conservation Resource owners allocate resources to maximize value With property rights, the owner bears the cost of conservation but also is guaranteed the full future benefits of conservation. Market prices provide an incentive for resource owners to allocate their resources between current and future use to maximize resource value: P F >P C  future use is more valuable than current us  conserve more, use less P F <P C  future use is less valuable than current use  conserve less, use more RESOURCE CONSERVATION

Externalities56  Property Rights and Conservation Competitive markets encourage efficient conservation With property rights, the equilibrium amount of conservation in a competitive market is where P F =P C But because P F =MB of conservation and P C =MC of conservation, this is also the efficient amount where MB of conservation=MC of conservation RESOURCE CONSERVATION

Externalities57 Which of the following statements is true? i.The known supplies of oil are decreasing. ii.The known supplies of cheap oil are decreasing. iii.We have enough known oil reserves to supply the entire planet for a century if the price is high enough to make extracting it profitable. 1.i only 2.ii only 3.iii only 4.ii and iii

Externalities58  Property Rights and Resource Depletion Property rights also prevent too rapid depletion of a resource Contrary to popular belief, resource depletion is less likely to occur with private property rights in resources, competitive markets, and unregulated prices than with common property rights and regulation. Markets and prices provide a self-limiting mechanism that prevents rapid depletion of a valuable resource. As a resource becomes scarcer, its price increases and consumption decreases so that depletion is avoided. RESOURCE CONSERVATION

Externalities59 Markets, Prices, and Resource Depletion As a resource is used up, the supply of the resource decreases, shown by the shift in the supply curve to the left. Supply at $30 per barrel decreases from 20 million barrels to 5 million barrels. The decrease in supply creates an excess demand of 15 million barrels. RESOURCE CONSERVATION

Externalities60 Markets, Prices, and Resource Depletion The higher price also makes it profitable to produce more of the resource from known but previously uneconomical sources. Quantity supplied increases from 5 million to 10 million barrels. Because of the excess demand, price increases from $30 to $40 and quantity demanded decreases from 20 million barrels to 10 million barrels. RESOURCE CONSERVATION

Externalities61 Markets, Prices, and Resource Depletion In the long run, higher prices also create incentives for... producers to search for and develop new sources of supply. consumers to substitute other activities that use the resource less intensively, and for... producers to develop alternatives that use less of the resource, both of which decrease demand, and for... RESOURCE CONSERVATION