Twelfth Edition, Global Edition

Twelfth Edition, Global Edition
ECONOMICS Twelfth Edition, Global Edition Michael Parkin 1

17 Notes and teaching tips: 4 ,6, 22, 27, 28, 33, 35, 48, 59, and 65. To view a full-screen figure during a class, click the expand button. To return to the previous slide, click the shrink button. To advance to the next slide, click anywhere on the full screen figure. Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action. (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining. (2) Once or twice a semester, set an assignment, for credit, with the following instructions: (a) Find a news article about an economic topic that you find interesting. (b) Make a short bullet-list summary of the article. (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article. Use the Economics in the News features in your textbook as models. EXTERNALITIES 2

After studying this chapter, you will be able to:
Explain how externalities arise Explain why external costs bring market failure and overproduction and how property rights and public choices might achieve an efficient outcome Explain the tragedy of the commons and its possible solutions Explain why external benefits bring market failure and underproduction and public choices might achieve an efficient outcome 3

Externalities in Our Lives
An externality is a cost or benefit that arises from production and falls on someone other than the person or the firm choosing the action. A negative externality imposes a cost and a positive externality creates a benefit. No man (or woman) is an island. The main theme in this chapter is how to analyze the impact of negative or positive externality on the market allocation of resources, as well as the government’s ability to enhance efficiency: Cost externalities cause social costs to be under appreciated by resource allocation decision makers in the market, creating too much of the activity creating the externality to be produced. Benefit externalities cause social benefits to be under appreciated by resource allocation decision makers in the market, creating too little of the activity creating the externality to be produced. There are some correcting policies that the government can use to increase efficiency, but some are more effective than others. 4

The four types of externality are Negative production externalities Positive production externalities Negative consumption externalities Positive consumption externalities 5

Negative Production Externalities Negative production externalities are common. Burning coal to generate electricity emits carbon dioxide. Logging and clearing forests destroys the habitat of wildlife and adds carbon dioxide to the atmosphere. Other examples are noise from aircraft and trucks, pollution of rivers and lakes, and air pollution in major cities from auto exhaust. Classroom activity Check out Economics in Action: Opposing Trends: Success and Failure 6

Positive Production Externalities Positive production externalities are less common than negative externalities. Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit growers gets an external benefit from the bees, which pollinate the fruit orchards and boost fruit output. Honey producers get an external benefit from the orchards. 7

Negative Consumption Externalities Negative consumption externalities are a common part of everyday life. Smoking tobacco in a confined space poses a health risk to others. Noisy parties or loud car stereos disturb others or cellphone ringing in class. 8

Positive Consumption Externalities Positive consumption externalities are also common. When you get a flu vaccination, everyone you come into contact with benefits. When the owner of an historic building restores it, everyone who sees the building gets pleasure. 9

Negative Externalities: Pollution
We begin by distinguishing between three costs. Private, External, and Social Cost A private cost of production is a cost that is borne by the producer of a good or service. Marginal private cost (MC) is the private cost of producing one more unit of a good or service. An external cost of production is a cost that is not borne by the producer but borne by other people. Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer. 10

Marginal social cost (MSC) is 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 + Marginal external cost We express costs in dollars but remember that the dollars represent the value of a forgone opportunity. Marginal private cost, marginal external cost, and marginal social cost increase with output. 11

Valuing an External Cost Suppose that there are two similar rivers, one polluted and the other clean with 10 identical riverside homes. The homes on the clean river rent for $2,000 a month, and those on the polluted river rent for $1,500 a month. If the pollution is the only detectable difference between the houses, then the rent difference of $500 per month is the pollution cost per home. With 10 homes on the side of a polluted river, the external cost of pollution is $5,000 a month. 12

External Cost and Output Figure 17.1 shows the relationship between cost and output in a paint industry that pollutes a river. The MC curve shows the marginal private cost of producing paint. It costs the producer $1 per gallon to produce 3 million gallons of paint. 13

If a firm pollutes a river, it imposes an external cost. The MSC curve shows the marginal social cost of producing paint. The vertical distance between the MC and MSC curves is marginal external cost. MSC = MC + Marginal external cost 15

Equilibrium and Amount of Pollution Equilibrium in the market for paint determines the amount of pollution. Figure 17.2 shows an unregulated market for paint. The quantity of the paint produced is where marginal private cost (MC) equals marginal social benefit (MSB). 16

At the market equilibrium, MSB is less than MSC, … so the market produces an inefficient quantity of the good. At the efficient quantity of the good, MSC = MSB. With no regulation, the market produces too much paint and creates a deadweight loss. 18

Three approaches to overcoming the inefficiency are Establish property rights Mandate clean technology Tax or price pollution Establish Property Rights Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts. Establishing property rights can confront producers with the costs of their actions and provide the incentives that allocate resources efficiently. 19

Producers with property rights have two possible responses Use an abatement technology Produce less and pollute less Using an Abatement Technology An abatement technology is a production technology that reduces or prevents pollution. The producer considers alternative technologies and adopts the least-cost alternative. 20

Produce Less and Pollute Less An alternative to using abatement technology is to cut production and pollute less. By cutting pollution, the firm gets a higher income from renting homes on the river. The decision turns on costs and the firm will choose the least-cost alternative. 21

Efficient Market Equilibrium Figure 17.3 illustrates how property rights achieve an efficient outcome. The producer of the good bears all the costs. So the MSC curve includes the cost of producing paint plus either the abatement cost or the cost of pollution. The supply curve is the curve S = MC = MSC. The role of property rights in the market. Explain that when the property rights are well defined, the owner of that right receives the social benefit and bears the social cost of using that resource. Property rights “internalize” the externality. 22

The market outcome is efficient because at the quantity of paint produced MSC equals MSB. The producer bears the cost of pollution or abatement. 24

Negative Externality: Pollution
The Coase Theorem The Coase theorem is a proposition that if property rights exist, only a small number of parties are involved, and transactions costs are low, then private transactions are efficient. There are no externalities because all parties take into account the externalities involved. The outcome is independent of who has the property rights. 25

The Coase solution works only if transactions costs are low. Transactions costs are the cost of conducting a transaction. For example, the transactions costs of buying a home include fees for an agent, a mortgage loan advisor, and legal assistance. When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality. 26

Mandate Clean Technology When property rights are too difficult to define and enforce, public choices are made. Regulation is the government’s likely response. Tax or Cap and Price Pollution Two main methods that the government uses to cope with external costs: Taxes Cap-and-trade The best government policies emulate, rather than replace, the market process. Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it. Make the polluters discover (and bear) the social costs of pollution. In the case of cost externalities like pollution, the government can choose from three policies: emissions charges, pollution taxes, or marketable pollution permits. All three policies require the government to initially assess the social marginal costs and benefits from pollution activities to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies. Classroom activity Check out Economics in the News: A Carbon Reduction Plan 27

Taxes The government can set a tax equal to the marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost. That is, MC + tax = MSC. This tax is called Pigovian tax, in honor of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion. Classroom activity Check out Economics in Action: Taxing Carbon Emissions 28

Figure 17.4 shows how a pollution tax equal to the marginal external cost can achieve an efficient outcome. At the quantity of the good produced MSC = MSB. The government collects a tax revenue. 29

Cap-and-Trade A cap is an upper limit—each firm is set a pollution quota. A government that uses this method must first estimate the efficient quantity of pollution and set the overall cap equal to that quantity. In the efficient allocation of pollution quotas, each firm has the same marginal social cost. To make an efficient allocation, the government needs to know each firm’s marginal cost of production and marginal abatement cost. 31

The government solves the allocation problem by making an initial distribution of the cap across firms and allowing them to trade in a market for pollution permits. Firms with low abatement costs sell permits and make big cuts in pollution. Firms with high abatement costs buy permits and make smaller cuts, or no cuts, in pollution. The market price of a permit confronts polluters with the marginal social cost of their actions and leads to an efficient outcome. A cap-and–trade can achieve the same efficient outcome as a Pigovian tax. 32

Coping with Global Externalities The United States has made its own air cleaner by adopting the measures you’ve just seen. But to solve the global warming problem requires public choices at a global level. A lower CO2 concentration in the world’s atmosphere is a global public good. And like all public goods, it brings a free-rider problem. Carbon reduction also faces carbon leakage—a tendency for non-participants in carbon reduction to increase emissions. Classroom activity Check out At Issue: Should We Be Doing More to Reduce Carbon Emissions Check out Economics in Action: A Global Prisoners’ Dilemma 33

The only major attempt at international coordination of carbon reduction is the Kyoto Protocol, signed by 37 countries, not ratified by the United States, and renounced by Canada. Some governments (British Columbia in Canada and Ireland) have introduced a carbon tax. Some governments (the United Kingdom) have the equivalent of a partial carbon tax on gasoline. Without a mechanism to compel participation in a global carbon reduction program, countries have an incentive to leave the task to others. 34

Negative Externality: The Tragedy of the Commons
The tragedy of the commons is the overuse of a common resource that arises when its users have no incentive to conserve it and use it sustainably. Examples include the overfishing of Atlantic Ocean cod, Pacific Yellowfin tuna, and South Pacific whales. The traditional example from which the term derives is the common grazing land surrounding British villages in the middle ages. The tragedy of the commons arises from Unsustainable use of a common resource Inefficient use of a common resource Classroom activity Check out Economics in Action: The Original Tragedy of the Commons 35

Unsustainable Use of a Common Resource Many common resources are renewable—they replenish themselves by the birth and growth of new members of the population. A common resource is being used unsustainably if its rate of use persistently decreases its stock. A common resource is being used sustainably if its rate of use is less than or equal to its rate of renewal so that the stock either grows or remains constant. 36

Figure 17.5 illustrates the sustainable catch curve SCC. As the stock of fish increases, the sustainable catch increases to a maximum. As the stock increases further, the fish must compete for food and the sustainable catch falls. 37

If the catch is less than the sustainable catch at a given stock, such as point Z, the fish stock grows. If the catch exceeds the sustainable catch at a given stock, such as point A, the fish stock shrinks. The SCC shows the sustainable catch and an unsustainable catch for a given stock that keeps the stock unchanged. 39

Inefficient Use of a Common Resource Figure 17.6 shows why overfishing occurs. The supply is the marginal private cost curve, MC. The demand is the marginal social benefit curve, MSB. Market equilibrium occurs at 800,000 tons per year and $10 a pound. 40

The marginal social cost curve is MSC. The efficient quantity is 300,000 tons per year. At the market equilibrium, there is overfishing and a deadweight loss arises. 42

Achieving an Efficient Outcome It is harder to achieve an efficient use of a common resource than to define the conditions under which it occurs. The three main methods used to achieve the efficient use of a common resource are: Property rights Production quotas Individual transferable quotas (ITQs) 43

Property Rights By converting the common resource to private property, fishers face the full social cost of their actions. The marginal social cost curve becomes the supply curve and the resource is used efficiently. 44

Production Quotas By setting production quotas that total the efficient quantity, the resource might be used efficiently. The figure shows the profit on the marginal ton of fish. A fisher who cheats will increase his profit, so there is an incentive to overfish. 46

Individual Transferable Quotas An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer (sell) the quota to someone else. A market in ITQs emerges. If the efficient quantity of ITQs is assigned, the market price of an ITQ confronts resource users with a marginal cost equal to MC + price of ITQ. With MC + price of ITQ equal to MSB, the quantity produced is efficient. Classroom activity Check out Economics in Action: ITQs Work 48

Figure 17.7 shows the situation with an efficient number of ITQs. The marginal social cost equals MC + price of ITQ. Fishers make MSB equal MC + price of ITQ, and the outcome is efficient. The market price of an ITQ equals the marginal social benefit minus the marginal cost. 49

Positive Externality: Education
Knowledge comes from education and research. And both bring external benefits. We’ll look at education. Private Benefits and Social Benefits A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the private benefit from consuming one more unit of a good or service. An external benefit is a benefit that someone other than the consumer receives. 51

Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy. Marginal social benefit is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else on whom the benefit falls. Marginal social benefit is the sum of marginal private benefit and marginal external benefit. That is: MSB = MB + Marginal external benefit. 52

Figure 17.8 illustrates the marginal private benefit, marginal external benefit, and marginal social benefit. Marginal external benefit is shown by the vertical distance between the MB and MSB curves. 53

Figure 17.9 shows how a private market underproduces an item that generates an external benefit … and creates a deadweight loss. 55

Government Actions in the Market with External Benefits Figure illustrates an efficient outcome. Buyers pay the market price. Taxpayers must pay the rest of the MSC. 57

Government Actions in the Market with External Benefits Three devices that the government can use to achieve a more efficient allocation of resources in the presence of external benefits are Public provision Private subsidies Vouchers Let the consumers determine the composition of public good to be provided. In the case of benefit externalities like education, the government has three policy choices: public provision, private subsidy, or vouchers. All three policies require the government to initially assess the social marginal costs and benefits to find the optimal level of education to be consumed. However, only the public provision policy forces the government to continually assess what type of education should be provided in a dynamic world of ever-changing technology. The policies of private education subsidies or educational vouchers force the students to determine what types of education would be best, because they now face an opportunity cost for their decisions as to what school to attend. An informed and motivated clientele, armed with vouchers or subsidies to allocate across the different qualifying educational institutions, would drive the composition of educational opportunities supplied by the different educational institutions. 59

Public Production Under public production, a public authority that receives payment from the government produces the good or service. 60

Private Subsidies A subsidy is a payment by the government to private producers. If the government pays the producer an amount equal to the marginal external benefit, the quantity produced is efficient. 61

Vouchers A voucher is a token that the government provides to households, which they can use to buy specified goods or services. Figure shows how vouchers worth $15,000 per student can achieve an efficient outcome. 62

Bureaucratic Inefficiency and Government Failure Are pubic provision, subsidized private provision, and vouchers equivalent? No. The behavior of bureaucrats combined with rational ignorance leads to government failure. 63

Problems with Public Production Public production might lead to underproduction as bureaucrats seek to maximize their budget by budget padding and waste. Problems with Private Subsidies The subsidy budget has to be administered by bureaucrats and they might blow out the costs of administration and cut the size of the subsidy. Producers receiving the subsidy might allocate some of it to lobbying for a larger subsidy and less to production. These actions will lead to an inefficient outcome. 64

Are Vouchers the Solution? Vouchers have four advantages over public provision and private subsidies: Vouchers can be used with public production, private provision, or competition between them. Governments can set the total value of vouchers to overcome bureaucratic overproduction. Vouchers spread the public contribution thinly across millions of consumers, so no one has an interest in wasting the value of the voucher received in lobbying. Classroom activity Check out Economics in Action: Education Quality and Cost: Charter Schools 65

4. By giving the buying power to the final consumer, producers must compete for business and provide a high standard of service at the lowest attainable cost. For these four reasons, vouchers are popular with economists. But they are controversial and opposed by most education administrators and teachers. 66

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